After severely underperforming its peers in 2007 and 2008 (-9.7% and -46.1% total returns), the PIMCO High Income Fund (NYSE:PHK
) regained form in 2009 and 2010 as its high beta levered credit portfolio posted scintillating returns (133.1% and 31.9%) to move it above the 90th percentile of high yield closed end funds in its Bloomberg peer group. In 2011, the fund posted a pedestrian 5.8% return, less than the much less risky unlevered IG credit universe (NYSEARCA:AGG
) 7.7%). This 2011 return, while low, was however in the 61st percentile of high yield bond funds as speculative grade credit spreads moved outwards. The 2011 performance of its underlying assets painted a different story as net asset value return of -5.2% put it in the 4th percentile of peers.
PHK Historical Total Return (Top) & Net Asset Value Return (Bottom)
click to enlarge
How could a fund whose underlying assets performed so poorly post a better than average return versus its peers? The answer is simple: Investors bought the PIMCO name, the steady dividend income, and ignored that they were bidding up the value of the fund to a premium far in excess of its net asset value. The graph below shows the market value of PHK versus the underlying net value per share of its underlying assets.
Since inception, the fund's market return has been 11.81%, but the underlying net assets have returned just 8.14%. This 367bp difference is captured in the premium over net asset value that the fund currently trades. As of 12/31/11, the fund's investments paid a coupon of 7.94%. The fund is paying out to investors a monthly dividend of $0.121875. Annualizing this steady figure and dividing by net asset value ($1.46/$7.39) equates to a cash flow yield of 19.79%. If PHK is only earning 7.94% on its assets, and is paying our 19.79% plus its 1.04% management fee, then either it: a) owns deep discount near term maturing assets that it continues to recycle into other deep discount assets (not the case), b) it earns exceptional short-term trading gains (not reflected in the NAV growth, c) it is paying investors some of its dividend in the form of a return of their own capital, or d) it is continuously issuing new shares whose partial proceeds are returned to all investors.
Yes, PIMCO is winding down the fund's capital base to pay its off-market dividend. Net assets have been declining for a number of years as they are liquidated to pay the fund's high dividend rate.
|Common Shares Out
PIMCO is also offering new shares incrementally as seen above. I wish that I could sell a stake in my net worth for 70% more than its value, which is the current premium of the market price to the net asset value of the fund. The dividend is clearly unsustainable given the decline in net assets, and the fact that the CCC subset of the Barclays U.S. High Yield Index is priced to yield 11.6% to maturity. Even levering these bonds 21% and assuming a zero default rate (Moody's average annual default rate for CCC rated bonds betwen 1920-2009 is 13%), PHK could only barely meet is current distribution. This seems like a very unlikely outcome. A much more likely outcome is that the value of the shares collapse towards the net asset value over time as the underlying portfolio continues to shrink.
How much is the market overvaluing the underlying assets? Given the net of the coupon cash flows received on the assets, the dividends paid to fund holders, and the expenses taken out by managers, the net assets will be exhausted at the current rate of decline in just shy of eight years. If you valued a 7.75 year straight bond that paid monthly coupons at a rate equal to the dividend yield on PHK (11.58%), for the premium to be 170% of the par (the market price relative to the NAV), then the market yield on this hypothetical bond would have to be 1.9%. This is obviously not the correct discount rate for a levered speculative grade cash flow stream. The market is both overvaluing the fund and clearly not assuming that the fund's net assets are exhausted in this time frame; attributing value to the PIMCO brand while believing that asset cash flows can be increased to the level of the dividend outflows in time. More likely than seeing the asset cash flows from the underlying assets increase in a difficult market environment, the outflows to investors are going to decrease, and that could well mean a lower dividend rate, which should lower the premium to NAV. If the dividend is not decreased, potentially PIMCO could issue more shares in the fund, and use the proceeds to continue their above market distributions. Either a decline in the dividend rate, or a dilutive new share issuance is a material negative for current holders, but may be the only paths to longer-term sustainability of the fund.
I cannot in good faith suggest that one short the fund despite its massive overvaluation. Given almost no institutional ownership of PHK, the shares would be very difficult to short en masse. Also, the premium to NAV has sustained for nearly three years. Shorting the fund in early 2009 at a 30-40% premium may have made intuitive sense, but the trade would have gone massively against the short. The negative carry on the short would make this a tough trade to finance given uncertainty about the timeframe until a dividend cut or equity issuance. If you own PHK, sell. It has been a good run, and the first holders out of the fund will reap commensurately larger rewards given the high premium. If you do not own PHK, stay away and look for better risk adjusted returns in discounted high yield closed end funds. If you want to take a swing at this attractive short, buy another closed end high yield fund to offset some of the negative carry on the short, but be forewarned that the premium could irrationally persist as it did last year against disastorous NAV returns. The persistency of this premium to NAV pressures the finance tenet of market efficiency with the inability to successfully short this over-valued fund proving daunting for potential arbitrageurs.
I hope this discussion more broadly paints a clear picture of high premium closed end funds, and the potential cost of buying a brand without a clear understanding of the underlying cash flow stream. Similar to my article about BAB, you are not buying a manager or a track record of success, but an underlying group of assets, which in both cases appear to have been bid up in price.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.