We wrote a piece back in late 2013 on the ability to earn strong returns on the Pimco Dynamic Income Fund (NYSE:PDI) as well as a marketplace article titled, "The Greatest Bond Fund Ever?" The CEF has been an excellent way to gain access to some of the bond company's best ideas in the MBS space. It benefited greatly from its inception time, or vintage, accumulating assets just after the mortgage market bottomed. They were able to pick-up dirt-cheap subprime MBS that were so toxic, no one would touch them with a ten-foot pole.
Since inception, May 2012, the fund has returned a 16.3% annualized on price and 16.9% on NAV. But as we noted in our recent piece on the Western Asset Mortgage Defined Opportunity Fund (NYSE:DMO), a similarly focused fund, the opportunity in the space appears to be on the wane. This is due to the lack of a large amount of issuance, especially subprime, and the rapid fall in outstanding issues.
The current premium is 1.5%, which is about 380 bps above the one-year average but well off the high of a 4.5% premium. The current distribution on NAV is 9.84%. The UNII trend has been to the downside over the last three earnings periods but coverage remains strong at 92% over the last three months and 120% FY to date.
So far this year, the fund has benefited from their exposure to Brazilian interest rates, which increased over the course of the last six months. For those investors that are weary of higher interest rates, the fund does have a short position on the long-end of the U.S. treasury curve. Overall levered effective duration is essentially zero. In terms of that aspect of the risks of investing in the fund, PIMCO has been able to mitigate that via swaps. However, they are still exposed to higher borrowing costs should rates rise.
However, exposure to MBS, which saw some spread widening over the early part of the year, hurt the funds performance. Non-agency MBS continues to be the focus of the fund with 71% of the funds assets in the category. High yield credit was a detractor in the first quarter but has since rebounded in the second but represents just 4% of the assets of the fund.
These hated securities after the recession are now darling with many institutional investors herding into new issues - with investment grade ratings by the NROs. The asset class as a whole is being supported by the lack of supply and the recovery in U.S. housing. PIMCO was able to purchase these busted MBS at, in some cases, cents on the dollar, which provided a massive tailwind. In each of the last three years, they declared special dividends equal to 12.3 months, 10.6 months, 8.5 months, and 5.8 months of monthly distributions.
The trend is our friend but we think the days that this guy is able to essentially double its monthly distribution via the special dividend at year-end are over. UNII as of May 2016 was just $0.14, equating to just $0.34 in the special dividend this year. Of course, the first part of this year was a particularly poor one for the funds credit bets. Since March 31, UNII has fallen three cents from $0.17. Like DMO, we are curious as to why investors are willing to pay a 2-4% premium for this fund when they could have purchased it a year ago at a 8.5% discount when industry dynamics were better.
Outstanding non-agency MBS:
However, in a yield-less world, the ability to acquire shares in a fund that holds these 'special' MBS securities that generate strong yields is unique. We think the market is finally realizing that the risks in this space are overstated. Sure, the standard deviation on price is over 13.2%, which is only slightly lower than the S&P 500. But PDI has performed essentially in-line with the S&P 500 since it incepted. Most importantly, the standard deviation of the NAV is just 7.46%, about 40% of the S&P 500.
MBS spreads widened slightly over the first quarter but have tightened a bit since on lower rates. Prepayment speeds could pick up if mortgage rates fall further. 30-year fixed rate mortgages fell to just 3.50%, down 16 bps from last week and 3.8% in March. Our caveat with the fund is that this could buoy some of the prepayments in the funds subprime securities. Investors must weigh the likelihood that these older-vintaged mortgages that have yet to be refinanced since the financial crisis, with the opportunity going forward. Eventually, these homes that were purchased between 2005-2008 where the owner then was substantially underwater and did not qualify for a refinancing, could be now above water and/or looser lending standards could payoff these loans.
While expensive, we don't think the shares warrant a sell. For one, the fund is holding some great-paying MBS and for the time being, is likely to continue holding them and paying out. The fund was launched at the right time picking up for cents on the dollar the toxic waste of MBS. That opportunity is now passed and the managers are now having to reinvest maturing securities into other areas. Thus, past performance is unlikely to be repeated anytime soon.
Mortgage delinquency rates continue to decline and recently fell to 4.84%, the lowest since early 2008. By historical standards, the rate is still high but it is falling precipitously back towards its pre-financial crisis levels around 3%. That should be highly supportive of MBS, especially the low-quality (at least at the time of issuance) variety held in PDI.
(Source: St Louis Fed)
PDI still offers a great yield and a sustainable payout with a clear tailwind from the housing recovery. The fear of higher interest rates, which would hit a mortgage-related CEF like PDI from higher borrowing costs, both to lever the fund and to mortgage originators (mREITs) who borrow money to buy mortgages and then securitize them. But the fund does have derivative positions that hedge the higher rates. Additionally, PIMCO's clout and size allow it to borrow at ridiculously low interest rates. While the risk from another housing bubble is always present, we think the fund is a unique 'bubble' of assets that should be fairly insulated even if rates rise or housing prices fall again. It would take another 2008 housing collapse scenario for the this fund to see a massive 50%+ decline.
But a housing decline would cause the value of these securities to fall, but continue to pay. Given the premium in the shares, we think investors need to weigh the likelihood of a 'cheaper' opportunity in the near-term over missing those monthly distributions. For example, if you need to wait six months before the shares are at a 3% discount or wider, then you missed $1.323 in distribution income in order to get the shares at $25.70, assuming the NAV stays the same. In the end, you saved $1.20 in price but missed out on $1.323 in income.
We think PDI remains a core holding for any fixed-income allocation and one where dollar-cost averaging could work very well. The CEF wrapper allows the fund to hedge interest rates and lower the effective duration to zero but still generate yields of 9.8%. Where else will you find that in today's low-yield world? While the returns of the past, including special distributions like we realized last year, are probably over, the fund still has a lot of legs as it benefits from housing prices rising and lower MBS supply.
Disclosure: I am/we are long PDI, DMO.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.