While we've been accused of "beating a dead horse" with regards to our focus on PIMCO High Income Fund (PHK), we can assure those readers that this horse is alive, well and overvalued based on our analyses.
Say "Uncle": For those readers who have been "cranky" on this point, you will be pleased to know we will be going "radio silent" on this matter post this article. We believe this article and the one immediately preceding it ("PIMCO's CEFs Trading at High Premiums: Is There A PIMCO 'Put'?") establishes the reference point for future illustrative purposes.
We've Been Admonished Before: We've received the same rebukes in 2009 when we began to focus our attention on the Cornerstone Funds' excessive premiums. In particular, we analyzed Cornerstone Progressive Fund (CFP) which hit a premium peak of 75% in 2009. In our report entitled, "Closed-End Funds: A Legalized Ponzi Scheme?" (12/16/09), we cited the following text:
"Conclusion: Cornerstone Progressive Return Fund's current share price ($9.10) has been vastly inflated by rookie investors chasing an ephemeral yield composed almost entirely of return-of-capital. It is estimated the correct price for the shares to be around $5.75. This would represent an 8.4% discount from its current NAV and a 37% decline from its current price."
Have a Cigar: CFP's stock price is currently trading at $6.67 per share, or 27% below the price at the time of our observation. This is during a period when the Eqcome CEF Index appreciated 8.5%. (CFP's share price would have been lower but it did a non-transferable rights offering at a premium in the interim.)
Irony is not Funny: The irony of the CFP situation is that investors are still paying a premium of over 30% for a portfolio of CEFs that can be bought individually at discounts. The current "draw" of the stock is its yield of 16% of which 30% is now a return of capital. CFP has reduced its distributions annually since 2009.
Marginal CEF Investors: So, it appears the distribution yield is the one criterion on which marginal investors tend to focus-pretty much to the exclusion other metrics. Is the marginal CEF investor that unsophisticated? Apparently, yes. This allows "gaming" of CEF stocks.
Looking at PHK's Valuation from Several Angles: In a separate article we dealt with our analysis of PHK being over-valuated on a premium basis relative to its peers, (see, "PIMCO's CEFs Trading At High Premiums: Is There A PIMCO 'Put'?" 4/12/12). In this current article we will be looking into the sources of PHK's distribution and its sustainability.
PHK's Distribution Sourcing: In order to assess PHK's distribution capacity, we built a simple model for the purpose presenting our case with empirical evidence, thereby permitting counterpoint arguments based on facts.
A Quick Read: In the chart below, cell B-1 is the current premium of PHK's stock price over its NAV per share: 64.1%. In order to determine the sustainability of its current distribution, we then generated an estimated net investment income ("NII") based upon its leveraged net assets per share of $11.02 (B-5). We then multiplied the gross leveraged assets per share times the portfolio coupon (yield) of 8.3% (courtesy of CEFConnect.com) which in turn generated an annualized NII of $.915 per share (E-5). We assumed no-cost debt and no investment management fees.
Based on no-cost debt, the implied NAV portfolio yield is 11.8% (F-7). However, based on its stock price premium of 64.1%, the implied yield on market value is 7.2% (G-8). Yet the current distribution yield based on its share price of $12.77 is 11.5%, or $1.463 per share. So, there is $0.55 per share of non-recurring fixed-income earnings supporting the current annualized distribution.
Backing into the Distribution: Let's take the $1.463 per share distribution (E-9) and subtract out the current return-of-capital feature of its distribution of $.398 per share (E-11). The result is a $1.064 per share needed to support the current distributions from-fixed income operations (E-12).
Based on our model, NII is estimated at only $0.915 per share (E-13). Subtracting out estimated NII leaves approximately $.15 per share of non-NII earnings to support its current distribution level. We have generously annualized the 6 month dividend revenue line (Sept 2011), which we assumed would be recurring from investment in equities, of approximately $0.10 per share (E-15) to arrive at an additional $.05 per share coming from non-recurring sources to support the current distribution (E-16).
This implies that approximately 30% of the current distribution is coming from non-NII sources (return-of-capital and non-recurring NII sources [H-17]).
In cell D-19, we have calculated the impact of a 1.0% increase in interest rates expenses. We believe this is approximately $0.032 per share, or a 3.5% change in NII.
For Your Consideration:
1. First of all, a CEF with a 60% plus premium is difficult to sustain over a 12 month period of time-as we have seen in the case of CFP.
2. PHK's assets are mostly classified as Level II. By definition such assets are valued indirectly and would be approved by PIMCO's valuation methodology. So PIMCO, the organization, is telling you that you are overpaying for the stock based on NAV.
3. Despite PHK's distribution-NII gap, PIMCO has a very large trading and investment organization and may be able to allocate assets and earnings to certain of its funds to "shore-up" its investment objectives.
4. A drop in the annualized distribution yield, the equivalent of its return-of-capital component, would still generate an annualized monthly distribution yield of approximately 8.0%; if all non-recurring NII were not to be funded, the annualized yield would be 6.6%. However, a reduction in the distribution rate would be accompanied by a sharp decline in the share price.
5. Bill Gross, co-founder of PIMCO, has been a manager of this fund since 2009 and is an important franchise to protect for the organization.
6. PHK's shares are difficult to "short" making downward pressure on the stock price less efficient.
7. PIMCO's market makers can easily "prop up" the stock for their own trading accounts.
8. Lastly, we've previously been consistently wrong on the trajectory of this stock and believe the stock will likely continue to be over-valuated until there is a rise in interest rates.
As an additional caveat, we do not have access to the calculations for earnings and profits that constitute the characterizations of the distributions and therefore are exposed to a "blind spot".
Why Bother? Since our focus is on generating supplemental income for retirement while protecting invested capital, we caution long-term income-oriented investors that this may be an inappropriate time to be buying PHK stock for that purpose. For traders, you're on your own.
However, if the distribution is cut the stock price will likely plunge and, depending on the depth, acquiring some shares on the drop might be worthy of consideration.