The Not So Obvious Reason Why PIMCO CEFs Trade At A Premium

Includes: PCN, PHK, PTY
by: Bengal

There has been a lot of discussion about the premiums in various closed-end-funds, in particular the PIMCO CEFs (such as PHK, PTY, PCN, etc). Recently there was a Barron's article which discussed some of the funds with very high premiums, such as PHK, but there was no analysis of any kind regarding why there should or should not be a premium for such funds.

Broadly speaking, there are 4 key reasons why, all else equal, a CEF should trade at a premium to its NAV. The first 3 are more or less widely known, but I will list them for completeness. It is the 4th reason that is not discussed much.

  1. There is more demand than supply for that CEF. The PIMCO CEFs have been around for quite some time, and they trade relatively frequently, so this is likely not a factor.
  2. The manager is viewed very favorably by the marketplace. PIMCO is one of the leading bond houses in the world, so it is reasonable to expect that this in and of itself should lead to a premium, but this factor is well known and not particularly illuminating to talk about.
  3. The NAV is not reflective of the cost of assembling the portfolio. With fewer banks on Wall Street (Lehman, Bear, etc. all gone), the bid/offers on trading fixed income securities have sky-rocketed for the retail public. Some infrequently traded bonds can have up to 10 point bid/offer spreads (check the TRACE data on various bond trades, e.g., on fidelity or any other broker that provides TRACE data and you can see this for yourself). Assembling a portfolio of fixed income securities could reasonably cost 5 percentage points or more, thereby justifying a premium of the same or more. Also, PIMCO is likely getting far better execution than a retail investor would get on bond purchases and sales, and this is worth something (i.e., a premium to NAV). However, this factor is also widely known in the market place and often discussed on blogs and comment boards.
  4. THERE IS A STRUCTURAL REASON THAT MOST PIMCO CEF COMMON SHARES SHOULD TRADE AT A PREMIUM. This brings us to the final reason, which is the reason that is not discussed much, if at all. Most (but not all) of the CEFs that PIMCO has, have an ARPS (auction rate preferred securities) component that provides leverage to the shareholders of the CEF. These ARPS are currently paying rates of as low as 25 basis points per YEAR (yes, per year). The market price of the ARPS, for the holders of the ARPS, is about 70-80 cents on the dollar (why? because the ARPS is a piece of paper that pays 25 basis points a year, similar to a money market fund, but that cannot be redeemed for par). I won't go into the long history of the ARPS and the failed auctions since 2008 (it's all in the PIMCO CEF public filings), but given that the ARPS trade at a discount to "NAV", it is mathematically consistent that the equity of the CEF should trade at a premium. If your liability structure is 80% equity, 20% ARPS, and the ARPS trade for 75 cents on the dollar, then a sum of the parts analysis results in the equity trading at a (100%-0.75×20%)/80%-1=6.25% premium. And this has nothing to do with the market's perception of the strength of the manager…it's just a reflection of the fact that the fund has cheap financing in its capital structure. The cheaper the financing cost on the ARPS is, the higher the premium for a CEF should be, all else equal.

All of the information about the ARPS is public knowledge and can be found in the PIMCO public filings. The fact that the ARPS market price is about 70-80 cents on the dollar can be verified by looking at bid/offers on secondary exchanges where these types of auction rate preferred securities can be traded. I won't go through the exercise of calculating the premium component of each of the PIMCO CEFs attributable to their ARPS, but it is easy enough to do. Be mindful that the terms of the ARPS for each CEF varies and as always, the devil is in the details.

For full disclosure, I have owned for quite some time many of the PIMCO CEFs (e.g., PTY and PCN that Mr. Gross recently added to his positions in), but I do not own any PHK.

Disclosure: I am long PTY, PCN, PML, PFN, PFL. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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