Here is a story with a potentially sad ending. It may conclude with thousands of small investors losing a lot of money, as their hunger (greed?) for high yield collides with a leveraged, too-good-to-be true investment.
About two weeks ago, Barron's published an article on the PIMCO High Income Fund (NYSE:PHK). The summary of the article was that this closed-end fund was trading at a tremendous 70% premium, and that its assets are leveraged. Any sort of disruption, like a distribution cut, could mean trouble for investors.
I have been watching this fund for several years, but I could never justify investing in it at such a premium. After the Barron's article was published, there has been significant price pressure on it, so I decided to take another close look. Based on what I know today, I would not be buying this security for client accounts and if I owned it, I would sell. I don't short closed-end funds, but if you are so inclined, this is a candidate.
In the category of leveraged, monthly distribution, junk bond closed-end funds, why would one pay a premium? There needs to be a compelling reason, because there are numerous alternatives in that category. The only reason is that one thinks the management of that fund will deliver superior results, either current income or capital growth. That is the only reason. The primary objective of the PIMCO High Income Fund is to seek high current income. So there is the answer: on Friday (October 5, 2012) investors believed PIMCO will be able to continue to provide a 10.28% annual cash flow. They believed this cash flow was superior to other alternatives, and that it was sustainable.
It seems as though this article has shaken free some investors. On October 5, it closed at $14.23, and on October 18 it closed at $12.27: a 13.8% drop in its trading price. Its premium has been cut to 47%. That is still a huge premium, but it may be worth it if the PIMCO team can sustain the distribution via investment income. Since the price has dropped so much, the yield is now up to 11.9%. I am certain that is getting a lot of investors' attention.
That's more like the return profile of a well performing equity versus a bond. However, these are junk bonds and they should have a return profile similar to equities. You are risking your capital, your principal, just as you do with a stock. And you are doing so with distressed companies.
But what about the distribution? Is it at risk? As the Magic Eight Ball says, "Signs point to yes." To understand why, let us first take a look at the trend that has been accelerating over the past year. This fund has paid a consistent distribution every month for years: $0.121875 per month. A distribution may consistent of income the fund generated through investment activity, it may consist of investors' capital being returned to them, or it may be a combination of both.
The ratio of the distribution that comprises investors' capital being returned to them should be a fundamental concern of potential and current investors. This often referred to as Return of Capital (ROC). If a distribution is merely a return of capital, then why are you investing? Essentially, you are paying an investment management firm to take risk with your capital, charge you a management fee, and merely return your own money back to you. That's not good. A healthy distribution will consistent of income generated through leveraged investments.
In the case of PHK, you can see that increasingly it is not able to pay its $0.12/month distribution without tapping into its capital.
ROC Ratio for PHK
Trailing 12 Months: 19.5%
Trailing 6 Months: 21.5%
Trailing 3 Months: 31.9%
Last Month: 43.1%
The ratio of ROC for PHK is accelerating. Many closed-end funds will occasionally return capital as part of their distribution. This is because investors, particularly closed-end fund investors, may rely on a fixed income. The operative word here is "occasionally."
If this onerous trend continues (to use a PIMCO term: becomes "the new normal") you will still have (at this moment) an 11.9% yield, but 43% is just you getting your money back. If you eliminate ROC from the yield, and look at your actual income, that drops to 6.8%.
Does this sound like the type of investment for which you would pay a 47% premium? If yes, than further consider that the 6.8% income yield is being generated through 21% leverage. If you are still not convinced, consider that the yield (including ROC) on the net asset value is 17.6%. Does it seem plausible that it is sustainable?
This, of course, assumes that the 43% ROC deviation becomes the norm, but it is certainly trending that way. I do not know if that will abate, but I do know that PIMCO has handicapped its capability to keep the distribution at its current level by comprising 19.5% of the last year's distributions with ROC.
Investors need to understand that not all distributions are created equally. Focusing on the consistency of the payments, without considering new, detrimental developments, is being blinded by the hunger for yield. Failing to consider the sustainability of a 17.6% yield on NAV is reckless.
Disclaimer: The author currently has no position in PHK. Material within this article does not constitute investment advice and is meant for educational and discussion purposes only. Past performance does not guarantee future results. The price of PHK when this was authored was $12.27. Distribution and NAV information was provided by Allianz and PIMCO.