A lot of investors found out last Friday that Closed-End funds (CEFs) can trade pretty wildly at their market price levels even if their Net Asset Values (NAVs) barely budge. The father of value investing, Benjamin Graham, said it best when he said that:
In the short run, the market is a voting machine but in the long run, it's a weighing machine.
No where will you find that voting machine affect more in evidence than in CEFs, where emotions can immediately dictate the market price move of a fund despite an NAV which may move more like a tortoise. As you might know, CEFs are relatively illiquid compared to ETFs or other securities so you don't find as much institutional ownership in these funds because it is hard to invest a large amount of assets and even harder to withdraw.
What this means is that you see more individual investors in CEFs than in any other asset class and thus, you see more emotional decision making than in any other asset class. And as we know, emotional decision making is often wrong. Oh sure, institutional investors, market makers and even other CEF funds own CEFs and will overcome individual investors when they decide to buy or sell these funds, but no where will you get the influence from individual investors "piling on" than in CEFs.
For example, in the Fall of 2008 when the financial crisis was at its worst, you could buy stock based CEFs at -25% to even -30% market price discounts to their NAVs during short spike down periods despite the fact that in a worst case scenario, if the fund ever had to liquidate its assets for whatever reason, you would have received close to the NAV price back. So while many investors were throwing in the towel on these funds back then, little did they know the value they were giving up and that roughly a year later, many of those same funds would be up 100% in total return and trading at a premium valuation.
But this is where more sophisticated investors who do their homework have an advantage because in the long run, your competition in CEFs is not institutional investors, who have greater resources and capabilities than you if say, you were trying to pick individual stocks for example. No...your competition in CEFs are mostly individual investors who generally don't understand what to look for in CEFs and are much more prone to make investment mistakes.
One Still Very Over-Priced PIMCO CEF
Friday's drop in the PIMCO CEFs may have been the opportunity many investors were waiting for to get involved in the PIMCO funds, but I doubt that will be the case for some of them when we look back a year from now. PIMCO manages mostly municipal bond and taxable bond CEFs, including one hybrid bond/equity equivalent fund, the PIMCO Global StocksPlus & Income fund (NYSE:PGP).
I have written several times on PGP, which is really a heavily leveraged bond fund that uses its cash flow to buy large positions in S&P 500 mini futures. As a result, I include PGP in my equity CEF tables and analysis even though it doesn't own any stocks. But all of the PIMCO CEFs tend to use large amounts of leverage, swaps and even derivatives in the case of PGP, which generally increases the volatility of these funds but also allows them to offer higher yields than what you would find even in most other CEFs.
So let's first take a look at what happened on Friday because despite all of the headline news, there really were only a handful of PIMCO CEFs that made headline moves. Here are the 1-day market price changes in percent of the PIMCO funds in reaction to the Bill Gross departure news compared to their 1-day NAV price changes.
Certainly, the 1-day market price moves for all of the PIMCO funds were greater than the 1-day NAV moves but only in a few cases was it lopsidedly so. But what I want you to notice is that generally, the funds with the highest yields and the largest market price premium valuations had the largest 1-day drops.
One might expect that to happen as these funds could be considered the most overvalued and risky of the bunch but the question is, how did these funds get to such extreme market price premiums in the first place? Before last Friday, PGP was trading at an unbelievable 80% market price premium to its NAV, by far the highest of any CEF.
Last Friday brought that premium valuation down to only a mind numbing 67% premium, and there seemed to be plenty of buyers in PGP when it opened on Friday down -13% and fought its way back to down only -5.7% by the end of the day. But who in their right mind would even buy a fund over $20 that, if it had to liquidate tomorrow, could only pay you back $14.13?
A lot of individual investors, that's who. Certainly, there are institutional investors in PGP who have probably owned the fund for quite some time, but I can't imagine any sophisticated investor doing their due diligence on PGP and coming away Friday saying, "What an opportunity!"
Because despite its lofty premium, PGP has been a very average performing fund at the NAV level over the past year and doesn't even make my top 30 list of YTD total return NAV performance equity based CEFs.
There you see PGP third from the bottom out of about 100 equity CEFs I follow (only 35 or so can be shown in a screen shot). And that doesn't even include the REIT based or MLP focused CEFs, which I don't include in my tables but would add another 30 or so funds that have had stronger total return NAVs than PGP this year.
But don't tell that to the legions of PGP fans who bid up the fund's market price in 2014 to an 80% market price premium before last Friday, despite the multitudes of other equity based CEFs that go begging at double digit discounts and have had much better NAV performances and just as attractive a yield. Here is PGP's Premium/Discount chart YTD and except for the drop at the extreme right of the chart, it's been a ramp up for PGP this year despite showing very average NAV performance.
I don't know how you see value in a fund at a 67% market price premium just because it's down -5.7% in one day. Remember, when you buy a CEF at a lofty premium, the fact that you are buying the fund's assets at a lofty premium too only tells half the story. Because just as important is the fact that when you buy a fund at a premium, you don't even receive the full yield of what the fund is paying!
In PGP's case, the fund is responsible for paying $2.20/share each year out of its NAV of only $14.13. That is a very difficult NAV yield to achieve each year and results in an NAV yield of 15.6%, second only to the Cornerstone funds as the highest NAV yields of any CEFs. But new investors in PGP would still only be receiving a 9.3% market price yield even if they bought the fund at its down closing price of $23.67 on Friday. You've really got to believe that a fund is invincible to give up that much yield and to pay that high a price but there seem to be plenty of individual investors who do.
That's because PGP has attracted an almost cult like following among small investors because the fund has never cut its distribution, even during the financial crisis back in 2008 when the NAV dropped to only $6. Now PGP can have incredible NAV performance when its income and appreciation strategy is hitting on all cylinders. That's because PGP is a heavily leveraged bond fund (high yield and mortgage backed securities mostly) that also goes out and buys large positions in the S&P 500 mini futures. So PGP basically needs a strong equity market and bond market to keep its high flying strategy going.
The problem with PGP that nobody likes to talk about is that the fund is still paying the exact same $2.20/share distribution each year with a $14.13 current NAV than when it came public in 2005 with a $23.83 NAV. And then consider how far interest rates have fallen since PGP went public (good for bond prices but bad for bond yields) and you realize that this fund has to be taking on more and more risk to achieve that $2.20/share annual distribution with that low of an NAV. For comparison, there are many other leveraged equity CEFs that can have just as strong an NAV upside as PGP that have significantly higher NAVs but yet trade at a fraction of the price! It is literally insane what individual investors give up in other CEFs to play a fund that could blow up in their faces if PIMCO ever decided to cut the distribution in PGP to a more reasonable level.
Now I can hear a lot of investors saying yeah, but PGP just keeps going up and has been a great fund to own over the years, Friday notwithstanding. But has it? Getting back to the short term voting machine vs. the long term weighing machine, has the market gotten it right on PGP over time?
Actually it has. Because if I sort all of the CEFs I follow by the difference between their total return NAV performance and their total return market price performance since the end of 2011, which is about the time the markets started their uninterrupted ramp up, PGP comes in with the second worst performance difference. Even if I took out Friday's drop, PGP would still come in at second worst.
Now PGP, with a 85.3% NAV total return since 2012 has been a very strong performer if you just look at its NAV but that uber high premium valuation has kept its market price in check over the same time period. So this is what I'm talking about when I say that CEF market prices can do some pretty crazy things in the short run but in the long run, they are the most predictable asset class I know.
Which PIMCO CEFs Are Now Attractive?
I don't mean to pick on PGP, which I think is a fantastic fund even if I think PIMCO should have cut the distribution a long time ago to help deflate the premium bubble the fund still finds itself in. But when you're the 800-lb gorilla of excessive valuations, you've got to expect some criticism.
Going back to the PIMCO table at the beginning of this article, there are several PIMCO CEFs that were attractive even before Friday's drop, based on their relative valuations to their NAV performances.
I'm going to exclude the municipal bond funds since that's a whole article in itself but let me take the same approach as I did in the table above and sort all of the PIMCO taxable bond CEFs by the YTD difference between their total return market price performance and their total return NAV performance.
Here you see PGP still finds itself on the bottom while the PIMCO High Income fund (NYSE:PHK) is on top. Of course you have to take into consideration that this is a relatively short 9-month period and that PHK still trades at a very high 37.7% market price premium even after Friday's -6.1% price drop. But based on this rough analysis, PHK, with a 20.1% NAV total return YTD and a 12.5% current market yield, is relatively attractive if you can get over the 37.7% premium valuation.
The other part of this analysis that I don't take into account is which fixed income asset classes may outperform or hold up better going forward? Government bonds, corporate bonds, high yield bonds, municipals, mortgage backed securities, preferreds, etc.? I don't know and I'm not going to speculate in an area I don't feel comfortable in. I can only comment on these funds relative valuations and their historic NAV performances.
That being said, one fixed-income class I have been buying as a hedge against higher interest rates in the future are the floating rate security CEFs, which generally include securities tied to LIBOR plus a spread but wouldn't really benefit much until the Federal Reserve really got aggressive in moving rates up. Still, floating rate securities don't seem to be able to get a lot worse even if they don't pay out much currently.
But the fixed-income markets haven't exactly been rewarding CEFs with floating rate securities in their portfolios and most still trade at very low valuations. In fact, the only PIMCO taxable fixed-income CEF that trades at a double digit discount of -10.7% is a fund that includes a relatively large position in floating rate securities, the Dynamic Credit Income fund (NYSE:PCI).
I'm guessing that the markets are saying that even if the Fed raises rates beginning in 2015, it won't be enough to really benefit these securities much. That may be the case, but I still think that PCI is attractive at a -10.7% discount since you really can't pigeon hole one PIMCO fund as a floating rate fund or one as a government security fund or another as a corporate bond fund. Except for the municipal bond funds, all of the PIMCO taxable fixed-income funds have fairly diversified portfolios spread among global government securities, mortgage backed securities, investment grade bonds and high yield bonds mostly.
The difference really lies in what sectors they are overweight and their use of leverage, swaps and credit risk. Be aware though that if you decide to invest in the PIMCO taxable fixed-income CEFs, several like the Income Opportunity fund (NYSE:PKO), the Dynamic Income fund (NYSE:PDI) , the Corporate & Income Opportunity fund (NYSE:PTY) and the Corporate & Income Strategy fund (NYSE:PCN) all had large capital gain distributions last year and may declare large gains again in December.
You generally pay a premium for the management of PIMCO CEFs and that superior management has paid off with superior returns and yields over the years. But for some funds, last Friday may end up being a warning shot that risk and reward has its limits, even for the PIMCO funds.
Disclosure: The author is long PCI.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.