Pimco Corporate & Income Opportunity Fund Should Perform Well In 2015

| About: PIMCO Corporate&Income (PTY)
This article is now exclusive for PRO subscribers.


Continued policy of low rates will benefit high-yield funds.

PTY increased its distribution a few years ago.

Exposure to the banking sector will benefit the fund if rates rise.

The purpose of this article is to determine the attractiveness of Pimco Corporate & Income Opportunity Fund (NYSE:PTY) as an investment option. To do so, I will review PTY's recent performance, characteristics and holdings, and current trends in the market in an attempt to determine where PTY may be headed in the new year.

First, a little about PTY. The fund's stated objective is to seek high current income with capital preservation, with capital appreciation as a secondary objective. This fund invests at least 80% of its total assets in a combination of corporate debt obligations, both short and long term, corporate income-producing securities, and income-producing securities of non-corporate issuers, such as the U.S. government securities, municipal securities and mortgage-backed securities. The fund is managed by Allianz Global Investors Fund Management LLC. PTY is currently trading at $17.90/share and pays a monthly dividend of $.13/share, which translates to an annual yield of 8.72%.

Year to date, PTY is up around 3.7%, excluding dividends, and over the past 52 weeks the fund is up a little under 3%, also excluding dividends. Coupled with its distribution, the fund is largely positive for the year, and has outperformed the Dow Jones Index, a popular benchmark, which has returned around 4% year-to-date. When compared to iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG), the funds have returned similar percentage gains in stock price, but PTY's yield of over 8% easily beats the 2% yield sported by AGG. Therefore, PTY has rewarded investors recently, but the market as a whole has done well in 2014, so it is important to take a fresh look at this investment option to see if it will continue to perform well in 2015.

To begin, the number one reason I believe PTY will have a profitable new year has to do with its attractive yield and the continuation of a low-rate policy by the Federal Reserve. Importantly, the Federal Reserve has renewed its commitment to low interest rates for a "considerable time." This is important because low rates force investors to pursue alternative types of investments, rather than just putting their money in savings accounts. The stock market as a whole is perhaps the biggest beneficiary of this government policy, as investors pour money in looking for higher rates of return. Debt funds have also benefited, as dividend paying stocks and ETFs have gotten so popular that the yield on many of those investments hover in the 2-3% range. For investors seeking a higher stream of income, closed-end funds have become a widespread alternative. PTY has not been an exception to this trend, and with a cheap money policy all but guaranteed to continue in to the new year, PTY will continue to attract investor interest. Aside from an over 8% yield, monthly distributions make the fund a lucrative alternative to many other investments that pay dividends quarterly. Given that rates are not set to begin rising, at a modest pace, until mid-2015, I expect PTY to attract inflows for at least the next 6-9 months.

Secondly, PTY increased its distribution in May 2012, from $.115/share to $.13/share, and has been reliably paying this increased amount ever since. An ability to increase the distribution is critical as we enter 2015 because, as rates do inevitably rise, investors will begin to demand a higher yield for alternative investments, such as PTY. Investors will be less likely to flee such investments if they have a proven track record of raising the distributions, and with it the overall yield. If investors remain confident that PTY will continue to maintain, and conservatively increase, its payout, the fund should not experience damaging outflows when rates do rise.

A third reason I like PTY has to do with its exposure to the banking sector. Unlike some CEF's, PTY is more than just a government debt fund, it has holdings in corporate debt as well, notably the banking sector which is its top industry holding, at 8.4%. The upside that I see to holding debt in this sector is that it provides a nice hedge for the fund when rates rise, or if they rise more than anticipated. The banking sector, among others, benefit during times of rising rates because margins improve, increasing profitability. The central theme is that rates on loans rise faster than rates on deposits, which benefits the banks making the loans and holdings the deposits. Thus, the banking sector will become less of a credit risk, a benefit to PTY which owns debt in this sector. This exposure will help negate some of the negative pressure PTY will see if rates rise and investors feel tempted to flee the fund.

Of course, investing in PTY is not without risk. The biggest risk is if rates do rise sooner than expected, or more aggressively. While I just mentioned PTY has a minor hedge against this, the overall effect will probably be negative for the fund. Investors will dump closed-end funds for less risky investments that will begin to offer more competitive yields. While I personally have faith in the Fed's pledge to keep rates low through the beginning of 2015, things could change. Additionally, the Fed is currently considering dumping its "considerable time" pledge in its next policy meeting. If that happens, investors may be spooked and the outflows could begin, even if the timetable for raising rates remains the same. An overreaction caused by investor anxiety, could hurt bond funds in general, including PTY. Another risk that is more specific to PTY has to do with the large premium the fund currently trades at, currently at 21.35%. While the fund has traded profitably at a premium for some time, there is always the possibility that investors decide the premium is no longer worth risk, in which case PTY will fall quickly. However, there are other Pimco funds, such as PGP and PHK, which trade at premiums that are much higher than PTY, currently at 57% and 52%, respectively. So PTY is not currently at an unsustainable level, at least for the short-term. That being said, there are funds that trade at much lower premiums, and even discounts, so the risk that PTY faces is very real in this regard.

Bottomline: PTY has rewarded investors in 2014 and there are many reasons to expect similar performance to continue in the new year. Many of the characteristics that allowed PTY to perform strongly, such as continued low rates by the Fed and a continued search for higher yield debt by investors, will remain in early 2015, if not longer. PTY has a reliable track record of paying its distribution, and has even increased it in recent years, a trend which, if it continues, will surely be a positive catalyst for the fund. PTY is a diversified fund that invests in corporate, government, and emerging market debt, among other assets, and is poised to continue its strong track record next year. I encourage investors to take a serious look at this fund.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.