This article is part of a monthly series where we analyze a select group of funds within the Income Fund universe. Here we look at the Dynamic Credit and Mortage Income Fund (NYSE:PCI), which is a PIMCO fund focusing on Mortgage-backed Securities, or MBS, and global High Yield corporate credit.
Our main conclusion is that while we expect the fund to perform well in the coming quarters due to a supportive environment for MBS and credit spreads, we expect the volatility to pick up, which is likely to keep the fund from outperforming its dividends.
Looking at the performance of the fund since 2013, we can see that in gross terms, the fund went nowhere up to about 2016 and has performed well since then, rising above the initial level of $25. Poor performance in 2013 was a function of the Fed taper tantrum (and the associated growing discount), and 2015 was marked by weakness in the High-Yield sector as well as an overall risk-off environment leading into early 2016. After the US elections in November of this year, the fund sold off relative to its NAV following the potential uncertainty on interest rates, inflation and mortgage policy, but it has since recovered.
Asset Drivers of Performance
In order to get a macro picture of what drives the performance of the fund, we regress the fund returns across the major asset classes. Perhaps unsurprisingly, High Yield Credit, Mortgages and Treasuries all score highly, with t-values above 2.
The betas of the High Yield and Mortgage factors are positive (in the same direction) while the beta of the Treasury factors is negative suggesting that the PCI NAV tends to increase as Treasuries drop in price. This has to do with the relationship, among other things, between interest rates and mortgage prepayments.
Breaking down PCI returns over the previous month, all 3 components (Treasuries, Mortgages and High Yield Credit) registered negative returns, but the positive regression-based impulse from Treasuries largely offset the negative impulse from the other two factors.
Monthly Return Breakdown
Digging into the actual drivers of returns over the previous month, we see that the drop in NAV, fees and an increase in the discount contributed small negative returns, which were almost offset by the dividend for the month (which in our calculation below we gross up by the fees).
On a gross basis PCI was marginally down by 0.7% on the month. This pause is in contrast to the 17.7% return of the fund year-to-date but is explained by the increase in interest rates and uncertainty by the potential new policies of the new administration.
In terms of fundamentals, we believe the current environment is supportive of Mortgage-Backed Securities for two reasons. First, while high interest rates will lead to convexity-related selling (especially in light of increasing durations over the last few years), this should be mitigated by the fact that a large share of securities is held by the Fed which does not hedge duration. Secondly, we expect the supply of MBS to fall as prepayments decrease.
However we do not expect net performance to be significantly above zero due to increased volatility. In the table below we show the return of the fund (across 1M to 12M) for various readings of 1-Month S&P 500 Volatility. As expected, rising volatilities is not supportive of returns.
We believe that the Volatility cycle is turning due to tighter labor markets and policy uncertainty and this may limit the outperformance of PCI in the coming quarters.
To close with a less-serious indicator, especially given the short trading history of the fund, we see that December has been a challenging month; however, we would buy the dip given the chance, especially if the discount were to fall below 10% (currently at 8.5%).
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.