The purpose of this article is to determine the attractiveness of the PIMCO Income Opportunity Fund (NYSE:PKO), as an investment option. To do so, I will look at recent fund performance, current holdings and allocation, and trends in the market to attempt to determine how well it will do in 2017.
First, a little about PKO. PKO is a closed end fund whose investment objective is to seek current income as a primary focus and also capital appreciation. It invests a substantial portion of assets in a variety of mortgage-related securities and also may hold common stocks. Currently, the fund is trading at $23.44/share and pays a monthly distribution of $.19/share, which translates to an annual yield of 9.73%. In addition, the fund typically pays a special distribution in December, the most recent of which was $.34/share last month. Over the past year, the fund has performed strongly, up almost 11%, excluding its high yield. And 2017 has seen continued strong performance, with PKO up 1.21% since the start of the year. In comparison, the iShares Core Total U.S. Bond Market ETF (NYSEARCA:AGG), a common benchmark, is essentially flat for the past year, while yielding just over 2.5%. Despite PKO's recently strong performance, I will outline a few reasons why I believe it will continue to perform well in 2017, even with the Federal Reserve's plan to increase rates this year.
First, in general terms, I expect 2017 to continue to be a good year for high yield funds, such as PKO, because the persistent low rate environment will continue. This strategy has served investors well since the recession, and this year will be no exception. It is true that the Federal Reserve (Fed) raised rates a second time in December and, the larger takeaway, is the Fed is looking at potentially three hikes this year. However, even if all three hikes do materialize, it will occur over a 12 month period, and will still leave rates at historically low levels. With this realization, investors will need to continue to search beyond traditional government bonds for an attractive yield, and high yielding funds will continue to be an attractive alternative.
Secondly, I think PKO in particular is a good option because it is trading at an attractive valuation. Even after its impressive run, the fund trades at a small discount to net asset value (NAV). While its current discount is small at -.21%, this compares to the majority of Pimco closed end funds trading at premiums, some of which are very large. In fact, of the 20 closed end funds highlighted on Pimco's website only four of them, including PKO, trade at discounts. This is important because debt investors have many options to choose from when looking at initiating a new position in a fund, and, all else being equal, a fund trading at a discount to NAV is safer than investing in a fund with a premium. In addition to its attractive valuation, the fund has a reliable history of paying its distributions, without a distribution cut, since its inception in 2007. Some Pimco funds, such as the PIMCO High Income Fund (PHK), have recently experienced cuts to their distributions and the funds have dropped in price dramatically. Currently, there is no reason to expect a cut from PKO and its most current announcement, on January 4th, continued its consistent payout.
A third reason why I like PKO has to do with its portfolio's composition, specifically the maturity durations. Over half the fund's portfolio (51%) has a duration of between 1-3 years, with half of that amount maturing in less than 1 year. This is especially attractive in a rising rate environment because as shorter term debt matures, it can be re-invested at the higher rates. Therefore, I would stay away from funds that are overweight longer-term debt and PKO fits that bill.
Of course, investing in PKO is not without risk. For one, the Fed could raise rates faster, or in larger increments, than the market expects. If this occurs, I would expect dividend funds and debt funds, including PKO, to feel some downward pressure, certainly in the short term. The fund would probably begin to trade at a discount, which would puts investor's principle investment at risk. However, I do not see this trend occurring, as the Fed has shown in recent years that it is trying hard not to surprise the market, and has crafted announcements carefully to clearly define expectations for future rate hikes. Secondly, the total annual expenses for the fund are 2.63%. This is clearly not cheap, and greatly exceeds the expense ratio of most dividend ETFs and even other bond funds. For example, AGG, charges an expense ratio of .06%. Obviously, fees add up, and matter quite a bit in the long-term as it can erode overall investor returns. However, the performance of PKO has clearly justified paying an above average fee. If that continues, investors have to bite that bullet for the reliable yield the fund provides.
Bottomline: While 2017 will see some changes, a new President, new government, and a more aggressive Fed, historical low rates will still remain. Therefore, high yielding CEFs like PKO should continue to perform well. With a yield around 10%, and a consistent record of paying it, PKO will continue to provide income-minded investors a sold alternative to treasuries and dividend funds that are yielding under 3%. Even with its recent strong performance, I expect PKO to be a lucrative choice this year and would encourage investors to take a serious look at this fund.
Disclosure: I am/we are long PKO.
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.