In our previous article, we explored techniques investors can use in comparing two funds. Specifically, we focused on NAV correlation and a returns regression analysis. In this article, we review a third method, which is less quantitative and more qualitative in nature. As in the previous article, we use (nearly) everyone's favorite pair of closed-end funds: PIMCO Dynamic Credit and Mortgage Fund (NYSE:PCI) and PIMCO Dynamic Income Fund (NYSE:PDI).
For those not yet involved in the heated debates in the comments sections of our previous articles on this pair, we will summarize the situation very briefly. Both funds are multi-sector fixed-income funds with PDI allocated more to MBS and PCI allocated more to High-Yield bonds (with the gap converging). PDI yields a bit more and pays a higher special dividend than PCI. PDI also trades at a 7% premium whereas PCI trades at a 3% discount. The question we have been analyzing is whether these funds should trade at a 10% difference in discount.
Our own view is that we prefer PCI to PDI. Our primary reasons are that allocations to high-premium funds are liable to share price risk, and buying funds at a premium leaves too much yield of the underlying portfolio on the table. The counterargument is that premiums can go sky-high (take a bow PHK) and that a clean arbitrage is not possible if the portfolio of the high-premium fund is not easily replicable or bought via another fund. There are other rational arguments that can justify a high premium. However, we will leave that to future articles.
Bringing it back to the main point of this article, the third type of fund comparison we can do is very simple - by looking at the actual underlying allocations of the funds. In practice, this is harder than it sounds because fund screener sites do not publish detailed breakdowns, and an enterprising analyst has to go to annual reports or specialist services in order to extract the right data.
Portfolio Composition Analysis
We divide our analysis into two parts - corporate bonds and ABS. We ignore allocations to cash FX and focus in on these two largest components of the portfolios.
On the corporate bond side, we see that PDI has a smaller overall allocation to this sector (information that is readily available on screener sites) and that for half of the sectors PDI matches PCI quite closely, and for the other half, it is not invested at all.
On the ABS side of the ledger, we see that PDI and PCI have a large difference in whole-loan CMOs. Without going into the weeds, these are unsecuritized non-conforming mortgages that tend to carry both interest rate and credit risk and so yield significantly more than your friendlier agency mortgages.
We can stop here with a good micro-picture of the two portfolios but as many investors know - price discovery and transparency on CMOs can be quite tricky, and this fact can easily filter through and potentially distort other kinds of analysis.
For example, one thing we would expect from a higher-yielding fund like PDI when compared to PCI is higher volatility (which goes with higher yield like a horse and carriage - or love and marriage for those looking forward to Valentine's Day). When looking at price volatility, this is exactly what we find. However, looking at NAV volatility, we are surprised to find that PDI has lower NAV volatility than PCI.
One possible explanation of this is that the crack staff at PDI is able to find assets that both have a higher yield and lower volatility and, at the same time, keep this information from the PCI team next door. The other explanation is that the higher allocations to less liquid assets mean these assets don't have easily observable prices and so either get marked "to model" or don't have regularly updated prices which, in either case, will understate the volatility of PDI. When we look at the constituents of the portfolio on Bloomberg, we find that 27% of the PDI portfolio does not have a price while only 14% of the PCI portfolio does not.
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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.