The Outlook For RCS Is Mostly Negative

| About: PIMCO Strategic (RCS)

Summary

RCS currently trades at a large premium to net asset value.

RCS recently cut its distribution.

Rising rates will hurt riskier debt options the most.

The purpose of this article is to determine the attractiveness of the PIMCO Strategic Income Fund (NYSE:RCS), 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 RCS. RCS is a closed-end fund whose objective is to generate a level of income that is higher than that generated by high-quality, intermediate-term U.S. debt securities. Its secondary objective is capital appreciation. The majority of its portfolio consists of mortgage debt (over 70%) and US government bonds. Just over 4% of its portfolio consists of investment grade debt. Currently, the fund is trading at $9.42/share and pays a monthly distribution of $.07/share, which translates to an annual yield of 8.92%. This was recently lowered from $.08/share last month. Over the past year, the fund has performed strongly, up over 8%, excluding its high yield. Compare this return to a standard bond fund, such as the iShares Core U.S. Aggregate Bond ETF (NYSEARCA:AGG), a common benchmark, which is down around 1%, while yielding under 2.5%, and you may conclude that riskier funds like RCS are a better option. However, I see the recent strong performance unlikely to continue, and I expect the fund to perform poorly in 2017, for a few key reasons.

First, and in my opinion most importantly, Pimco cut the distribution for this fund by 12.5% from $.08 to $.07 in February. This is incredibly bearish for three key reasons. One, the primary reason investors look to RCS is for a high, and reliable, yield. If that income is cut, as just happened in February, the fund automatically becomes less attractive to potential, and current, investors. Two, RCS trades at a large premium to net asset value (NAV) at over 22%. Investors may be willing to bid up a fund like RCS if it offers reliable high income, but now that income has gotten cut, the premium for the fund is greatly at risk. This could subject investors to substantial loss of principal. Three, while the current distribution still offers an attractive yield, there is the strong possibility that future cuts might arise, hurting the fund's long-term outlook. This is because, according to Morningstar's most recent synopsis, RCS currently has negative net income for undistributed funds. This means that it is paying out in distributions more than it earns in income. This is unsustainable in the long run so, barring income gains, the distribution will likely have to be cut again to compensate for this.

Second, RCS trades at a large premium to NAV, almost 23%. This needs to be emphasized because this makes the fund extremely risky. Since rates have remained at historic lows, RCS' premium has gone up as investors have bid up the cost to own high yielding debt. While this is true for the majority of Pimco funds (of the 20 closed-end funds highlighted on their website, only 2 trade at discounts), RCS is trading at the third highest premium, and there are two Pimco funds that are currently trading at discounts. My sense is that future investors would consider lower priced options, which are also yielding similar amounts, before they initiate new positions in RCS at these levels.

Third, the interest rate outlook is looking more hawkish. The Fed's most recent announcement indicated that the first rate hike of the year will be this month, and Yellen also added the Fed expects "to raise rates twice more later in the year". This is more aggressive tightening than some investors were expecting and is a marked turn from 2015 and 2016 when rates were only raised once. As rates continue to rise, investors will gradually shift away from riskier options because the yields will go up for safer alternatives. This trend will especially impact RCS, given the fact that the fund holds about two-thirds of its debt with maturities between 3-10 years. Given the current climate, I would favor funds that hold more short-term debt, so that when that debt matures, it can be re-invested at the higher rates. RCS won't have that option for at least 3 years. I expect the fund to decline in value due to its holdings, high premium, recent distribution cut, and negative residual income. These characteristics all point to a poor outlook for RCS.

Of course, there is some potential upside to RCS. If the fund manages to sustain its new distribution rate for the long term, the 9% yield is still attractive, even in a rising rate environment. Additionally, as the economy improves, default rates tend to decline. This is crucial for RCS because it relies so heavily on mortgage related debt. Consumers and borrowers are more likely to pay back their debt when the economy is strong, so continuing strength should keep defaults low in the portfolio. However, I don't expect a few potential positives to outweigh the risks that weigh on the fund. Proving to investors that the new distribution is sustainable will take time, so investors will not realize that benefit soon. Additionally, other Pimco funds exist that are exposed to mortgage debt and a strengthening economy, so this alone would not justify choosing RCS over less risky options as it is not a fundamental differentiator.

Bottom line: RCS has performed strongly since the beginning of the year, and the strengthening economy should keep default rates low, benefiting debt funds of all types. However, RCS has a number of negative characteristics that should give investors caution. A high premium to NAV, negative income, and a recent distribution cut are all clear signals to steer clear. With rates set to rise, investors will be more critical of high yielding funds, and I expect only those with solid fundamentals to continue to outperform. With so many alternatives available, I would encourage investors to avoid RCS at this time.

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.

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