What has just happened?
On March 22 the PIMCO Dynamic Income Fund (NYSE:PDI) filed an At-The-Market Offering with the SEC. The maximum offering price is just over $275m and up to 9.5m shares. The number of new common shares is relatively large at just over 20% of common net assets. The shares will be sold at the market price over a period of time.
What is an ATM offering?
In an ATM offering a fund raises additional capital by selling new shares into the market at the then current price above the Fund Net Asset Value. This allows the fund to allocate capital into new investments without having to sell existing investments. A side-benefit (which we don't think applies to PDI) is that an increase in the number of shares may increase trading volumes of the fund and tighten bid-offer spreads.
Why is PDI doing this offering?
The optimistic answer is that PDI is raising cash because the management team has spotted a particular opportunity in the market in which they want to invest and deliver alpha.
The cynical interpretation is that the management team want to increase gross fees of the fund (no doubt to keep up with rising California house prices!).
Our view here is that the fund is simply trying to monetize the very high premium-to-NAV in a shareholder-friendly and NAV-accretive way.
Has the selling of new shares started?
We don't know for certain but judging by the monthly outstanding shares trend, we think it has. While the entire uptick in shares outstanding is probably not due to the offering (a part of it is probably from the DRIP) a bulk of it looks like it may be.
What will PDI do with the cash?
We can't know for sure. We do know, however, that in the fund commentary the management team has stated that they expect global and US growth to move higher. The company outlook for interest rates is on the order of 3-3.5% on 10-year Treasury yields. This tells us that they expect risky assets to perform well, interest rates to increase and the housing sector to continue strengthening. This suggests interest-rate hedged positions in CMOs - a current core holding of the portfolio.
In any case, PDI are unlikely to significantly deviate from the fund mandate as the funds have to be invested according to the fund's objective.
The timing of the investment is fairly quick - the key statement from the prospectus is below.
It is presently anticipated that the Fund will be able to invest substantially all of the net proceeds of an offering in accordance with its investment objectives and policies within approximately 30 days of receipt by the Fund.
A relatively long uninvested period (unless done as a defensive risk management exercise) is not in the interests of the shareholders whose yield will be effectively lowered.
Is this a dilution?
It is true that some shelf offerings are indeed dilutive - however an ATM offering (where the share price is above the NAV) is accretive to NAV. In this particular case we calculate that shareholders get a bump of about 0.49% to NAV as a result of the offering. Even taking into account the costs of the offering, this is a net positive.
I'm a shareholder - what should I be worried about?
The first thing to think, if not worry about, are the fees. The majority of fees are the 1% paid to JonesTrading in order to sell the funds. In addition to this there are the offering costs and registration fees with the total fees of about 0.20% of common net assets.
The second thing to worry about is whether PDI will be able to source the same high-performing, high-yielding assets in its current portfolio. The general school-of-thought is that in a Mark-to-Market world, this is not an issue as the fund will be able to buy (paying some spread or bid-offer) roughly the same assets as it is currently holding for the same price as they are currently marked in the fund portfolio.
While this is generally true there is some risk for PDI as the portfolio it holds is relatively illiquid. The majority of assets are Level 2 assets with about 5% Level 3 assets defined as assets where "observable inputs are not available". As illiquidity tends to correlate with yield, it is possible that to acquire higher-yielding securities, PDI may either struggle to source them or will need to pay larger bid-offer to acquire them.
The third thing to think about is the impact on the share price. As we highlighted above the maximum amount of new shares is quite large - just over 20% so dumping all of this will no doubt have a negative impact on the share price, though this hasn't happened yet as the PDI price has risen almost 3% since the offering.
What will help is the current risk-on environment where the PDI distribution rate is still very high relative to Treasuries. Something else to keep in mind is that it is very much in the interests of the fund to maximize the share price so as to collect as much cash as possible for the maximum number of shares on offer.
No matter how long we stare at the price action of PDI and its close cousin PCI, we can't tell the negative impact on PDI yet. That said, judging by the latest data, the number of sold shares is still very small at less than 1mm as of April month-end so there is more to come.
The final thing to ask is - is PDI buying assets at the top of the market at the tail-end of an extended macro and investment cycle? We will let this remain a question for discussion because we ourselves don't know the answer to this and only time will tell.
We think this action by PDI is a net positive to shareholders as the premium-to-NAV is very high and monetizing it makes sense. Further, the management team has shown its ability to deliver alpha in a risk-controlled way and so deserve the benefit of the doubt here.
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