Members of Yield Hunting: Income Solutions received this analysis early with significantly greater detail on when to get in, what thethoughts were of a distribution cut, and how long the selling would last.
Almost simultaneously we saw two news factors emerge on PIMCO closed-end funds on October 16th. For one, there was a negative article on PIMCO Credit and Mortgage Income (PCI) posted on Seeking Alpha by Maks F.S. In the article titled, "PCI - Not For Me," Maks, a well-known CEF writer on the site, went through a litany of data points on why he wouldn't buy or own PCI.
One of the central points of the piece was that most people do not know what is in the fund, not even most advisors. He writes:
PCI is also not an easy fund to write about because it has so many moving parts and it is NOT an easy to understand fund like the majority of closed-end funds are.
The author makes the mistake of confusing derivatives and complexity, i.e. moving parts. While derivatives are received like a four-letter word to many investors, in the bond world they are a positive, especially for a high-quality firm like PIMCO. This firm more than any other, save for a few of the top hedge funds, has been exceptional at constructing highly complex debt portfolios with defensive postures to rising rates. In addition, they have built a deep bench of analysts that use bottom-up analysis to find the best securities in a specific sector.
But how do they find the sector they want to be in?
Each year, the company puts on a "Secular Outlook" where they invite dozens of speakers for a three-day event. The hope is to identify "the key forces, whether political movements, demographics, technology, and other fundamental trends, that will drive the global economy and financial markets.
The PIMCO Secular Forum is an integral part of our investment process, which combines a disciplined “top-down” macro view with rigorous “bottom-up” research on individual securities, companies, sectors and countries. No investor has a crystal ball, but at PIMCO we do have a process that we have refined over 40 years to enable us to seek above-benchmark returns at benchmark levels of volatility while aiming to provide yield and preserve the capital we invest on behalf of our clients.
So yes, you are doing a little of the "In PIMCO We Trust" by holding shares of PCI (or any other PIMCO fund for that matter), but you are backed by an exceptional team of portfolio managers, analysts and traders. There are few if any fixed income teams with the depth of knowledge that PIMCO boasts simply because of the name recognition and large resources that they can deploy to give them an informational edge.
In the depths of the housing collapse, PIMCO played their contrarian hand and entered the non-agency MBS (we discussed what non-agency MBS are in our July update). We wrote:
A non-agency MBS is typically issued by a bank of mortgage originator and consists primarily of mortgages that do not qualify to being acquired by one of the quasi-government agencies. Much of these securities were issued between 2001 and 2007 during the "housing bubble." Very little new issuance has been created since the Financial Crisis.
Think of these securities as the crappy loans issued by Countrywide, Washington Mutual and New Century Financial - also known as CDOs (collateralized debt obligations). This is a reason why the credit quality exposure is blank. We have discussed this in detail in past reports but will reiterate again for new members.
After the financial crisis, the credit rating agencies (Moody's and S&P) reduced this sub-prime MBS to junk status (or in the majority of cases, to unrated which to most investors is the equivalent of junk). Prior to the financial crisis, most of these securities were rated investment grade (and in many cases AAA). If you recall from the movie "The Big Short" Steve Carell asks the lady from S&P how she could rate them AAA. She says that if they don't their clients would take their business elsewhere. Crazy, I know.
So after the cat was out of the bag and defaults racked up, the credit agencies were forced to cut the ratings on these securities. Most of the investors in these securities are institutional investors like pension funds. Again, recall from the beginning of the movie when they discuss the advent of the MBS and that the Michigan pension would buy $25 million.
But these investors have stipulations that they cannot own junk rated debt so once the credit agencies cut their ratings, the pensions were forced to sell. This was done at the absolute worst time and often at fire-sale prices. PIMCO was their to be a buyer of these securities as their credit analysis suggested that the discounts to par were so great that they were effectively pricing in 80%-plus default rates.
For reference, the negative piece we cited earlier had a table of the asset allocation breakdown. The table shows 29.6% in non-agency MBS. However, most of the ABS also is invested in the same type of security.
When visiting their office in 2012, I can recall one of the portfolio managers telling me that if the borrower was paying their mortgage in 2010, having made it through the financial crisis, the likelihood of still paying going forward was much higher than what was being priced in to the security. Funds like PIMCO Income (PONDX)(PIMIX) bought large baskets of these securities and a closed-end fund, PIMCO Dynamic Credit (PDI) was launched to hold it.
The author also cites the issue with the fund not covering the distribution through net investment income ("NII"). That is definitely true as the most recent monthly report shows a 61% coverage ratio. They thus have to fund some of the distribution through capital gains. We have again noted why this is the case in many of our prior write-ups. Essentially, the non-agency MBS trade is one of total return. Unlike most bond trades which are "interest only" with some marginal upside potential depending on the price paid, non-agency debt was purchased at substantial discounts to par. In some cases as low as 5 cents on the dollar. Now, PIMCO doesn't expect to get back par since many of the mortgages within the pool defaulted in the financial crisis. But it doesn't need many mortgages continuing to pay and eventually refinance to get back a multiple of their investment.
In addition, many of the non-agency positions are zeroes, meaning they pay no income like a traditional bond. These securities are issued at a discount to par and inch up to par as it approaches maturity. GAAP accounting is simplistic in that coverage ratios are calculated only by using net investment income divided by distribution. Capital gains are not a part of the coverage ratio.
But imagine a closed-end fund that only contains zero coupon bonds. GAAP accounting would say that the fund had a coverage ratio of zero but would have capital gains as the bond would amortize towards par as it approached maturity.
In summation, the GAAP earnings and UNII statement is not a great barometer of whether the funds' distributions are sustainable. But we do have a great way to gauge how well that investment strategy is working with a daily calculated NAV. We have said over and over that the NAV embeds all information whereas the monthly earnings releases are GAAP accounting. Compared to almost all other high-yielding debt structures (BDCs, mREITs, eREITs, MLPs, private equity), this is highly transparent.
To determine whether a fund has "earned" its distribution is actually quite straightforward. Simply look at the change of the fund's NAV on the last day of the month compared to the starting day of the month. If the difference is zero or above, than the fund earned its distribution. Done.
NII is simply not a good marker to analyze funds of this strategy. It's a total return play that we've periodically called the busted-to-rehabilitated MBS trade. PIMCO has played this one perfectly though they are not alone. They simply have the size and resources to take better advantage of the opportunity. These securities trade in very large blocks which restricts an individual investor from simply buying a single security. It can take months of research by a team the size of PIMCOs to analyze the underlying pools of mortgages and understand whether the entire block for sale is worth the price.
There also is a discussion about the leverage of the fund. Depending on how you calculate it, the leverage does make the fund much riskier than a traditional bond mutual fund or ETF, which do not have any leverage. In addition, the credit quality is a bit lower though PIMCO and we believe we are getting more than compensated for that added risk. The leverage is about 70% today or 0.70 turns. While that sounds high, think of your local community bank. While the business is slightly different in that they originate loans, you can think of PCI and a bank as being in a similar business. Those banks are typically levered 400%-600% or 4.0x to 6.0x. In some cases more.
Mortgage REITs are a closer comparison to PCI. They hold mortgages, in some cases originate them, and lever up. But they typically lever by 700%-1000%.
Fees are high. But we would argue that the 2% management fee is actually a good deal for access to one of the best management teams in the business. Often access to these types of managers is restricted for accredited investors only and comes with fees of 2% and 20% of profits, or more. The fund can be thought of as a pseudo hedge fund. PIMCO often places their top ideas in their closed-end funds including actual bond positions. Their open end funds are simply too large for many of these types of trades and the portfolio managers are forced to use derivatives to gain enough of the exposure that they want.
One thing we agree with him on is when he says "I don't believe retail investors belong in funds that even financial professionals have a hard time understanding."
But that is where we come in, helping our members and those who don't understand the complexity of a fund like PCI. Sure, an individual investor who is not in the industry may not fully understand what is going on, and some of it is a bit opaque. However, they should be able to understand the general investment philosophy and drivers of performance. We think most of our members could give us the main sub-sector investment that PCI (and PDI for that matter) invests in.
PIMCO Closed-End Fund Analysis
Looking at the UNII trends of the funds, one must have to remember that they are based on GAAP accounting which is substantially different than tax accounting and gets into the fine minutiae of custodial accounting. For the most part, GAAP accounting tends to ignore certain gains from hedging and trading positions, and understating tax accounting UNII which is what the special distribution at year end is based upon.
Still, the trends are likely consistent for both types of accounting methodologies and bears watching. For example, PCI saw GAAP UNII drop from $-0.05 to $-0.11 while PDI went from a +$0.10 to $-0.05. Those are some significant swings. But again, one month does not make a trend.
The coverage ratios over the last three months have been largely stagnant down just 3% in aggregate (Sept three-month coverage minus June three-month coverage). The big movers are PDI at +23%, PTY +20% and PZC +19%. It should be noted that the last cut their distribution significantly starting in August, helping to improve coverage.
The largest decliners in coverage are PCM at -34%, PCN at -19%, and PGP at -15%. PCI has lost 8.6% of coverage over that same period.
We are witnessing the latest bout of panic selling by a predominantly retail investor base. Many investors cannot stomach the volatility. If that is the case, they shouldn't be invested in closed-end funds in the first place. However, this low-yield environment and equity market valuations have forced investors out on the risk spectrum. We label these investors transient holders as they are likely to sell quickly at the first sign of panic.
This opens up an opportunity for those patient enough to buy when other shareholders are rushing for the exit. The last few of these opportunities have been beneficial for investors. While the NAV has flattened some recently, it is still in an upward trend. We will obviously keep an eye on it and the potential for a special distribution later this year.
Disclosure: I am/we are long PCI, PDI.
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.
Additional disclosure: The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned.
The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy.
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.