PIMCO New York Municipal Income Fund: The Premium Has Been Wiped Away

Summary

• PNF now trades at a slight discount to its net asset value (NAV), a compelling entry point.
• The fund has enough undistributed net investment income (UNII) to cover almost four months of distributions.
• I believe the late January, early February drop was too steep, and expect the fund to recover near-term.

Main Thesis

The purpose of this article is to explain why I believe the New York Municipal Income Fund (NYSE:PNF) is an attractive investment option at its current market price. The fund has seen a steep drop in 2018, but I believe that it is largely unwarranted. The drop has brought PNF down to a very reasonable valuation, trading at a slight discount to its NAV, which gives investors a cheap entry point in to a fund that normally trades at a premium. Furthermore, while income tax rates have dropped, they remain at a level where earning tax free income from municipal bonds is still a lucrative strategy. Finally, the fund's UNII figures are largely positive, giving me reasonable comfort the stated distribution is safe.

Background

First, a little background about PNF. The fund invests at least 90% of its net assets (and at least 80% of its net assets plus any borrowings for investment purposes) in municipal bonds that pay interest that is exempt from federal, New York State and New York City income tax. It also seeks to be "AMT-free" by avoiding bonds generating interest that may subject individuals to the alternative minimum tax. Currently the fund is trading at $11.69/share and pays a monthly distribution of $.057/share, which translates to an annual yield of 5.85%. Year to date, the fund has come under enormous pressure, and it has given investors a negative total return close to 9% when I last reviewed the fund in December. While my previous timing on this fund was completely wrong, I truly feel its recent troubles have been overblown, and would look at these lower share price levels as a great entry point. Despite some headwinds in the municipal bond market, largely due to tax reform, I think PNF is a quality fund that will bounce back, and I will explain why in detail below.

Valuation and NAV Discussion

One of the primary reasons why I am continuing to recommend PNF, despite its poor short-term performance, is because the fund is now trading at a cheap valuation when compared to its historical average. Currently, the fund is trading at a slight discount to its NAV, at -.34%, indicating new investors could technically buy in to the underlying assets for less than they are worth at fair value. While the discount is not huge, it is significant when considering where the fund has traded in the past. Over the past year, PNF has traded between a premium up to 11.37% down to a discount of -.43%, suggesting that PNF is now at the very bottom of its trading range. Furthermore, PNF's average, over the same time period, is to trade at a premium just shy of 6.19%, well above its current level. While PNF is well below its average and highs for the year, it is important to note that it is a fund that rarely trades at a discount, so opportunities to buy the fund this cheaply are rare. To illustrate, I have listed all the days over the past year when PNF was trading at a discount:

Discount to NAV	Date(s)
-.43%	2/20/18, 2/21/18
-.34%	3/1/18, 2/22/18, 2/5/18
-.25%	2/6/18
-.17%	2/26/18, 2/23/18, 2/12/18
-.09%	2/9/28

Click to enlarge

Source: Pimco

As you see, it is not very often when investors are able to pick up PNF at a discount, so initiating positions now in my opinion is a prudent course.

Of course, there can be legitimate reasons why PNF will be trading at a cheaper than average valuation, so that is not the only metric to consider. Recent tax reform changes have had an impact, not all positive, on the municipal bond market. Despite this, the value of PNF's underlying assets, which determine the fund's NAV, seem to be holding up fairly well. While the fund's NAV has dropped some since December, over the past year it has only lost about 1%, all while paying out distributions which in total yield over 5%. Since the NAV has remained relatively stable while the share price has dropped, this has caused the premium the fund normally trades at to evaporate. While this has not been great news for existing investors, it does indicate that the share price correction may have been a bit of an overreaction, as the underlying assets have continued to perform. Given that the reason for the evaporating premium is simply a share price drop, and not a fundamental change in the value of the fund's assets, I remain optimistic about the fund long-term.

UNII Figures Show Distribution Is Safe For Now

Another positive factor for PNF investors is the fund has a very solid track record of paying its distribution. Over the past ten plus years, PNF has reliably paid out the $.057/share income to investors, and I have little reason to doubt that will continue in 2018. While increasing interest rates could pressure municipalities, and therefore their ability to make good on their debt obligations, PNF has a pretty solid foundation as we move further in to the new year. According to Pimco's latest UNII figures, the fund currently has $.20/share in UNII in the bank, which is almost four full months of distributions. This gives the fund a nice cushion to pay out its stated distribution, even if current income falters. Furthermore, while the fund's fiscal year to date distribution coverage ratio is a worrisome 80.57%, the good news is that figure is on the rise. The three month rolling coverage ratio now stands at 84.23%, indicating that in the short-term income production has improved over its full fiscal year. That is a positive sign and, coupled with its reliable history and large amount of UNII in reserves, gives me comfort that PNF's high yield is currently safe.

Issuance Down, Demand Picking Up

When determining if municipal bonds are currently the right fit for your portfolio, it is important to consider the impacts on this sector from the recent tax overhaul. Some aspects are positive, such as keeping the income exemption on federal taxes. Other aspects, such as the lowering of corporate and individual tax rates, are negative, as they decrease the attractiveness of tax sheltered vehicles (since the savings are lower, in isolation). Given this mixed bag, each CEF should be reviewed in isolation to see if the changes offer a net benefit. In my view, PNF looks attractive, and not just because of the valuation as I mentioned above. What I like about PNF is it is focused on New York municipal bonds, which is a high-tax state and one whose residents will be impacted by the new $10,000 limit for deducting state tax against federal taxes. This has the ability to makes munis more attractive to NY citizens. Of course, if the demand goes up, PNF share price will benefit. This has clearly not panned out so far in 2018, but I believe as the dust settles from these tax changes, investors will be drawn to NY Munis once again.

Of course, demand is only one part of the price equation, supply is another. If supply continues to decrease, this could also make the existing Munis more valuable. And this aspect has already come to fruition, thanks largely to the tax provision prohibiting tax-exempt advance refundings. This led to a flurry of issuances last quarter, in order to beat the clock before the tax exemption expired. Many analysts expected this to cause a drop in issuances to start 2018, and that is exactly what has occurred. In fact, January issuance this year was 26% below the level from the same period in 2017. While demand has not sent prices soaring yet, NY Munis have been moving higher when compared to other states. To illustrate, the chart below shows that NY Munis (and New Jersey's Munis - another high tax state) are seeing their yield spread to ten year treasury bonds narrow, while the low tax state of Florida has not seen much movement:

Source: Bloomberg

For me the takeaway is that, while Munis have not rallied broadly, NY Munis are seeing more demand than other states. This helps give validation to the opinion that high tax states will likely see an increase in demand for their bonds, compared to the rest of the country, which is good news for PNF.

Bottom Line

Municipal bonds are supposed to be boring, but over the past few months they have been anything but. The major tax overhaul we saw come out of Washington had broad impacts on the municipal bond market, and the result so far has not been pretty. PNF has been on a steady slide downwards over the past couple of months, wiping out the fund's typical trading premium to the point where it now sits at a discount. However, this presents a real opportunity for new investors to buy in to a reliable fund at a below-average price. PNF has a solid history of paying its stated distributions, and its NAV has held up reasonably well during the recent market volatility. In 2017, municipal bonds performed quite well, with defaults totaling less than $1 billion, after omitting Puerto Rico. With supply tight, low levels of defaults, and the possibility of increased demand from the highly-taxed residents of NY, I believe PNF will head higher this year, and would recommend investors initiate positions in the fund.

Analyst’s 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.