Pimco Income Fund: A 5% Yield Still Looks Good

Summary

• Investors in class D shares of Pimco's Income Fund (PONDX) recently saw their shares convert to class A shares (PONAX).
• The funds are very similar, and PONAX's current yield remains attractive as low interest rates linger.
• The fund's net asset value (NAV) is essentially flat from a year ago, indicating the fund has held up well while other bond funds have dropped.
• Domestic inflation figures and global economic growth are both slowing, which should help bonds short-term.

Main Thesis

The purpose of this article is to explain why I believe Pimco's Income Fund Class A (MUTF:PONAX) is an attractive investment option at its current market price. The fund's distribution, based on its NAV, is yielding over 5% annually, which remains attractive as investor expectations on interest rates are pared back. The fund has held up reasonably well, considering that bonds have been under pressure over the past few months. Furthermore, economic growth on a global level is slowing down, which is raising doubts about the return of inflation, especially in the short-term. This bodes well for broad based bond funds, including PONAX.

Background

First, a little about PONAX. The fund seeks to maximize current income, with a secondary objective of long-term capital appreciation. The fund invests in a range of fixed income securities, predominately with a duration between 0-8 years. Its primary benchmark is the Bloomberg Barclays U.S. Aggregate Index, which covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. Currently, the fund is trading $12.21/share and pays a monthly distribution of $.0514/share, representing an annual yield of 5.05%. I was an investor in PONDX, which recently saw its shares converted to PONAX, as part of a consolidation effort by Pimco management. As someone who has covered PONDX in the past, and was directly impacted by this conversion, I wanted to assess PONAX's current outlook and determine if the fund makes sense to hold given our current market climate. I believe it does, and I will explain why in detail below.

US Inflation Figures and Fed Guidance

Inflation data always impacts bond funds, but it is especially important in today's market. Inflation data is driving Fed guidance on interest rate increases, and that, in turn, is causing some volatility in the bond market. Over the past few months, on the backdrop of a growing economy and tax reform, investors anticipated increased inflation and more hawkish Fed activity. However, over the past couple of weeks these expectations have cooled. The Department of Labor reported in March that the Consumer Price Index (CPI), a key inflation gauge that excludes food and energy, increased .2% in February. While this is an increase, it compares to a .3% increase in January, so price gains are currently slowing. Furthermore, core prices rose just 1.6% in February year over year, while the inflation measurement that includes food and energy increased 1.8 percent in February from a year earlier. The main takeaway from this is that both of those figures are below the Fed's inflation target of 2%.

So what does this mean for PONAX? To me, the result is largely positive. Fears over rising inflation were the main driver to the drops we have seen in the stock market recent. As the latest report shows, inflation is not getting carried away, and has actually slowed since January. Prior to the latest figures and Fed announcement, investors had been increasing the odds of a fourth interest rate increase this year. Currently, that expectation has subsided. The Fed's March statement indicated their guidance for 2018 was unchanged (which assumes three rate hikes). Even though its latest projections indicated they may be more hawkish in 2019, that did little to disrupt the bond market. The 10-year note, which yielded 2.89% before the Fed statement, briefly rose as high as 2.94%, before closing lower than the day before at 2.885%. Given that the Fed didn't express worries about inflation spiking out of control, I don't see the yield rising sharply in the short-term. This means PONAX's yield above 5% still has a nice spread over what long-term government bonds are offering, and I still view this as an attractive investment for the current year.

Global Growth Is Slowing

Global economic growth, another driver of recent inflation concerns, has also been subsiding. This has raised some doubts over how damaging inflation will be over the near term. The chart below illustrates the Citigroup Economic Data Change indexes, which measure the strength of economic releases relative to one-year averages:

Source: Bloomberg

As you can see, the synchronized global economic growth we had been witnessing over the past couple of years is reversing. Growth, while slowing across the board, is down sharply in important economic areas like the Eurozone and Japan. While many areas are still experiencing growth, which is obviously a positive, the growth is not getting out of control. This should help to calm inflation fears. Steady and/or below-average growth is not a recipe for out of control inflation, so I believe selling off bonds now over inflation fears is largely unwarranted at current levels.

Stable NAV, Quality Holdings

While it's undeniable that PONAX's NAV has declined since the start of the year, its longer-term trend is more reassuring. Over a one-year period, PONAX's NAV is essentially flat, clocking in currently at $12.21/share, while a year ago it was at $12.25/share, representing a decrease of .003%. Considering what has gone on in the bond market over the past year, this is pretty steady performance, all while paying out a distribution yield in excess of 5%. To further illustrate how PONAX has held up, consider that since the start of the year, its share price is down 1.5%. For comparison, the iShares Core US Aggregate Bond Index (AGG) is down 1.8%. This is noticeable out-performance, especially once you consider PONAX has a higher yield as well.

The other aspect I find attractive about PONAX is the fund's quality portfolio. Over 70% of the fund is invested in either government-backed debt or investment grade credit, which I view as a positive. As we face an increasingly complicated stock market and mixed interest rate outlook, I would advocate purchasing quality bond funds in lieu of highly leveraged, below-investment grade debt. Furthermore, the remaining portion of PONAX is largely mortgage related debt, which is a sector that has performed strongly over the past few years as foreclosures have declined and home values have risen. In fact, we ended 2017 on the backdrop of ever rising home prices, giving homeowners and would-be homeowners confidence in their purchases:

Source: Bloomberg

Coupling quality assets with a quality management team is a winning strategy, and that is exactly what Pimco's PONAX is doing at the moment.

Bottom-line

PONAX is a solid income fund that has out-performed its benchmark every year since 2012. As a fund focused on investment grade and government backed debt, the fund offers an above-average yield but with little default risk. As tax cuts and global economic growth increased inflation expectations, bonds have taken a bit of a beating. However, growth is beginning to slow, and recent CPI figures have showed that prices are not rising rapidly, soothing inflation fears. This bodes well for bonds, and Pimco's bond funds are some of the best in the business. While rates are rising, they are set to remain historically low for the next 12-18 months at least, making the above-average income PONAX provides all the more valuable. Given this backdrop, I continue to like PONAX, and would encourage investors to consider initiating positions in the fund at this time.

Analyst’s Disclosure: I am/we are long PONAX. 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.