An Update To The Greatest Bond Fund Of All Time

Summary

• The fund has been able to generate double-digit annual total returns since inception by investing in non-agency MBS.
• Interest rates have been neutralized through their pay-fixed swaps allowing the fund to return 2.65% YTD.
• As positive housing and employment trends continue for the rest of the year, the fund should continue to perform well.

Members of Yield Hunting received this report early and potentially with more actionable advice.

We have written in the past (HERE) how we believe PIMCO Dynamic Income Fund (NYSE:PDI) is the greatest bond portfolio of all time. We have detailed our thesis surrounding that several times - that the fund is essentially a distressed debt hedge fund. When the fund launched back in late 2012, they were able to allocate a large percentage of proceeds from the IPO to non-agency MBS.

Those are the largely subprime mortgage from prior to the financial crisis. PDI managers bought those formerly AAA rated - not all were AAA but almost all were investment grade rated - for pennies on the dollar. These were busted MBSs that no one wanted and the institutional investors were trying very hard to sell. Many pension funds, endowments, and insurance companies have strict ratings requirements that forced them to sell the securities once they were no longer investment grade.

An MBS is just a pool of mortgages that are then sliced up into tranches. As a borrower fails to pay, their house is foreclosed upon and the mortgage pulled from the pool permanently impairing its value. This was demonstrated in the movie The Big Short by Ryan Gosling's character when he kept pulling the jenga blocks out of the stack.

(Source: The Big Short)

The fund now has a five-year track record, which we posted below. The fund started trading May 25, 2012. It is hard to find a better quality asset that has performed so well.

(Source: CEFConnect)

In fact, since inception, the fund has outperformed the S&P 500 total return, and by a handsome margin.

PDI Total Return Price data by YCharts

When the fund initiated, they had ~46 million shares outstanding. Roughly one year ago, they filed an N-2 with the SEC to issue more shares through an At-The-Money offering. This is a fairly rare thing to do in closed-end funds compared to a rights offering. The fund sponsor trickles out new shares into the market slowly over time generating proceeds.

Today the fund has 50.8 million shares and still trades at roughly the same premium that it had when it started. The largest concern we had was if the non-agency MBS positions would be diluted away similar to what has happened in PIMCO Income (PONDX) (PIMIX). Below is an excerpt from the semi-annual report from December. The highlighted line shows that they were able to deploy some of the proceeds into the non-agency trade.

(Source: PIMCO Semi- Annual)

The fund is also fairly insulated from interest rates with a slew of pay-fixed swaps occupying the top ten holdings. Those swaps are on different sections of the yield curve with most occupying the long-end of the curve as indicated by the "- 10yr" in the first holding. As rates rise, the value of the swap increases and it is marked-to-market at a higher amount, which all else equal, increases the NAV.

(Source: CEFConnect)

Of course, should interest rates reverse course and head lower, the reverse could be true. These swaps would then act as a headwind to performance.

The other key variables remain housing and employment measures, which have all been trending positively. Housing remains in growth mode with prices rising on tight supply and new permits and construction pointing to further gains.

Employment continues its growth streak and we are starting to see some of the first signs of meaningful wage growth.

In the last PIMCO monthly UNII and earnings report, there was significant improvement to the key metrics. Our thesis that the January report, which showed the large declines in coverage and UNII figures being one-time expense driven, was likely correct. Whether that was the realization of some unrealized losses or the initiation of non-zero cost swaps remains to be seen. We're inclined towards the former.

Of the taxable funds, the average coverage ratio improved 15 points on the 3-month coverage ratio. We expect that to decline next month in the March report as, all else equal, the roll-off of December will likely hurt coverage. UNII improved by a nickel to minus one cent.

Of the taxable funds, 8 of the 11 improved coverage with only PCM Fund (PCM), PIMCO Strategic (RCS) and PIMCO Global Stocks Plus (PGP) seeing some deterioration. We were not surprised by the fall in PCM given how high the coverage ratio was in January. RCS's coverage continues to be weighed by the NAV, which had been falling slightly but has stabilized in the last month.

UNII:

(Source: Alpha Gen Capital)

Coverage:

(Source: Alpha Gen Capital)

Conclusion

PDI should continue to perform well through different interest rate environments so long as the housing market remains vibrant. These vintage MBS will slowly gain value and continue to throw off nice income streams even as rates rise. We have detailed the trade in full in previous writing on this fund and its brother, PIMCO Dynamic Credit and Mortgage (PCI).

While interest rates and financing costs have risen, the interest rate swaps that the fund has, has mitigated any pain that they would otherwise have felt. Since the start of the year, during a period of time when interest rates rose significantly, the fund has risen 2.64% handily besting both the Barclays U.S. Aggregate Bond Index and the S&P 500 Index.

We still believe this is the greatest bond fund of all time - at least in retail format available to everyday investors. Most of the "good" bond fund returns today are relegated to hedge funds that can lever up and delve into the dark corners of the market. But PDI has been able to simply buy and hold these non-agency MBS and watch them accrete in value while collecting a strong income stream. As investors in the fund, we have benefited mightily from it.

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Analyst’s Disclosure: I am/we are long PDI, PCI, PGP. 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.