PNF: Income Stream Cut For First Time Since 2007

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About: PIMCO New York Municipal Income Fund (PNF)
by: Dividend Seeker
Summary

PNF saw its distribution cut last month for the first time in over a decade.

The fund still trades at a premium over 9%, despite positive NAV movement this year.

The supply/demand story is positive for municipal debt, but investors need to be selective about which funds they purchase at premium prices.

Main Thesis

The purpose of this article is to evaluate the PIMCO New York Municipal Income Fund (PNF) as an investment option at its current market price. On the surface, I view New York municipal debt quite positively going forward. The high-tax jurisdictions within New York will continue to push New Yorkers in to tax-free income options, such as PNF. Given the new SALT deduction limits, residents of New York, California, New Jersey, and other states who are infamous for taxes should continue to fuel demand for muni debt, while supply remains on the modest side. This scenario is positive for debt funds going forward. Furthermore, New York's annual budget includes some positive developments for state revenues, which should help improve the state's fiscal picture.

However, there are some negative attributes for PNF as well. While the premium to own the fund has come down since January, the fund still trades at a premium price, which could limit upside potential. Additionally, PNF was included in PIMCO's latest round of distribution cuts, which was noticeable given the fund's long track record of maintaining its previous distribution level. Therefore, the fund's outlook is a bit mixed from here, warranting caution.

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." Currently, the fund is trading at $12.96/share and pays a monthly distribution of $.05301/share, which translates to an annual yield of 4.91%. While I have favored PNF for the most part since I started covering it, I was cautious on my outlook in my January review. This was primarily due to the fund's valuation, as well as some negative underlying fundamentals regarding NY debt obligations. Regardless, the fund has performed well since that time, returning over 4%, after accounting for distributions. With this in mind, I wanted to reassess PNF to see if I should change my current outlook, or if caution is still warranted. After a review, my outlook for the fund remains mixed, and I will explain why in detail below.

Distribution Cut - Small, But Significant

The first development I want to discuss is the recent distribution cut PIMCO announced for PNF, along with multiple other CEFs. This is never a positive development in my view, and it was not entirely shocking considering the income production metrics had been declining for some time, which I have pointed out in previous articles. In fairness, the cut was not large in size either, as the chart below illustrates:

Previous Distribution Change in Distribution Percent Change New Distribution (as of 4/1/19)
$.057/share ($.00399)/share (7%) $.05301/share

Source: PIMCO

As you can see, while the cut is certainly a negative sign, it was relatively small, and has not impacted PNF's overall yield in a truly meaningful way.

However, my larger takeaway has to do with the timing of the cut. While a 7% drop in isolation only hurts a little bit, it is particularly significant for PNF because the fund has maintained the $.057/share distribution for over a decade. In fact, the last time PNF cut its distribution was at the start of 2007. So, until now, the fund had a very solid history when it came to distribution consistency. To see a cut now makes me question what is going on with the underlying assets in the fund, and why management felt now was an appropriate time to cut. Therefore, my takeaway here is to watch this fund very closely over the next few months. If PNF is able to maintain this new distribution level, and bulk up its income reserves, I will regain some confidence in the fund. But if the trend continues downward, with this cut in the back of my mind, it will be hard for management to restore the faith I previously had in this investment.

Valuation: Not Expensive, Not Cheap

When I covered PNF back in January, I noted how its premium was getting a bit too steep for my liking. In the past, I had heavily recommended this fund, primarily due to its below-average valuation, when compared to other PIMCO offerings. Therefore, when the premium expanded, I was a bit more cautious on my outlook. Fortunately, PNF has seen its premium narrow since that time, primarily due to an increase in the underlying value of its assets. In fact, PNF's current premium is about 25% cheaper than where it stood at the end of January, and is below its year-to-date premium average, as the chart below illustrates:

Current Premium 9.2%
Premium in January 12.0%
1-Year Average Premium 7.0%
YTD Average Premium 12.1%
1-Year Premium High 15.7%
1-Year Premium Low (1.5%)

Source: PIMCO (with calculations made by author)

As you can see, PNF's current valuation is noticeably better than where it stood a few months ago, and it is cheaper than its short-term average. However, this does not mean the fund is "cheap". It still sits with a premium to NAV above 9%, which is generally above my comfort level for new positions. I rarely recommend buying funds above a 10% premium, so it is right near my typical limit. Furthermore, this premium is noticeably higher than the fund's 1-year average. Therefore, while PNF seems cheaper in the very short-term, it has actually typically traded at a cheaper valuation when the previous year is considered.

My takeaway here is mixed. PNF does not seem to be either a compelling buy or sell based on its valuation alone. At a 9% premium, PNF could easily go in either direction, so investors will have to consider the other attributes of the fund to gauge a clearer signal. For now, I would likely caution patience, but the fact is the fund has indeed proved it can trade at higher levels, so the valuation should not deter investors in isolation.

Positive Developments: Micro and Macro

Now that I have discussed some of my concerns, I want to touch on the positive attributes of the fund, of which there are multiple. To start, I want to highlight that municipal debt remains a popular source of tax-free income in many high-tax jurisdictions, as the SALT deduction limits have exacerbated this benefit. As high-income residents in places like New York seek to minimize their tax bills, funds like PNF will continue to have a place in those resident's portfolios. And this reality has been reflected in PNF's underlying value so far in 2019. In fact, the fund's NAV is up over 5% since the year started, which illustrates that the fund has the right types of holdings for our current market environment. This performance has also helped shrink the fund's premium, even as the share price has risen, which is a win-win situation for current investors.

With this in mind, let us consider just how popular muni bonds are becoming, not just in New York, but nationwide. According to data compiled by Bloomberg, investors have already put more cash in mutual funds that invest in state and local government debt through mid-April than they normally do in a full calendar year. The increase is especially noticeable when compared to 2018, but the trend already beats the past six years individually, as illustrated in the graph below:

Source: Bloomberg

As you can see, the demand is strong, to the tune of almost $30 billion since January 1st. Considering we are not even halfway through 2019, this result is particularly striking. Furthermore, I would expect continued demand because the primary reason for the inflows, an attempt to minimize the impact from the SALT deduction limit, is not going away any time soon. Given that the next election cycle is not until next November, investors should prepare for the status quo for both the 2019 and 2020 tax filing seasons.

While this is a bullish outlook, it was related to the broad muni debt market, and not just New York specifically. I now want to point out a couple of reasons why New York has begun to look more attractive, at least for investors in municipal debt. Namely, I am optimistic on the current year's fiscal position for the state and city, due to some proposals included in New York's 2019-20 budget, which was just recently released. For an overview of some of the changes made, I reviewed a report issued by the Office of the NY State Comptroller, prepared by Thomas DiNapoli, the current State Comptroller. After his summary report, I noticed three developments that should improve city and state finances over the long-term, listed out below:

  • Establishment of a congestion tolling program, in Manhattan's central business district, to fund repairs and improvements for the Metropolitan Transportation Authority.
  • A new requirement to compel internet marketplace providers to collect sales tax on behalf of third-party sellers.
  • Extension of the top personal income tax rate on upper-income residents (for five years)

Source: NY State Comptroller

My takeaway here is that New York has taken some meaningful steps to increase revenues, and for the long-term. Adoption of these new tolls and taxes are fundamental changes and, once enacted, will likely be around for a while. Further, the 5-year extension of the personal tax rate is long-term, and should help revenues going forward. In summary, I view this as longer-term progress, and not just temporary fixes, and provides me with more confidence in New York's fiscal position than I had before the budget came out.

Bottom-line

PNF has performed well in 2019, as municipal debt funds across the board have seen renewed levels of interest. Due to tax changes, residents of high tax states are piling money in to funds like PNF, to limit their tax exposure. This bullish momentum has seen PNF's underlying value rise by over 5% since the beginning of the new year, which has shrunk the market premium even as the share price has risen. Furthermore, New York's fiscal position seems relatively positive going forward, as the state is planning to extend tax increases and enact new taxes and tolls, to create new sources of revenue.

With that in mind, PNF could look like a smart investment choice going forward. However, investors do need to be mindful of the premium approaching 10% to buy the fund, as well as the recent distribution cut. While the after-tax yield on PNF is still impressive, a distribution cut often increases short-term volatility in a fund. Therefore, investors need to be prepared for some swings in the near-term, especially until PNF proves it can sustain the new distribution level. That said, my overall conclusion is investors need to determine why the are investing in PNF, as well as their time horizon. For long-term investors, the near-term volatility potential would just be a bump in the road, and no cause for real concern. For investors who may already have positions, or who have been patiently waiting for the right price to get in, they may want to hold off to see if they can buy-in when, and if, the premium declines to a more attractive level.

Disclosure: I am/we are long PCI. 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.