At High Dividend Opportunities we have been writing a series of reports to our members to highlight some of the best fixed-income CEFs, preferred stocks, and bonds. We have been increasing the allocation of our model portfolio to high-yield preferred stocks and bonds while still being able to achieve an overall yield of +9%.
The fixed income space is one of the most defensive and conservative ways income investors can get high yield while diversifying and reducing risk. In 2018, most fixed-income investments declined as fears of rising interest rates ruled the market.
We started the year bullish on high-yield and fixed-income securities. Back in January,we predicted that the Fed would slow down interest rate hikes, writing:
With slower growth and lower inflation, the Fed will become increasingly cautious with further interest rate hikes. Currently only two hikes are expected in 2019 (compared to four in 2018) and we would not be surprised if even this outlook was cut to only one or none.”
We identified that value stocks and fixed-income would be likely to start outperforming growth stocks. Since then, we have made numerous suggestions for quality preferred equity, bonds, and closed-end funds ('CEFs') investments.
January proved to be the bottom for many of these investments, and several of our picks are off to a fantastic start for the year. Unfortunately, investing cannot be done retroactively, so we need to continue finding the best opportunities for fresh funds flowing into our investment accounts.
Overall, we remain very bullish on the fixed-income space. While the spectacular start to the year might have some believing that a pullback is imminent, the long-term trends continue to favor fixed-income over growth investments.
In a recent report, we discussed PIMCO's Dynamic Credit and Mortgage Income Fund (PCI). A fund managed by the world-class asset manager Pacific Investment Management Company LLC (PIMCO). PIMCO has earned an excellent reputation and has several funds that can provide investors with stable and predictable dividends.
PCI is one of PIMCO's newer funds and was trading at a small premium to NAV when the article was published. Today, we take a look at one of PIMCO's older funds that has survived through the Great Recession and has a proven track record of reliable returns for income investors.
PIMCO Corporate & Income Opportunity Fund (PTY) has a strong history and has produced outsized returns for long-term investors. For fixed-income investors, PTY is definitely worth considering as a core holding.
PTY primarily invests in corporate bonds and notes, although they are diversified with almost 55% of their assets allocated to various other fixed-income investments.
These investments are actively managed, meaning that PIMCO can and will trade in and out of investments as management believes is appropriate. To improve returns, PTY has a leverage level of approximately 40% of assets. Their leverage consists of credit default swaps, preferred shares, and reverse repurchase agreements. Their portfolio turnover rate is typically 35-45%, so overall, PTY is quite aggressive about moving in and out of positions.
Since PTY primarily invests in fixed-income style investments, declining interest rates are generally going to be positive for net asset value (NAV). However, with their frequent trading, investors can expect PTY to perform differently than direct investments in bonds. The decisions made by the managers could have large impacts on the ultimate returns. This is why it is very important to pay attention to the historical track record of management.
For a fund that invests primarily in corporate bonds, PTY has had nothing less than stellar total returns.
Since inception in 2002, PTY has produced annualized returns in excess of 14%. PTY IPO'd at $15, so the vast majority of those returns were paid to shareholders in the form of dividends. It is this kind of consistent outperformance that has led to PIMCO's great reputation.
Like any investment in the market, PTY is not immune to price and NAV swings. Through the recession, PTY did have a drawdown of almost 60%. We are often asked "what-if" questions. Fear is growing and many investors believe that a full-blown bear market is going to begin at any time.
We believe that a bear market is still more than a year away, but we have to account for the reality that one could start tomorrow. This is one of the reasons why we have been moving into fixed-income investments.
Consider PTY crashing 60% from 2007 to mid-2009. It is never fun watching your investment account dip so deeply into the red. If anyone is selling an investment style that claims to avoid those occasional hits, be very cautious!
All investments in the market are vulnerable to large drawdowns. But as we can see from history, if you are in quality investments those drawdowns will recover. From the bottom in 2009 to 2010, PTY had an incredibly strong recovery.
Timing Vs Holding
So what if the market crashes and our PTY investment crashes with it? Looking at history, investors in 2008 had two options- they could have sold after the initial crash when it was "only" down 30%, hoping to buy back in at the bottom or they could have held through and waited.
Option 1 sounds very attractive. After all, if you can sell before the bottom and then buy back at the bottom you "saved" a large portion of the fall, and can benefit from the entire leg back up. Unfortunately, that tactic is much easier looking at historical charts.
Identifying the bottom in real time is much more difficult, investors could have easily believed that the bottom came in October or November 2008, and felt briefly vindicated when prices rose into January, only to feel the pain when it fell again in February/March.
Investors attempting to time the market run the risk of rebuying too early, or worse, waiting too late and having to buy in at an even higher price than they sold for. Plus you could have additional complications with tax implications and friction costs from buying and selling. We are not saying that such strategies are impossible, but they require a great deal of luck, even for those with great skill.
We suggest the buy & hold approach. Yes, it hurts to watch your statement balance go deep into the red. If you don't need to sell, and the investment is still high-quality, the price will rebound. One of the reasons why we have a strong preference for high-yield dividend investments is that dividends provide us with a consistent stream of cash from our portfolio.
Here is a look at how an investment in January 2005, when PTY was yielding 8.5%, the same ballpark it is yielding now. In 2006, PTY reduced the regular dividend towards the end of the year, however, they actually paid out more due to a larger special distribution.
Through the recession, an investor would have seen their income decline 9% from the initial year and 13% from the peak. So while there was a lot of volatility in price and NAV dropping 30% and then ultimately 60% from the peak, the volatility for income was substantially lower.
Income investors had two down years, which were more than made up for during the rebound as PTY paid oversized special dividends in 2009 and 2010. Having that stream of income continue to be deposited into your investment account monthly goes a long way towards alleviating the psychological pain of a bear market.
The performance of PTY in the last recession is precisely why we are focused on high-yielding income investments. During a bear market, when investors are panicking and selling to realize massive double-digit losses, we can be confident that our income stream will be impacted by a lesser amount. The funds streaming into our account monthly can be used for whatever we need, including being used to acquire "growth" stocks that are 40-60% less expensive than they were the prior year.
Premium Vs Discount
At HDO, we love a good discount and we frequently find and recommend opportunities that are on sale. PTY is not that type of opportunity. Over its history, PTY has rarely traded below NAV and has frequently traded at a premium of 20%+ over NAV, which is where it trades now.
The current premium is higher than average, but not the highest it has ever been. It is reasonable to believe that the premium will likely trend downward and there are certainly many investors who might pass on investing in PTY at all until the premium does decline.
It is important to remember that the premium/discount does not change based on market price alone. When we first published our PCI article to our members, PCI was trading at $23.17 and the NAV was $22.78 a 1.7% premium. Today, PCI's NAV is $23.14, and the premium is still over 2% as the market price has increased as well. Investors waiting for a "discount" would have missed the April and May dividend payments and would still be waiting with their cash on the sidelines.
With treasury yields generally continuing to decline as the year goes on, we expect this to be bullish for fixed-income investments. This is going to provide tailwinds for PTY’s NAV. So while the discount looks large now, we expect increases in NAV, combined with dividend distributions will be the primary drivers behind reducing the size of the premium.
Waiting for a lower premium does not necessarily mean it will be a lower price, or that the investment will achieve a larger total return. Investment’s like PTY are best looked at through the value of their income stream. This is an income stream that has historically proven to be reliable.
PTY’s dividends have primarily been funded from Net Investment Income, with only $0.14 considered “return of capital” over the past 5-years. PIMCO has proven to be good stewards of investor’s funds, and with the anticipated tailwinds for fixed-income investments, we believe PTY remains a very good investment today.
Misconceptions about PTY
PTY has been seeing its price increase lately due to declining treasury yields and due to expectations that the Federal Reserve will cut rates in the year 2020 if not earlier. While some will argue that PTY is trading at a large premium, we have to keep in mind that over the past several years we were in an environment where the Fed was hiking interest rates. Of course, rising interest rates is bearish for fixed income products like PTY. Now that interest rates are expected to further decline, we strongly believe that PTY will continue to go up in price. Valuations of high quality CEFs like PTY should be looked as a function of interest rates rather than as a function of premiums and discounts. Demand for PTY is only set to increase as interest rates decline over the next few years.
Note that PTY is a special fixed income CEF whereby the managers make money in both rising and declining interest rate environments. It is also worth to note that PTY has seen its price increase during periods of high volatility and when equities were sharply pulling back. The reason is that this is a defensive investment. I am personally long PTY and this is one of my largest positions.
PTY has consistently traded at a large premium precisely because it is one of the best managed CEF’s in the world. The fund has been tested under the toughest conditions, and while that did lead to a substantial drop in price and NAV, the level of income was far more stable.
We have identified clear tailwinds for fixed-income investments. Interest rates are declining and it is very likely that the Federal Reserve will be reducing target rates in the next year or two. That is bullish for fixed income because as rates drop, investments fixed at higher rates become more attractive and prices rise.
Second, while we don’t know exactly when a bear market is going to come about, it is only a matter of time. Signs of a slowing economy will encourage more investors to move into the relative safety of fixed-income investments. At HDO, we have been ahead of this movement and have been able to lock in yields at much higher rates than they are likely to be trading at next year.
These factors are creating an environment that is very bullish for PTY and NAV should continue to increase. Additionally, with increasing NAV and a favorable environment, we expect that the premium to NAV will remain above 20% for the foreseeable future. Each month, investors holding out for a “better deal” will find themselves missing a dividend payment.
PTY is an investment that is yielding over 8.6%, with the additional upside of special dividends which are paid in December- last year it was $0.07. They have a solid history of providing income even through bear markets, and maintaining NAV over the long-term. This is exactly the kind of investment we want to be in when the market sours.
PTY is a BUY under $18.60, which will lock in an 8.5%+ yield.
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Disclosure: I am/we are long PTY, 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.