Safety In Numbers: Using PIMCO CEF Distribution Coverage In Allocation Decisions

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Includes: PCI
by: ADS Analytics
Summary

The current macro environment is not supportive of growing CEF distributions making funds vulnerable to continued cuts.

Given this situation and the tendency of CEFs to drop sharply in price on distribution cuts, we think investors should pay attention to distribution safety signals.

We review the information provided by PIMCO on their CEF suite and find PCI as a clear standout featuring attractive coverage, UNII, covered yield and discount.

Income investors use closed-end funds for their high yields and distributions that tend to be more stable than those from ETFs and Mutual Funds. This distribution stability, however, can be a two-edged sword - when distributions are cut the fund's price often bears the burden of investor disappointment.

In this article, we review the information PIMCO makes available about their CEFs and how investors can use it to their advantage. Within the PIMCO CEF suite, we continue to like PCI which has relatively strong distribution coverage, high UNII and an attractive combination of covered yield and discount.

In this article, we focus on distribution coverage and UNII - metrics that PIMCO readily provide on a monthly basis for each of their CEFs. It's worth mentioning, however, that there are other metrics that provide a more holistic picture of distribution safety. These metrics include a downward sloping net NAV trajectory, overly high NAV yield, ROC section 19a notices and the lower-frequency NII income from annual and semi-annual reports. These indicators should be used as part-and-parcel of a broader distribution safety analysis.

Why Care About Distribution Safety?

The PIMCO fund PGP is a poster-child (among a number) for what happens when a fund cuts its unsustainable distribution. PGP has done this three times in the last five years and each time was met with sharp price drops. These drops represented permanent capital loss for investors in the fund.

Source: ADS Analytics LLC, TIINGO

Potential distribution cuts is something we follow for all the sectors we cover because a distribution cut is usually a double-whammy for investors: they lose a source of previously-stable (and usually higher than average) yield and they lose on the price action as such funds typically suffer steep price drops following the cut.

Macro Trends Driving Distributions Lower

Another reason to be careful about potential distribution cuts is because the current market environment has not been supportive of growing fund earnings. In fact, funds have been squeezed on all sides. We think three trends are driving distribution cuts.

Short-term rates have been growing steadily over the last few years as the Fed attempts to navigate away from its zero interest-rate policy. This has pulled other short-term rates like Libor higher which are used as benchmarks of short-term borrowings used commonly by CEFs as a source of leverage.

Source: FRED

Secondly, a flat yield curve presents little reward for extending duration offering little premium for both reinvested and borrowed cash.

Source: FRED

Thirdly, risk premia have fallen, particularly in the fixed-income space. Apart from a brief spike in credit spreads at the end of 2018, spreads have remained relatively tight, offering little compensation for taking credit risk.

Source: FRED

These market trends have combined to limit opportunities for CEF earnings growth, particularly those operating in the fixed-income space.

PIMCO Distribution And UNII Figures

PIMCO publishes distribution coverage and UNII figures on a monthly basis for their suite of CEFs with the latest available figures from April. Why are these figures important? They are key in gauging a fund's ability to maintain its distribution rate. PIMCO funds have historically tended to cut their distributions when distribution coverage sits well below 100% and UNII is negative, with a varying lag.

While there is some uncertainty around the distribution decision-making process at PIMCO as well as the fact that lumpy earnings can add noise to the data, it has become clear over the last few years that there is a historic pattern to distribution decisions which this data helps with.

There are two components to distribution safety that PIMCO makes available:

  1. Distribution coverage level and trend and
  2. UNII level and trend.

What we ideally like to see is distribution coverage > 100% with a rising trend and UNII > 0% with a rising trend. Of course, this rarely happens but it's the ideal scenario.

1. Distribution Coverage Level And Trend

The chart below captures both the level and trend of the 6-Month rolling distribution coverage for PIMCO CEFs with easy-to-see color coding. The majority of funds have coverage below 100% with most trending lower as well. The chart is fairly slim pickings. There are few funds with above 100% coverage and stable or rising trend.

As we suggested above, while this data is helpful, it does not provide certainty as to which funds will be cut and when. This is because the decision to cut by PIMCO is forward-looking, that is, the management team look at the landscape of potential opportunities to gauge whether the distribution is truly unsustainable. Last April, for example, the funds that cut distribution had varying degrees of coverage and UNII.

Source: PIMCO

PIMCO provides coverage for various periods. And although we like using 6-Month because it tends to be less volatile and more in line with semi-annual payment convention used by fixed income instruments, seeing coverage for the current fiscal period can be useful as well. In the case of PCI, the fiscal year period is longer than 6 months which explains the more muted trajectory of that coverage line. It may be useful to observe the 3-Month line for any change of direction, however, it should be used with caution as it tends to be more noisy.

Source: PIMCO

A way to get a quick snapshot of latest coverage figures for both 6-Month and the current fiscal year is with the following chart. In most instances, the two figures are not far apart. Fiscal year coverage tends to be higher for those funds with their fiscal year longer than 6-Month which suggests that fund earnings have fallen steadily over the last year.

Source: PIMCO

2. UNII Level And Trend

UNII, or undistributed net investment income is the other piece of the puzzle. The traditional view is that funds with a positive UNII balance can dip into it to pay distributions even if they are underearning it. This may not save the fund from an eventual cut but it may give it some breathing space. It's worth adding that for funds like PIMCO CEFs that use derivatives; UNII does not always present a completely accurate picture. Furthermore, a number of previous cuts included funds with positive UNII.

Straight UNII figures are not helpful because they are not easily comparable between funds due to different distribution levels. This is why we instead present UNII distribution ratios which give a sense of how many distributions are represented by the current UNII level. Viewed another way, this figure gives us the number of months worth of distributions that the UNII contains.

Two funds stand out to us here on the negative and positive side. On the negative side, the two recent cuts from PGP and PHK are not surprising in retrospect as they look the worst on the chart. On the positive side, the muni funds PCQ and PML have strong UNII and may have some room to go before they cut given their sub-100% coverage.

Source: PIMCO

Using This Data In Positioning

Distribution coverage and UNII are useful supporting metrics in gauging distribution stability but they only get you so far. One of our favorite combo metrics to use in gauging fund attractiveness is the combination of covered yield and discount. Covered yield combines current yield and distribution coverage and estimates what the fund is actually generating in earnings. The discount is indicative of both the riskiness of the fund's yield (the wider the discount the less risky the yield, all else equal) as well as the riskiness of the fund's price (a wide discount provides a margin of safety for the fund's price).

On this metric, we see that PCI is a clear standout. When we cross-check its distribution and UNII stats, we see that while its recent coverage trend is mixed, its 6-Month and fiscal year coverage is still above 100%. The fund's UNII distribution rate also stands at 1.5 - a favorable level.

Source: ADS Analytics LLC, TIINGO

Conclusion

Since the current market environment is not supportive of growing distributions, we think investors should pay attention to CEF distribution safety signals such as coverage and UNII. We review the latest figures for the PIMCO CEF suite and find that PCI remains attractive on these metrics.

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.