Seeking Alpha

PDI: Sometimes Great Funds Cost Too Much

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About: PIMCO Dynamic Income Fund (PDI)
by: Dividend Seeker
Summary

PDI is up over 10% since my last article almost four months ago.

However, the rising share price has been accompanied by a rising premium to NAV, which should make investors cautious.

While I remain bullish on mortgage debt, it is important to recognize non-agency MBS issuance is up markedly this year, which could pressure prices on the bonds.

Main Thesis

The purpose of this article is to evaluate the PIMCO Dynamic Income Fund (NYSE:PDI) as an investment option at its current market price. PDI is a fund I have recommended many times, most recently in mid-July. In general, I like the makeup of the fund, as it is invested heavily in non-agency mortgages that have performed quite well post-recession as incomes and home prices have grown, while mortgage delinquencies declined.

While I still believe PDI is a solid fund, I believe caution is warranted at current levels. This is primarily because the fund's premium to NAV has risen considerably, to the point where I cannot justify new purchases. While most PIMCO CEFs are seeing their premiums rise, PDI's level is well above its normal trading range. This tells me a correction could be coming soon. Furthermore, while the non-agency MBS sector continues to be beneficial for the fund, it is worth noting that the supply of these types of bonds is up markedly year-over-year. Investor demand has so far been robust enough to handle this increase, but if demand wanes, this influx of bonds could start to weigh on prices. Given this reality and the premium PDI trades at, this does not seem like an opportune time to pick up new shares.

Background

First, a little about PDI. It is a closed-end fund with a primary objective to "seek current income, with a secondary objective of capital appreciation." Currently, the fund is trading at $33.61/share and pays a monthly distribution of $.2205/share, translating to an annual yield of 7.95%. I most recently covered PDI back in July, when I felt the fund offered a compelling entry point. In hindsight, buying then would have been quite profitable, as PDI has seen a total return over 10% since that time, as shown below:

Source: Seeking Alpha

Given the run PDI has had in a short period of time, I wanted to reassess the fund to see if I should alter my outlook. After review, I am changing my bullish rating to "neutral", and I will explain why in detail below.

Premium Has Gone Way Up

I will begin the review with the primary reason for my shift in sentiment. Simply, this is the fund's valuation. While PDI was not "cheap" when I recommended it in July, its premium was actually under its 1-year average, and I do feel this fund warrants a premium price. As my readers know, I am a value-oriented investor, but that also means I will pay up for quality.

That said, there is a limit to how much I will pay for even quality funds like PDI, and the current price is certainly at (and likely past) that limit. To put the current valuation in perspective, I have compiled some relevant metrics in the chart below:

Fund Current Premium Premium in July YTD Premium High YTD Premium Low YTD Premium Average
PDI 23.2% 10.5% 23.2% 7.0% 15.4%

Source: PIMCO (with calculations made by Author)

As you can see, PDI's premium has surged higher in a short period of time. While this reality has helped deliver a robust total return to existing shareholders, it has greatly increased the price for new investments. Specifically, PDI's current valuation is resting at its highest level for the calendar year, which should make investors cautious from the start. Furthermore, the 23.2% premium sits well above the average price for the year, and is more than double where it sat just under four months ago in July. All things considered, PDI is clearly very expensive right now.

My takeaway here is investors need to recognize they are not getting a value price for these shares, no matter how strong PDI has been performing and what its outlook might be. While I generally believe PDI's underlying holdings are well positioned to register gains in 2020, investors need to be careful they are not overpaying for this exposure. While timing highs and lows of individual funds is near impossible, using history as a guide here tells me patient investors will likely get a better entry point in the future. On the surface, a 23% premium is simply too expensive for me, and it seems even more so when I consider how PDI typically trades. Given this reality, I feel moving to a "neutral" rating is most appropriate right now.

Income Production Remains Very Strong

My next point on PDI has a much more positive slant, and is a key reason why I would not be "bearish" on this fund. Specifically, this has to do with the fund's income production, which is of paramount importance for CEF investors with an income focus. Over time, PDI has proved itself to be one of the more reliable PIMCO CEFs when it comes to paying out its distributions. The steady, high income level delivered by the fund is the primary reason I have recommended it many times. And, based on current metrics, I continue to see plenty of strength in this regard.

To illustrate, consider PDI's UNII figures from my July review, compared against the most recent UNII report from PIMCO, shown below, respectively:

Source: PIMCO

As you can see, PDI's metrics have been strong for some time, and are getting even stronger. There has been a marked boost in the short-term coverage ratios, which tells me the fund has plenty of bullish momentum. Further, the UNII balance has more than doubled in a very short period of time. This tells me the income stream is very safe for now, as the fund has about three months of income in reserves to pay the distribution if current income falls. Additionally, it raises the likelihood of a special distribution in December to a very high probability. All in all, this is great news for PDI investors.

Clearly, I view this report quite strong, and the progress displayed continues a multi-month trend since the start of the year. While I view PDI's income stream as safe and attractive, the cost of obtaining access to this income stream does concern me, as I mentioned above. Therefore, it is up to each individual investor to decide if the price to own this future income is reasonable enough for them.

Non-Agency MBS: Delivering Gains, But Supply Rising

The next part in the discussion will center on the underlying holdings of PDI. This is a fund that is heavily invested in mortgage-related debt, with non-agency mortgage debt making up over half the fund's total assets, as shown in the chart below:

Source: PIMCO

While this figure is down from over 52% in July, you can see the performance of this sector will have a disproportionate impact on PDI as a whole, so examining the current environment for non-agency MBS is critical to determining if buying now makes sense.

As my readers know, this is an area I have been bullish on for some time, and I remain optimistic on the sector broadly today. Nationwide, the mortgage market has been performing well, and continues to improve year after year post-recession. This trend has been aided by low unemployment, rising wages, and rising home values. All of these factors contribute to homeowners paying back their mortgage obligations, on-time. In fact, according to the most recent figures from the St. Louis Federal Reserve, the delinquency rate on single-family residential mortgages sits at 2.59%, which is a post-recession low.

Clearly, when homeowners pay their mortgage debts on-time, this is a win for everyone - the homeowner, the bank/lender, the investor, and the economy as a whole. Further, while the current figures are strong, I expect mortgage delinquencies to continue to remain low, if not go even lower. One key reason is that home prices continue to climb, which gives homeowners additional incentive to remain current on their debts and not go in to default. After price growth slowed in August, national home prices increased 3.5% in September (year-over-year), according to data from CoreLogic. This solid reading helps continue a multi-year trend of rising home prices in every price point, as shown in the graph below:

Source: CoreLogic

As you can see, low default rates and rising home prices have been the story for some time, and that has boded well for PDI. In fact, the underlying strength in this corner of the market is the principal reason why PDI has seen strong gains to its share price this year.

However, while the story behind the broader housing market is solid, we have to consider PDI's unique exposure to the non-agency MBS market. This is a sector that offers exposure to non-traditional mortgages, which could be jumbo loans or other loans that do not meet the criteria to obtain the traditional agency-backing. In fairness, I have personally been advocating for exposure to this sector for quite a while, as I saw little risk to the sector compared to the higher yields it offered. But as 2019 has gone on, the supply story in this sector has begun to make me a bit more cautious, and that impacts my outlook on PDI.

To illustrate, consider that non-agency MBS issuance has soared in 2019, on a year-over-year basis and especially when we consider the years preceding 2018, as shown below:

Source: Bloomberg

Clearly, issuance is way up, and that should give investors some pause. While demand has so far been able to meet this uptick in supply, it has kept a lid on prices. In fact, this is a reason why PDI's premium has soared. While investors have clamored to buy the fund, the underlying value of PDI has not actually moved much in 2019, which is pushing up the market price premium:

NAV on 1/1/19 NAV on 11/5/19 YTD Gain
$27.26/share $27.28/share Flat

Source: PIMCO

My takeaway here is simply to be careful. While PDI has plenty going for it, the premium price it charges tells me investors need to be completely sure of the outlook for this fund before buying-in. While I still believe non-agency mortgage debt is worth the inherent risk for the higher income stream, there are other ways to obtain this exposure without buying a fund at a 23% premium. With supply rising across the sector, I don't expect robust NAV gains for PDI in the short-term. This means the premium will not be coming down unless the share price corrects a bit, and that is not a scenario investors who purchase now will want to see.

Bottom Line

PDI has performed very well in the short term, delivering a 10% gain in under four months. With this bullish momentum, strong income metrics, and a robust housing market, investors in PDI are undoubtedly liking what they see.

However, I am shifting my bullish outlook to neutral for a few reasons. One, the cost to own PDI is much too high right now. With a history of trading at a premium well below its current level, I believe being patient right now is a smart course. Furthermore, while non-agency MBS are broadly performing well, issuance of those types of bonds is up markedly in the last few years. This rise in supply could limit price appreciation from here, especially for funds that already charge steep premiums. Therefore, I am no longer recommending PDI at these prices, and will wait for a better valuation to do so again.

Disclosure: I am/we are long PCI, PNI, PMF. 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.