PKO: Despite Expensive Price, Shares Keep Pushing Higher

Dec. 17, 2019 8:03 PM ETPIMCO Dynamic Income Fund (PDI)26 Comments8 Likes

Summary

  • PKO investors have had a lucrative year in 2019.
  • The fund offers a high income stream, which should remain in demand next year, as the Fed keeps interest rates near historically low levels.
  • The premium to own PKO has risen quite a bit, which concerns me as a value-oriented investor.
  • With high yield spreads having narrowed considerably this year, I see limited upside potential to the value of those securities, which could limit PKO's total return.

Main Thesis

The purpose of this article is to evaluate the PIMCO Income Opportunity Fund (PKO) as an investment option at its current market price. I have been cautious on PKO for some time, and remain convinced this is the right mindset going in to 2020 as well. While this has been a fund I have owned in the past, I divested the holding as the premium to NAV rose to a level I found unattractive. In my view, the premium was due to come down, offering up a better buying opportunity, but that has not materialized in 2019. PKO continues to push higher, sending the premium to an unusually high level (for this fund). This has occurred because PKO's income stream is in demand, as interest rates have declined and below investment grade assets have posted strong returns this year. On this backdrop, it is certainly possible the fund could head even higher still in the new year.

However, I see reasons to be cautious. Aside from the expensive price, PKO's income metrics are a bit weak. My fear of a distribution cut is minimal, considering the fund recently announced a special distribution for December. Nonetheless, these metrics are something to keep an eye on in the short-term. Furthermore, PKO holds quite a bit of high yield debt. This has benefited the fund this year, but I see limited upside potential going forward due to the narrowing of credit spreads for the sector to historically low levels.

Background

First, a little about PKO. It is a "closed-end fund with an investment objective to seek current income as a primary focus and also capital appreciation. It invests a substantial portion of assets in a variety of mortgage-related securities and also may hold common stocks." Currently, PKO is trading at $27.62/share and pays a monthly distribution of $.19/share, which translates to an annual yield of 8.25%. When I reviewed PKO back in August, I reiterated my "neutral" rating. In hindsight, that call appears appropriate. While PKO has seen a pretty strong gain since then, the broader market, including both equities and fixed-income have been performing well, as shown below:

Source: Seeking Alpha

Heading in to 2020, I am reviewing all the funds I regularly cover, including PKO. After review, I continue to believe a "neutral" rating is appropriate, and I will explain why in detail below.

Premium Keeps Pushing Higher, NAV Growth Limited

Back in August, I highlighted PKO's growing premium as a reason for my cautious outlook, which was consistent with my outlook for many PIMCO CEFs. Clearly, the fund has pushed higher in the interim and, while good news for current investors, this reality has sent the premium to even higher levels. While this development gives me pause, it is worth nothing that PKO is not alone in this regard. The majority of the market, across most equity sectors, fixed-income sectors, individual stocks, and PIMCO CEFs, have all seen their valuations rise as the risk-on trade has come back strong. While last December was quite painful for investors, this December has started off very well, and expensive valuations do not seem to be much of a deterrent right now.

While it is entirely possible this momentum could continue from here, I have to remain focused on value. When premiums and earnings multiples are rising, it is easy to get caught up with the crowd and chase performance, but experience tells me these are the times to be especially selective about entry points. Missing out of further gains is painful, yes, but overpaying for funds is more detrimental to long-term performance, in my view. With this in mind, it is important to put PKO's current valuation in perspective, and the chart below has some relevant metrics related to the premium to NAV:

Current Premium 15.4%
August Premium 11.2%
YTD Premium High 16.2%
YTD Premium Low 5.9%
Average YTD Premium 10.1%

Source: PIMCO

As you can see, PKO is at a lofty price right now, and is actually less than 1% away from its high of the year. Further, it is well above its short-term average, which is a metric I use religiously when gauging buy and sell opportunities.

Of course, investors can view this information in a more positive light than me. For instance, PKO has moving higher and higher as the year goes on, so the momentum is clearly on the side of the bulls. The fund has the wind to its back so to speak, and could certainly push the valuation needle even further. Additionally, PKO has had positive, but slight, NAV growth in 2019, as shown below:

NAV 1/1/2019 NAV 12/13/19 YTD Gain
$23.72/share $23.93/share 1.0%

Source: PIMCO

My takeaway here is there are not any reasons to panic, but investors need to carefully consider buying at these levels. While the short-term trading history suggests the premium will persist, there does not seem to be a strong chance of it moving much higher, considering the modest NAV gain this calendar year.

Income Metrics Are Weak, Special Distribution Helps

My second point concerns the fund's income production, which is always a critical area when evaluating PIMCO CEFs. This is an area that has not impressed me in the short-term based on UNII metrics, but PKO has continued to deliver anyway. Further, its distribution history is very strong historically, which gives justification for ignoring short-term blips in coverage ratios, as the fund continues to find ways to meet its stated distribution obligations.

This time I continue to see pros and cons. Specifically, the latest figures from PIMCO's UNII report show a mixed bag for PKO. The fund has seen its UNII balance improve dramatically, but its coverage ratios do not impress. To illustrate, consider the UNII report from my August review, compared to the most recent report, as shown below, respectively:

Source: PIMCO

As you can see, this report does not exactly inspire confidence. However, investors buying this fund have to consider the longer term history, and put these numbers in perspective and not view them as a reason to avoid the fund all together. For a very recent example of why this picture does not tell the whole story, consider that on the back drop of weak UNII figures, PIMCO announced a $.16/share special distribution for PKO. This was a bit surprising, considering how the fund has been performing recently, and it speaks to the general strength of this fund. In fact, the majority of PIMCO CEFs did not announce special distributions, so PKO's inclusion on this list is very positive.

My takeaway here is to monitor the income story going forward. PKO's metrics give me some pause, but the fund has a way of delivering, so I will continue to expect consistent income from this fund until I'm given a very compelling reason not to. For income-oriented investors, I see PKO as a way to gain exposure to a highly reliable income stream. Whether the premium price is too high for that stream, is truly up for each individual investor to decide.

High Yield Spreads Indicate Limited Upside

I now want to discuss PKO's underlying holdings, to offer further justification why my neutral outlook makes sense. During my prior review, I discussed the non-agency MBS sector, because that is PKO's largest individual sector by weighting. This time around, however, I want to take at the high yield sector, because this area makes up almost 27% of total assets, so it is also very important for the overall performance of the fund, as illustrated below:

Source: PIMCO

To begin, this is an area that has benefited PKO over 2019. While fixed income as a whole has done well this year, on the backdrop of declining interest rates, modest economic growth, and continued investor confidence in the market, high yield has done exceptionally well. Essentially, investors have been willing to take on extra risk on the prospect of higher total returns, and that has indeed been happening. To illustrate, consider the year-to-date return of the the high yield corporate bond index, compared against the year-to-date return of the U.S. aggregate bond index, as shown below:

Source: S&P Global

Clearly, high yield has been a winning play this year, and so has PKO by extension. While this is a positive story, the downside is it will be difficult for gains like this to continue. As the sector has soared, the spread between high yield and investment grade credit has narrowed considerably. In fact, the current spread is the lowest it has been since Q1 last year, as shown below:

Source: Lord Abbett

My takeaway here is this is justification for caution. Clearly, the high yield sector has been in demand, and investors are more than likely quite pleased with this exposure. However, using this graph as a historical guide shows us that spreads will have a difficult time tightening further, as it does not happen often. While I am not forecasting a rapid widening in spreads any time soon, I would expect total return will be limited to much smaller gains going forward.

Low Sovereign Yields Provide Support For High Yield

While I have struck a cautious tone in this piece, I want to reiterate that I am not "bearish" on the high yield sector, or PKO. In fact, I believe 2020 will offer positive returns in most investment categories, but at more modest rates than what we saw this year. I suspect equities and fixed income products will see inflows due to continued economic growth, more clarity on geopolitical issues such as U.S./China trade relations and U.K./EU separation negotiations, and, most of all, low interest rates around the world.

My point here is that, despite concerns over corporate profitability and rising debt levels, investors are going to be forced to take on risk to earn a reasonable income stream. While interest rates have declined markedly in the U.S., they have around the world as well, to the point where multiple governments are offering negative yields on their sovereign debt. Further, even with three interest rate cuts in the U.S. this year, government bonds stateside are offering the highest yield in developed markets, as shown below:

Source: Goldman Sachs

My point here is options are limited, and this supports high yield sectors. In fact, not only are sovereign yields low on an absolute basis, but on a relative basis as well. The graph above shows current yields are at the lower end of the 12-month range for every country on the list. Therefore, when we consider how well high yield debt has performed over the past twelve months, I see current yields as a key tailwind helping the sector to further, but more modest, gains in 2020.

Bottom line

PKO continues to perform. Despite less than stellar UNII reports recently, the fund has maintained its 8% distribution rate, and even delivered a special distribution paid this month. With exposure to the mortgage debt market and high yield corporate credit, I see opportunity for this fund in the short-term. However, there are reasons to be cautious. PKO trades at an expensive price and, using history as a guide, could fall quite a bit if it reverts back to its longer term average. Further, as low interest rates have come to be expected by investors, any uptick in rates in the new year could stall the current bullish momentum. Therefore, I continue to express caution for PKO at these levels, and recommend investors consider new entry points very carefully.

This article was written by

Dividend Seeker profile picture
7.41K Followers
CEF/ETF income and arbitrage strategies, 8%+ portfolio yields

Macro-focused investor and Finance professional. Born and raised in New York, but have escaped to North Carolina. I was a D1 athlete in college (men's tennis) and compete competitively to this day. My Bachelor's and MBA are both in Finance.

I provide reasoned, fact-based analysis of different funds and sectors. I list my portfolio here so readers can gain insight into what I am buying/holding, what I'm not, and how that lines up with the views I present in my articles. 

Broad market: VTI; VOO; QQQ; DIA, RSP

Sectors: VPU / BUI; VDE / UCO; KBWB; XRT

Non-US: EWC; EWU; EIRL; EWA

Dividends: DGRO; SDY, SCHD

Municipals/Debt Funds: NEA, BBN, PDO, BGT

Stocks: WMT; JPM, MAA

Cash position: 20%

Follow

Disclosure: I am/we are long PCI, PCK. 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.

Recommended For You

Comments (26)

To ensure this doesn’t happen in the future, please enable Javascript and cookies in your browser.
Is this happening to you frequently? Please report it on our feedback forum.
If you have an ad-blocker enabled you may be blocked from proceeding. Please disable your ad-blocker and refresh.