Seeking Alpha

PIMCO CEF Relative Value Ideas

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Includes: PCI, PCN, PDI, PFN, PHK
by: ADS Analytics
ADS Analytics
Research analyst, value, debt, closed-end funds
Summary

The combination of CEF market inefficiencies and the presence of CEF discounts presents an opportunity for successful relative value analysis and trading.

One relative value approach, which we discuss here, attempts to find funds holding broadly similar portfolios that are trading at wide discount differentials.

Potential relative value opportunities flagged within the PIMCO CEF suite are PFN over PCN and PCI over PHK and PDI.

The discount dynamic of closed-end funds adds an interesting second layer of potential alpha for fund investors. Just as investors look at valuations of underlying asset classes to guide their allocation decisions, they should and do consider the discount valuations of closed-end funds themselves. This second layer of valuations driven by movements in fund discounts creates a new set of opportunities for both tactical and strategic investors.

Just about anyone can point to a switch or a relative value trade that worked out for them. However, in order to build a consistent and ultimately successful investment process, we have to approach it in a systematic way. In this article, we take a look at such a relative value approach for closed-end funds.

As a case study, we use the PIMCO suite of multi-sector closed-end funds because they are large, familiar to fund investors and mostly managed by the same group of senior managers. Our approach identifies potential opportunities in the PIMCO Income Strategy Fund II (PFN) over PIMCO Corporate & Income Strategy Fund (PCN) and the PIMCO Dynamic Credit & Mortgage Income Fund (PCI) over the PIMCO High Income Fund (PHK) and the PIMCO Dynamic Income Fund (PDI).

The Flavors of Relative Value

There are many different ways to think about relative value ideas. At Systematic Income we follow two different approaches:

1. Price Cointegration: This approach, which is very common for pair trading of stocks, finds funds that share a common price trend with deviations from this trend flagged as potential opportunities.

2. Portfolio Cost: This, arguably more intuitive, approach, which we introduce and describe in this article, tries to identify funds that hold a broadly similar set of assets but trade at an unusual discount differential.

The Portfolio Cost approach illustrates the three principles which form the bedrock of our fund market analysis: margin of safety, not taking uncompensated risk, and CEF market inefficiency.

Margin of safety is the familiar concept applied to the CEF market where we attempt to rotate into similar assets which, for one reason or another, are undervalued by the market.

Holding funds which are trading at elevated valuations rarely makes sense, particularly when there are similar cheaper alternatives. Holding such overvalued funds while there are cheaper alternatives is an example of taking uncompensated risk, something we try to avoid.

Our third principle has to do with the fact that the CEF market displays an unusual amount of inefficiency which is what often allows these relative value opportunities to persist.

Portfolio Cost Relative Value Approach

Our relative value approach hinges on two key factors: 1) Finding pairs of funds holding similar assets and 2) selecting the pairs that are trading at divergent absolute or relative discount valuations.

In order to gauge whether two funds have broadly similar portfolios, we use the following metrics:

  • NAV return correlation - This is the familiar metric of co-movement in NAV returns.
  • NAV return differential - This metric ensures that a pair of funds have not had widely divergent NAV returns, an obvious sign that the funds do not hold similar portfolios.
  • NII NAV yield differential - Net investment income NAV yield is essentially a measure of fund earnings which should be similar for funds holding similar portfolios. We have to be mindful, however, that varying expenses, leverage costs and fluctuating distribution coverage figures can skew this metric somewhat.

Why can't we just use NAV correlation? The somewhat technical answer to this question is that NAV correlations measure co-movement around the respective trends. So two funds could have a high positive return correlation but steadily diverging trends. So, while a high NAV correlation is necessary, it is not sufficient to identify funds holding very similar assets.

And for measures of cost we use both absolute and relative metrics: discount differentials as well as the percentile rank of the most recent discount differential relative to history. We try to identify fund pairs that not only trade at a large discount differential, but also trade at a differential that appears extreme relative to its own history.

It may seem self-evident, but it is still worth asking why we are looking for funds with more attractive discounts. After all, there are many examples of funds trading at a premium that just keeps steady or grows with time. One reason is that funds with wider discounts tend to be less fragile in the sense that any negative surprise, be it distribution cuts or performance, is punished much less by the market. For example, just last year PHK and PGP suffered double-digit daily losses on negative distribution surprises.

The second reason why we look for funds with more attractive discounts is that wider discounts translate into lower prices which in turn translate into higher yields, all else equal. This allows investors to allocate less capital to achieve a given income stream.

Whenever talking about PIMCO CEFs, we would be amiss to ignore historic valuations. Current average discount of the PIMCO funds is close to a historic high. And while relative value opportunities can still make sense at elevated absolute levels of valuation, investors should keep this in mind to make sure it still suits their investment approach.

Source: ADS Analytics LLC, Tiingo

Results

The table below shows the top picks from our calculations. The table is split into two sections: three portfolio similarity measures and two measures of portfolio cost.

The table is sorted by fund pairs with highest portfolio similarity and widest cost disparity so that the most attractive pairs (those with most similar portfolios and widest cost disparity) are shown at the top.

Let's take a look at some of the individual pairs.

PCN vs. PFN

PCN and PFN have a 92% NAV return correlation over the past year and a 3-year total NAV return differential of 1.7% or about half a percent per annum.

Source: ADS Analytics LLC, Tiingo

Looking at total NAV returns, PCN has marginally outperformed PFN over the last three years.

Source: ADS Analytics LLC, Tiingo

Another way to look at relative performance is by plotting the gross NAV as a ratio. This chart shows clearly that after trending until 2016, the performance of the two funds has been pretty similar since then.

Source: ADS Analytics LLC, Tiingo

A set of similar recent returns is supported by a similar allocation. One difference between the two funds appears to be a somewhat larger mortgage allocation by PCN as well as slightly more leverage overall.

Source: PIMCO

On the pricing side, the two funds have a discount differential of 23% which is at a 95th percentile, meaning the current figure is higher than 95% of historic observations. We can see this in the chart below where the PCN premium has clearly pulled away from PFN.

Source: ADS Analytics LLC, Tiingo

We can see this more clearly in the following chart which plots the discount differential of the two funds.

Source: ADS Analytics LLC, Tiingo

Are there good reasons for this absolute and relative disparity in discount valuation?

The relative discount picture stands in contrast to fund yields. PCN current yield is 2% below that of PFN which makes this situation slightly unusual as tighter discounts tend to go with higher yields. On a 12-month trailing yield basis, we can see that PFN has had the advantage over PCN for the last couple of years.

Source: ADS Analytics LLC, Tiingo

So, what could be driving the PCN premium?

One reason could be that PCN has consistently delivered about a 0.5-1% additional return in NAV per year than PFN. Part of this could be due to the fact that PCN pays a lower rate on its ARPS. Another could be the higher leverage and a larger allocation to non-agency RMBS which have performed particularly well. We think both the ARPS and the RMBS drivers will be less impactful going forward as PIMCO has been shedding its ARPS and non-legacy RMBS assets are fully valued.

Another reason may have to with a stronger coverage and UNII position by PCN although this advantage has persisted for some time. It would be a stronger case for PCN had the two funds traded at a similar premium. However, given they have been trading at different premium levels suggests that the difference in coverage is already priced in.

Source: Systematic Income CEF Tool

We have to remember, however, while these factors can drive a difference in discounts, it is harder to explain a sudden change in discounts so we think the relative value case for PCN over PFN still holds. In other words, while there is some evidence that PCN should trade at a higher premium than PFN, the sudden surge in its premium does not make sense to us.

PDI vs. PCI

PCI and PDI have a 89% NAV return correlation over the past year and a three-year gross NAV return difference of just 0.3% or about 0.1% per annum.

Source: ADS Analytics, Tiingo

On the pricing side, the two funds have a discount differential of 11.5%.

The chart below shows three-month rolling NAV daily return correlation of the two funds. The fact that the rolling correlation has moved higher over the last three years is not by chance as it coincides with an investment objective shift by PCI to look more like PDI.

Source: ADS Analytics LLC, Tiingo

Looking at total NAV returns, PDI had been outperforming PCI since 2017 until PCI closed the small gap recently.

Source: ADS Analytics LLC, Tiingo

Let's now have a look at the relative pricing of the two portfolios.

PDI has historically traded at a tighter discount to PCI and this looks to have grown with time.

Source: ADS Analytics LLC, Tiingo

The discount differential is more clearly seen in this chart with PDI trading at around a 10% premium to PCI over the last few years.

Source: ADS Analytics LLC, Tiingo

One potential reason for the PDI premium may have to do with slightly better coverage and UNII, but we don't find this argument totally convincing as the relative coverage position of the two funds has flipped around without affecting the relative discount position.

Source: Systematic Income CEF Tool

Much like the case of PCN vs. PFN, we think part of the PDI premium has to do with stronger historic return over PCI. However, this outperformance over PCI is clearly non-repeatable given the one-off appreciation of non-legacy RMBS assets as well as the convergence of the investment objectives of the two funds.

At the moment, PCI is trading at a slightly higher current yield than PDI as well as a higher TTM yield which we think should support PCI in relative terms.

Source: ADS Analytics LLC, Tiingo

Unlike the case of PCN vs. PFN, there has been no recent divergence in discounts between PCI and PDI. However, we think PCI and PDI are even more similar to each other than the other pair which suggests that the absolute discount differential should go away.

In other words, while we think PCN and PFN could trade at different discount levels, their recent discount divergence doesn't make sense to us. And in the case of PCI vs. PDI, we don't think these funds should trade at a different absolute discount level at all.

What does this approach exclude? This approach excludes multiple factors that many investors rightfully deem relevant. For example, by construction, it doesn't work for portfolios that are different from each other. It also doesn't look at yields or expenses. That said, we can argue that ultimately yields and expenses represent distributions and costs paid out from total NAV returns so they are not fully independent signals.

Where can this approach go wrong? One way this approach can go wrong is in the way that the two portfolios differ. Recent market behavior offers an example. Consider two funds A and B that share 94% of the portfolio with the remaining 6% invested in the Argentina century bonds in fund A versus long-term US Treasuries in fund B. Recently, the Argentina bond shed a third of its value while US Treasuries have consistently rallied, which would have led to a roughly 3% underperformance of the second fund year to date, all else equal. While this can certainly happen (as it did in TEI and some PIMCO funds), it would be quite unusual. This is why understanding portfolio composition is as important as its valuation and why this approach should serve as a complement to fundamental research.

Takeaways

We think the relative value approach we outlined in this article can be used by a broad set of investors. Tactical investors can benefit from potentially fast-moving dislocations while more strategic investor can effectively upgrade their core holdings by rotating into cheaper expressions of their desired assets. For this reason we like PFN over PCN and PCI over PDI.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.