- A key part of building an income stream is to have core investments that can be counted on to be reliable in any conditions.
- When looking at CEFs, we want a high-quality manager, a good strategy and proven income generation.
- This CEF consistently hits all of our targets.
- PCI offers an 8.5% yield with lower price volatility.
- Looking for a portfolio of ideas like this one? Members of High Dividend Opportunities get exclusive access to our model portfolio. Get started today »
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At High Dividend Opportunities, some might say we are obsessed with dividends. When we think about it, we are guilty as charged. Your brokerage account will focus on the big number, that number will change second to second, and it's a measure of how much money you would have if you had sold every stock in your portfolio at a specific point in time.
Investors will put great weight on that number, even when they have no intention of selling anytime soon. Even though anyone who has invested through a few bear markets, through the flash crash, through a few waves of panic, is all too keenly aware of how quickly that number can change for the worse.
For most people, what's the ultimate purpose of their investment accounts? In most cases, it's to provide an income during retirement, so that when they are unable or simply no longer wish to work, they do not need to sacrifice their standard of living.
We focus on building an income stream. After all, if income is what you need, why wouldn't generating income be your primary focus? A large part of our strategy is to invest in funds that can be relied on to provide stable income in a variety of economic conditions. Through a bubble bursting, housing collapse, coronavirus or whatever fears the market is reacting to, we want to know that our dividend payment is coming in.
PIMCO Dynamic Credit and Mortgage (PCI) is one of five "must-own" funds that we have in our model portfolio. This is a super high-quality fund that we can rely on to provide us with a stable dividend through a wide variety of macro-economic conditions. PCI pays a monthly dividend of $0.174, for a yield of 8.5% at current prices. Additionally, PCI has paid a special dividend in six of the past seven years in addition to their regular payments (and would boast that 8.5% yield even higher). Here's a look at PCI's historic special dividends:
Here's a look at why PCI is among the best CEFs in the market.
One of the largest factors in choosing a CEF is the manager. Unlike ETFs, CEFs are actively managed. This means that the manager is actively making decisions to buy and sell based on their research, projections, and experience. An ETF will have a set of fixed rules and will buy and sell as an investment passes or fails the test.
With the introduction of people making decisions, a CEF can outperform the market or underperform the market depending on the decisions they make. PIMCO has earned a very good reputation in the bond world and has proven themselves to be a world-class team with numerous funds that have materially outperformed the market.
With PCI in particular, PIMCO has been able to consistently outperform peers, both on a market price and NAV basis.
When it comes to choosing a manager, PIMCO is clearly best in class.
PIMCO explains the goals of PCI as,
The fund utilizes a dynamic allocation strategy across multiple fixed income sectors, with an emphasis on opportunities in developed and emerging global credit markets, to pursue current income as a primary objective and capital appreciation as a secondary objective.
This goal aligns very well with our portfolio goals - current income first, capital appreciation secondary. Since CEFs are actively managed, how they go about achieving those goals is subject to change at the manager's discretion. PIMCO releases regular commentary that's available on their site discusses their economic outlook and their strategic positioning.
We continue to emphasize a "bend-but-don't-break" philosophy by targeting assets that are resilient across multiple economic scenarios. In particular, we target investments that are linked to real estate, benefit from high barriers to entry and have strong asset coverage.
PCI has historically been heavily invested in non-agency MBS (mortgage backed securities). Mortgages remain their highest exposure. Here's a look at their current allocation.
PCI's focus on MBS also explains why their leverage is so high. For MBS, it's extremely common to use "reverse repurchase agreements." This is where the borrower utilizes the security they are buying as collateral and "sell" it to the lender with the agreement to buy it back at a point in the future at a set price.
These agreements are usually very short term, 30-90 days and occur at very low interest rates. It's a type of borrowing that can comfortably allow for substantial borrowing. Compared to other institutions that invest in MBS, say mREITs, PCI's leverage is actually quite low.
Looking at their leverage statistics, we can see reverse repurchase agreements make up most of their borrowing.
While all leverage creates a level of risk, the risk with these types of agreements is fundamentally different than say if PCI issued senior notes for a similar amount of money.
Price vs. NAV
CEFs trade similar to equities in that they have a fixed number of shares that trade on the open market. When you buy PCI, you are buying from another investor, not directly from PIMCO. This means that the price can often be separated from NAV (net asset value) and it can trade at a discount or premium to NAV.
Since we are focused on income, our primary concern is that PCI is capable of continuing to make dividend payments. We are less concerned about the price swings which represent what the market is willing to pay for the income stream. One possible warning sign for a CEF is if their NAV is being eroded away as it pays dividends.
We can test this by looking at PCI's change in NAV since inception, compared to PCI's "total return price" which includes the impact of dividends.
PCI has been able to consistently pay out dividends without eating into the NAV. Since inception, PCI has paid out over $13/share on an original NAV of $23.88.
The bottom line is that PCI is a reliable source of consistent dividends.
Today, PCI is priced at 4% premium to NAV, around its lowest premium in the past 12 months.
Investors looking at this chart might say something like "Hey, PCI has historically traded at a discount, I will wait for it to come back down." We heard this when we wrote about PCI back in March 2019. At that time, PCI had just started trading at a premium.
Since then, PCI raised its monthly dividend, paid a special dividend of $0.45/share and the price is still higher than it was, even after the market correction. The reason? The price of PCI has little to do with premiums and discounts and more to do with general interest rates. For example, today, the 10-year Treasury yields have tumbled to their all time lows at 1.3%.
Consider PIMCO Dynamic Income Fund (NYSE:PDI), a very similar fund. It has the same managers, similar exposure to mortgages, similar leverage and has actually slightly underperformed PCI over the past three years on a NAV basis.
PDI is a little bit older than PCI. Here's a look at PDI's premium.
Once PDI started trading at a premium, it didn't look back. The premium continued to climb and is now at a substantial 20% premium to NAV. Investors waiting for it to get back to a discount are still waiting three years later.
A large portion of what drives the premium or discount to NAV is the value of the dividend stream. We believe that rather than getting wrapped up in whether a CEF is at a premium or discount to NAV, investors should consider the relative safety and value of the income stream, relative to other investments that yield over 8.5%.
Low Rates Here To Stay
We have seen a long-term trend across the world of declining interest rates. Government bonds in many parts of the developed world have even started providing negative yields. This is a trend that's set to continue.
As bonds continue to have lower yields, high-quality CEF investments like PCI will continue to become more valuable as well. Investors who wait for a dip will very likely discover that in the future they will be investing at even lower yields. We are in an era of low rates and for the longer term.
This is why it's important to take advantage of high yields today. The hunt for yield is set to continue and likely to drive up demand for quality CEFs such as PCI and PDI driving prices up even further.
Lower Price Volatility
In the current turbulent market, many investors look for lower price volatility investment. In order to test the price volatility of PCI, we can simply look at the impact of the current market correction. PCI has been 50% less volatility than the S&P 500 index (SPY). Take a look at this chart:
Both PCI and PDI offer dividends that we have every reason to believe will be stable, possibly even increasing. Both have proven they can sustain their dividends without sacrificing NAV.
PIMCO is one of the best operators in the business and has a proven history of being responsible stewards of our capital. Their goals of providing a high current income first, with capital appreciation second, align well with our portfolio goals. Their mortgage-focused strategy is a good one as our own analysis of the sector concludes that the fundamentals are very strong.
For PCI vs. PDI, we prefer PCI. It has a slightly higher current yield thanks to trading at a lower premium to NAV. PCI will follow a similar path as their impressive track record increases and they continue to pay out a generous dividend. Could we see PCI eventually trade at a 20% or even larger premium to NAV? Absolutely.
The combination of having a longer track record, combined with the macro-movement towards declining treasury rates, will provide strong tailwinds for PCI. From here, PCI is much more likely to get more expensive than it is to get cheaper.
Getting 8.5% today, with confidence that the cash flow will continue through a variety of economic conditions, is a great deal on a high-quality fund like PCI. That is why PCI is one of our must-own core funds.
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This article was written by
Rida Morwa is a former investment and commercial Banker, with over 35 years of experience. He has been advising individual and institutional clients on high-yield investment strategies since 1991.Rida Morwa leads the investing group High Dividend Opportunities where he teams up with some of Seeking Alpha's top income investing analysts. The service focuses on sustainable income through a variety of high yield investments with a targeted safe +9% yield. Features include: model portfolio with buy/sell alerts, preferred and baby bond portfolios for more conservative investors, vibrant and active chat with access to the service’s leaders, dividend and portfolio trackers, and regular market updates. The service philosophy focuses on community, education, and the belief that nobody should invest alone. Lean More.
Analyst’s Disclosure: I am/we are long PCI, PYY, PDI. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.