PDI: Despite The Drop, It Is Still Not Cheap (NYSE:PDI)

Summary

PDI has gotten caught up in the recent sell-off. While this has presented more attractive entry points, the fund still has a sizable premium to NAV.
With mortgage refinancing at high levels, PDI is likely to see its income come under pressure sooner rather than later.
Given the 12% drop since my last review, downside seems relatively limited from here. Further, even with an income cut, PDI's yield should still be attractive as interest rates have declined.

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 liked for a long time, although I gave it a neutral outlook towards the end of last year. While I still found the underlying holdings attractive, PDI, like many PIMCO CEFs, began trading at a premium to NAV that I simply found difficult to recommend. While the fund continued to trade generally in-line with the market in the months that followed the review, it has come under heavy selling pressure as the risk-off trade has gained the upper hand.

Given the sell-off, across the market and in PDI, it may seem like a reasonable time to begin entering in to the fund. While I would not fault an investor for using this logic, and I do believe PDI will trend higher from here, I am still not optimistic enough to give it a higher rating. While the fund's drop offers investors a much better valuation than it did last quarter, the truth is the premium is still quite high. While PDI does have a history of trading at above-average premiums, that does increase the inherent risk of the fund. This reality may not be what investors are looking for right now, as volatility continues to rattle both equity and debt markets. Further, its sister fund, PIMCO Dynamic Credit Income Fund (PCI), still offers a much cheaper buy-in point. Finally, while I continue to recommend non-agency MBS exposure, there are risks on the horizon for this sector. Refinancing activity has picked up markedly as interest rates have dropped, and that reality is likely to pressure the income stream of PDI going forward.

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 $29.14/share and pays a monthly distribution of $.2205/share, translating to an annual yield of 8.57%. PDI is a fund I cover regularly, and often recommend. However, during my most recent review in November, I cautioned against new positions. Simply, I felt the fund was too richly priced to justify. In hindsight, I was correct, although I may not have been bearish enough, as the fund has seen a sharp drop since that time:

Source: Seeking Alpha

Given the current volatility we are seeing, I wanted to reevaluate PDI to see if I should change my outlook. While I generally feel now is a reasonable time to initiate positions, I still see some downside risks to the fund that make me leery of going "bullish" at this time, and I will explain why in detail below.

Premium Has Dropped, But It's Still Not Cheap

I will begin this review as I usually do with PIMCO CEFs, with a discussion regarding the fund's premium. As I noted above, this was a key reason why I downgraded my sentiment from bullish to neutral in my prior review. As the recent sell-off shows, high premium funds are absolutely susceptible to large swings when volatility roils the market, and PDI clearly has taken a beating. While the bad news is there has been heavy losses for current investors, the good news is that the new entry point is much more favorable. In fact, when we consider PDI's typical trading range, the current premium sits near its low for the past year, as shown in the chart below:

Fund	Current Premium	Premium in Nov Review	1-Year Premium High	1-Year Premium Low	1-Year Premium Average
PDI	9.3%	23.2%	24.5%	9.1%	17.6%

Source: PIMCO

Analysis of the short-term valuation figures indicates that PDI's current premium is near the bottom end of its range. This could pique investor interest, as the fund clearly has a history of trading well above its NAV. While a premium above 9% is still rich, when we consider that PDI has often rewarded investors who initiate positions at that level, it may not seem as expensive as it would if we were discussing a different fund.

However, I would caution investors against getting too ambitious at these levels. Yes, the entry point appears attractive on the surface, but we have to consider that many CEFs have seen their premiums slashed over the past few weeks. Therefore, PDI, in isolation, may not necessarily represent the best value for new money. Case in point is PCI, which after its drop on 3/9, is actually sitting with a premium in the 3% range. Given that its make-up is quite similar to PDI, investors may consider that fund the right move for now.

Furthermore, there is a second point that makes me cautious on PDI. Specifically, this is the fund's NAV movement, which has been negative since 2020 began. While the fund has still delivered a high income stream, its underlying value has indeed declined slightly since January 1, as seen below:

NAV on 1/1/20	NAV on 3/6/20	YTD Change
$27.13/share	$26.67/share	(1.7%)

Source: PIMCO

My takeaway here is a bit mixed, and is a key reason for my neutral outlook. In fairness to PDI, I do see current levels as being appropriate for longer term investors. The fund's trading history suggests it will likely recover soon, and its next move could very well be to the upside. However, given how investors are fleeing risk right now, a 9% premium also suggests further downside is also realistic. Until market sentiment shifts, I would be cautious on buying any fund with a premium to NAV near the double digit range, and that includes PDI.

Income Production Metrics Showing Declines

I will now turn to another important attribute for PDI, which is the fund's income production. Clearly, with a yield near 9%, many investors are choosing to invest in PDI for its high, and reliable, income stream. Therefore, assessing the sustainability of its distribution is critical.

To begin, I want to point out that PDI does have a great track record of paying its stated distribution, and there are not any major red flags that suggest immediate trouble for the fund. In fact, the most recent UNII figures from PIMCO are relatively positive, although they have shown a sharp drop from November. To illustrate, the charts below are the UNII reports from November and February, shown below, respectively:

Source: PIMCO

The most important point here is that PDI's metrics were quite strong in November, yet have weakened considerably since then. On the bright side, the UNII balance suggests the income stream is safe for the immediate future, as the fund has roughly a month of income in reserves to pay the distribution if current income falls. Additionally, its fiscal year-to-date coverage ratio remains over 100%, which is a positive sign.

However, there are points of concern as well. While the UNII figure is positive, it is down since my last review. Further, all the coverage ratios are down, which is a troubling trend. Particularly, the 3-month coverage ratio under 100% indicates the income is under pressure for now and, as I will discuss in the next paragraph, this is something I expect to continue going forward.

Non-Agency MBS: Credit Risk Is Low, Prepayment Risk Is High

I will now shift gears to the underlying holdings of PDI. This is a fund that is heavily invested in mortgage-related debt, which has been the case for some time. Specifically, half the fund's holdings are non-agency MBS:

Source: PIMCO

Clearly, the performance of this sector will have a disproportionate impact on PDI as a whole, and this is precisely a reason why I have advocated buying the fund in the past. The sector has greatly recovered since the recession, and mortgage delinquencies continue to register bullish figures.

To illustrate, consider the single-family home delinquency rate, which recently hit a post-recession low of 2.35%, as shown below:

Source: St. Louis Fed

From a broad, macro-perspective, this is a very positive trend. It is a good signal for the health of the American housing market, and it also supports the underlying credit quality of the primary sector in PDI's portfolio.

As I mentioned, mortgage debt is an area I have favored for a while and, importantly, I continue to today. With more robust underwriting standards and falling delinquency rates, I prefer this type of debt over corporate bonds, as corporations in both the investment grade and non-investment grade spaces have racked up large amounts of debt.

Therefore, I have to make clear that I view the mortgage sector as a safe way to earn income right now, but there are headwinds on the horizon. While I believe mortgage-related CEFs will ultimately hold up well in the months to come, I absolutely expect income streams to decline going forward. While income cuts will hurt, I believe the yield spread offered by funds like PDI will remain attractive regardless. Simply, if PDI were to see a distribution cut in the 10-20% range, its yield will remain well above what treasuries and corporate bonds are offering, which will keep investor demand high.

Of course, investors may be wondering, why would PDI see a distribution cut if the underlying assets are performing well? This is a great question, and it comes down to what is going on in the mortgage market right now. Specifically, there has been a marked increase in mortgage refinancing, as homeowners rush to take advantage of lower interest rates. In fairness, this is a trend that has been going on for a while, starting with Q3 last year when the Fed started cutting interest rates. To illustrate, consider the number of refinanced mortgages, as a percentage of total mortgage originations. While they were low for most of 2019, there was a sharp uptick by the end of Q3, which then pushed even higher by the end of Q4, as shown in the graph below:

Source: YCharts

It is evident the share of refinanced mortgages has been rising quickly, and has eclipsed the long-term average, which is around 45%. While the 50.7% Q4 number is only slightly higher than the average, the metric moved higher still at the end of last month. Specifically, for the end of February, this figure was sitting just under 61%, according to data compiled by the Mortgage Bankers Association. Therefore, this is a figure that has been rising, and rising fast, in the short term.

The implication here is that a large number of outstanding mortgages are being refinanced, which means old debt is being retired and re-issued at lower, prevailing rates. Essentially, this means if fund managers like PIMCO want to continue to hold a large amount of MBS in funds like PDI, they are likely going to have to fill the fund with securities that are yielding markedly lower amounts. The impact on PDI will be that the fund will struggle to earn its current level of income. Once the current UNII balance has been used up, a distribution cut is a very real possibility.

My overall point here is, as with all investments, mortgage MBS have their pros and cons. I still believe in the sector and, even with lower yields, believe they will be attractive for the remainder of 2020. However, given that income streams in the funds that hold them will likely be cut, I would advocate buying CEFs at discounts, or slight premiums, to limit the fallout from any cut. While PDI's premium is near its annual low, it is still higher than alternative options that are on the market today, so I would be cautious in taking out too large of a position in this particular fund right now.

Bottom Line

PDI has seen a sharp drop over the last few months, and will likely pique investor interest. While I feel the fund will trend higher from here, I am maintaining a neutral outlook because the fund's premium still concerns me, especially since I believe a distribution cut will likely occur sometime this year. This will limit the total return, and dampens out optimism for the fund. There are other options I have covered recently and prefer, such as PCI and BlackRock Income Trust (BKT), which have similar holdings of MBS. Therefore, I would caution investors to tread carefully from here, and be very selective about new positions at this time.

This article was written by

Dividend Seeker

8.48K Followers

I began my career in financial services in 2008, at the height of the market crash. This experience has shaped my investment strategy - which is focused on diversification, dividends, and growth opportunities. I am a competitive tennis player, and I competed at the Division I level in undergrad. I have a Bachelors and MBA in Finance.

(He is a contributing author for the investing group CEF/ETF Income Laboratory where he specializes in macro analysis. Features of CEF/ETF Income Laboratory include: managed income portfolios (targeting safe and reliable ~8% yields) making use of high-yield opportunities in the CEF and ETF fund space. These are geared toward both active and passive investors of all experience levels. The vast majority of holdings are also monthly-payers, for faster compounding and steady income streams. Other features include 24/7 chat, and trade alerts. Learn more.)

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