Select PIMCO Taxable CEFs Trim Distributions
Summary
- Lower asset prices have led to a wave of distribution cuts across the CEF space as many funds have had to deleverage in order to comply with their leverage covenants.
- PIMCO has not been immune to this trend with three distribution cuts announced on June 1st in PGP, RCS, and PHK.
- What these funds have in common is their relatively large deleveraging over the past two months as well as lower distribution coverage.
- We remain overweight PFL and PFN over PCN as well as PDI over PCI - due to their more muted deleveraging and more attractive discount valuation.
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Over the last few weeks and across a number of articles we have been focused on the changes in leverage of PIMCO CEFs. Our view has been that changes in borrowings are key drivers of fund earnings and, by extension, distribution sustainability. Today we saw three taxable CEFs cut their distribution substantially. In this article, we take a look at whether anything we learned over the past week prepared us for these cuts and what the outlook is for the remainder of PIMCO CEFs.
Our takeaway is that the three funds making cuts have seen relatively large deleveraging while maintaining less robust distribution coverage. We remain overweight those PIMCO funds that have seen relatively little deleveraging and are trading at attractive discount valuations. We are overweight the Income Strategy Fund (PFL) and Income Strategy Fund II (PFN) over the Corporate & Income Strategy Fund (PCN) as well as Dynamic Income Fund (PDI) over Dynamic Credit and Mortgage Income Fund (PCI).
What Just Happened?
On 1-June PIMCO announced July distributions for their monthly-paying CEFs. Three of the taxable funds saw substantial cuts with no cuts across municipal CEFs. 
Source: PIMCO
On 13-May we suggested investors remain wary of two of these funds given their more vulnerable stance. The fact that PIMCO has made these cuts is not a complete surprise for three main reasons. First, in the last two months, we have seen more than 150 distribution changes in the CEF space - 90% of the cuts. The few raises have largely been confined to the municipal sector.
Secondly, PIMCO funds, by and large, have been cutting their borrowings. The cuts in March were made largely as a result of hitting leverage caps. The cuts in April are a bit harder to explain since there did not appear to be hard constraints on the funds which suggest they could be more secular in nature. In other words, it is possible they were done as a way to "right-size" the leverage of the funds over the near term.
The third reason is that the drop in short-term rates has lowered coupons on many floating-rate assets such as non-agency RMBS which PIMCO funds are overweight.
So are these cuts a sign that investors should rotate out of PIMCO funds in anticipation of further wholesale cuts? Not really.
One reason for optimism is that PIMCO tends to "kitchen sink" distribution cuts rather than make cuts in dribs and drabs. In other words, the company tends to leave distributions unchanged for long periods of time between cuts.
So while there is no reason to rotate out of the funds, particularly for investors with a constructive view on the market, it is important to understand that there is significant variation in distribution vulnerability across the PIMCO funds. We discuss various metrics that investors can use below.
Anticipating Distribution Cuts
Of course, it's not possible to anticipate exactly the distribution changes of the PIMCO funds as they don't feature managed distribution policies. However, there are a number of important metrics we track on the service and that investors can use as well that have done a good job in anticipating distribution changes across the CEF space.
Changes in fund borrowings allow the fund to dial-up or dial-down its earnings.
Existing distribution coverage is important because a healthy starting level can allow the fund to maintain a distribution despite a drop in earnings.
Changes in fund earnings are clearly an important indicator since they translate directly to the fund's ability to maintain their distribution.
Section 19 releases provide estimates of distribution sources. They are not perfect as the estimates can be reclassified later on but they can give a good sense of how much of the fund's distribution comes from net investment income.
Underlying asset exposure can allow investors to forecast the trajectory of earnings. For instance, loan funds that hold floating-rate assets have suffered significant drops in earnings due to the fall in Libor.
Leverage cost structure and hedges flow directly into fund's earnings. For instance, funds that rely on floating-rate credit facilities can stand to benefit when short-term rates fall as their costs will drop as well. Some funds partially hedge their floating-rate exposure and so will benefit to a lesser extent.
Long-term net NAV trajectory can allow investors to see whether the fund has tended to overdistribute historically. Overdistribution is not sustainable over the long-term as the fund will need to either cut the distribution or issue additional shares to boost its assets.
Key Recent PIMCO CEF Developments
On our view the key factors in explaining recent distribution changes across PIMCO CEFs are 1) changes in borrowing and the knock-on effect on fund earnings and 2) recent distribution coverage.
In the chart below we show cumulative changes in outstanding borrowings across the taxable CEFs. Funds that have cut distribution are circled in red. A glance at the chart shows that three of the four funds that have seen the largest cuts in borrowings since their semi-annual reports (filed either in Dec-19 or Jan-20) are also the funds that have cut distributions.
Source: Systematic Income, PIMCO
The chart shows that just knowing relative changes in leverage already gets us pretty far in being able to explain distribution changes.
Let's add distribution coverage to the analysis to see whether it adds any information. The chart below shows latest 6-Month distribution coverage (on the y-axis) versus the change in borrowings (on the x-axis). Funds with larger falls in borrowing and low distribution coverage are circled in red indicating greater vulnerability and vice-versa in green. There are clearly no sharp lines separating more vulnerable from less vulnerable funds so the circles are purely illustrative.
Source: Systematic Income, PIMCO
Adding distribution coverage shows that PCN, despite a sharp drop in borrowings, was actually less vulnerable due to an already high distribution coverage. The vulnerable circle also includes PCI as it saw a fairly sharp cut in borrowings. However, we have less confidence in the sustainable earnings and coverage level for PCI as it has been very volatile. For example, the chart below shows the last nine months of PCN and PCI coverage with PCI showing much more volatility.
Source: Systematic Income Investor CEF Tool, PIMCO
Finally, we would mention the trajectory of monthly EPS or earnings per share of various funds. PIMCO does not release average monthly EPS figures - it only releases total earnings (or more specifically, net investment income) fiscal year to date which is not readily comparable across funds given their different per share amounts and fiscal year starts. On the service we back into monthly EPS which then allows us to make more of an apples-to-apples comparison.
The reason why looking at EPS is useful above and beyond looking at distribution coverage is that the distribution coverage time-series can be skewed by changes in distributions. In other words, distribution coverage is not directly comparable between months having different distributions. Looking at EPS controls for this issue and focuses on what the underlying portfolio is actually producing.
The chart below shows how average monthly fiscal-year EPS has behaved over the last few months. The funds that have cut distributions are circled in red. This metric is not something you would want to use on a standalone basis but it does add some confirmatory evidence to the picture showing that funds that ended up cutting distributions did suffer fairly significant drops in earnings as well.
Source: Systematic Income, PIMCO
Current Views
Where does all of this leave us?
Our views on the taxable PIMCO CEF suite on the service depend on a number of factors such as discount valuation in an absolute fair-value sense and relative to other funds, underlying asset exposure, current leverage, coverage, and other factors.
We remain underweight PCN relative to PFL and PFN. These three funds hold broadly similar portfolios - which is why they are the closest CEFs relative to each other based on the NAV return correlation metric that we calculate for all CEFs.
Source: Systematic Income Investor CEF Tool, PIMCO
Among these funds, PCN does boast the lowest fee, highest historic NAV return and highest distribution coverage. However, the historic NAV return point is no longer relevant in our view given the three funds have effectively become mirror copies - which was not the case when PCN earned its outperformance. Secondly, distribution coverage has begun to converge among the three funds owing to the fact that PCN has cut its borrowings well in excess of the other two funds and now boasts a significantly lower leverage.
Source: Systematic Income Investor CEF Tool, PIMCO
On the discount valuation front PCN is much less attractive with a 97th 5-year discount percentile vs figures in the mid and low 70s of the other two funds. We can see this dynamic in relative discounts with the premium of PCN growing well in excess of the other two funds.
Finally, PCN has a substantially lower yield even after you adjust for its somewhat higher distribution coverage.
Source: Systematic Income Investor CEF Tool, PIMCO
We are also overweight PDI versus PCI. The premium differential between the two funds is around fair-value and, given the fact that PDI managed to increase borrowings while PCI decreased them sharply, our view is that the higher current leverage of PDI should enable it to outperform PCI in both earnings and returns over the medium term.
A final important point is that the three cuts have not yet made it onto CEFConnect so investors should not rely on the website for current yields. For example, the current yield of 12.47% for the Global StocksPLUS & Income Fund (PGP) is actually 9.16% with the new distribution.
Conclusion
Given the sharp volatility we have seen over the month of March and the knock-on deleveraging impact across PIMCO CEFs, it is not a surprise to see PIMCO finally succumb to making cuts. As we suggested earlier the cuts have been made across those funds that deleveraged to a greater extent and had a lower distribution coverage profile. We remain overweight those funds that have seen relatively little deleveraging and are trading at attractive discount valuations.
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Comments (22)
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Don't count PTY out .
Long PTY, PCI, BME and PIMIX.
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