- We think too much is being made of the lower coverage in the UNII report and that those ratios tend to ebb and flow over time.
- We do not foresee a distribution cut to the non-agency MBS funds (PCI, PKO, PDI) and only low chances to other taxables. PHK and PGP are at higher risk of cuts.
- For now, I'm in watching mode. Sort of like I was last month. The only changes I have made are to nibble at PKO and PDI with my distributions.
- We would be trimming/selling PIMCO muni CEFs in favor of other holdings on our conviction lists. We can rebuy funds after they trim the distribution and investors sell off the shares.
- In October 2019, PCI's coverage ratio was below 38%. Did the fund cut its distribution? No.
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(This report was issued to members of Yield Hunting on May 26th.)
Branding matters. Think of this. In the 1980s, PepsiCo (PEP) began running commercials with The Pepsi Challenge, where people would try two colas as a taste test and select which they liked better. Not surprisingly, Pepsi was the favorite choice. However, more surprisingly, Coca-Cola (KO) did the same taste trials and it found similar results - people preferred Pepsi.
Coca-Cola noted that this was due to their sweeter formula, which led them to creating one of the most dreadful of all marketing decisions ever, Coke II. The real interesting thing is that people tend to say they prefer Coke to Pepsi. That is borne out by market share, with Coke having a much larger market share than Pepsi.
The moral of the story is that people by product based on factors outside of taste. Relating to the closed-end fund ("CEF") world, people buy funds based somewhat on brand over "taste."
Enter PIMCO - the Mercedes, the NY Yankees, or the Coca-Cola of the bond world.
PIMCO funds are renowned income tools for individual investors. Today, they yield in excess of 11%, thanks to the much lower prices compared to three months ago. The distribution remains unchanged, giving your DRIP a bit of octane.
PIMCO recently released its monthly Earnings Report for April. The data wasn't all that positive but not overtly alarming either. No moves are necessary outside of small preferences on incremental buys. Coverage ratios, a la income production, was significantly below the distribution for the PIMCO Dynamic Credit Income Fund (PCI) and modestly so for the PIMCO Corporate&Income Strategy Fund (PCN), the PIMCO High Income Fund (PHK), the PIMCO Strategic Income Fund (RCS), the PIMCO Income Strategy Fund (PFL), the PIMCO Income Strategy Fund II (PFN), and the PIMCO Global StocksPLUS&Income Fund (PGP). They were slightly better for the PIMCO Income Opportunity Fund (PKO) and flat for the PIMCO Corporate&Income Opportunity Fund (PTY). The PIMCO Dynamic Income Fund (PDI) was only slightly below its distribution.
From the data table below, you can see PCI under-earned its distribution by 14 cents, meaning it only produced about 3 cents of net investment income.
So, what to make of this?
Well, we know that PCI delevered the most during March and April, dropping borrowing by over 22%, followed by PCM Fund (PCM) at 20%. The fact that PCM delevered by nearly as much as PCI, while generating a penny more than the distribution at the same time PCI was underproducing, suggests that some (or the majority) of the shortfall for PCI isn't due to the decline in borrowing.
Conversely, the results do confirm what we wrote last month, suggesting PKO and PDI were the best-positioned, as they added new borrowing over the last two months. PDI underperformed by two cents (which is fairly meaningless), while PKO outperformed by that penny. In any given month, each fund will earn a few pennies above or below the distribution payment, which is why these funds typically report three-month average net investment income to get a more smoothed average.
*Please note, we make a distinction between leverage (the percentage of leverage) and borrowing (the dollar amount of total loans).
Coverage ratios declined based on that lower net investment income production in the last couple of months. I don't put much stock in short-term results where coverage falls for a time period. Over long periods of time, the fund may have coverage above and below 100% for several months and then rebound or subside. It would be highly likely that the brains at PIMCO have managed this portfolio and modeled it out with some degree of certainty.
Over longer time frames using the fiscal year to-date distribution coverage ratios shows that PCI and PDI are at 84% and 103%, respectively. This is the most important indicator for distribution stability. While the numbers aren't Herculean strength, the weakest, at least among the non-agency MBS funds, i.e. PCI, is still relatively okay at 84%+.
The weakest funds are PHK, which I believe is poised for a distribution cut in the next few months, PGP at 76% and very low coverage for the last three months, and PTY at 76.6%. The latter, I think, is likely still safe from a distribution cut.
The two strongest funds remain unchanged from last month and where my incremental long-term dollars will head: PDI and PKO. PDI's FY YTD coverage remains the only PIMCO fund over 100%. PKO is not that far below at 93%. The only reason my incremental dollars are going here is because the valuations are similar, with all three funds (PCI, PDI, PKO) trading a couple hundred bps below their one-year average discount.
The other question is why PCI's UNII fell so much during the month, while PCM's was only down a penny. The intricacies of fund accounting are very obscure, and without seeing all transactions, it is impossible to know. For this month, I won't even speculate and will wait until the next few months (when new annual reports come out). We will also have to see what happens in the May results around 4 weeks from now.
The exposure in the fund remains half non-agency MBS and the rest mostly high yield corporates from US and non-USD credits. In fact, I get a high degree of statistical fit on PCI's NAV from just three positions: the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), the iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB), and the Semper MBS Total Return Fund Investor Shares Inv (SEMPX).
The data doesn't suggest any hard conclusions as of yet. The lower UNII and coverage levels for PCI and PTY (along with a few others) may just be due to bond switches and a mismatch of income. UNII is a bit low at -29 cents, but that can rebound fairly quickly. I'm not overly concerned, but, of course, I would be less so if the fiscal YTD numbers were stronger. There are just two months left in the fiscal year, and it is unlikely to reach 100% before then. However, that doesn't mean the distribution is to be cut for certain. Not even close.
Remember, with lower rates filtering through the mortgage market, refinancing is becoming more available for millions of homeowners. These mortgages are prime for refinancing after 13+ years of principal paydown and rising home prices. The question is if these borrowers are the ones in mortgage forbearance. That would obviously preclude them from being able to refinance. The chart below shows residential mortgages being in good shape going into the downturn, unlike in 2008. Any mortgages that are refinanced are pulled out of the MBS pool at par, putting upward pressure on the price of those securities, and thus improving NAV.
For now, I'm in watching mode. Sort of like I was last month. The only changes I have made are to nibble at PKO and PDI with my distributions. I haven't sold any shares of either PCI or PDI. PKO is slightly lower-yielding, which is largely due to the lower leverage. Again, I do not think PCI or any of the non-agency MBS funds will cut in the near term. For one, the FY coverage is still ok. Second, we have not seen a 19a notice, which typically precedes cuts with some funds.
In the end, I just don't think it matters all that much. NAV performance pf PCI and PKO since the lows is about 180 bps different.
But since April 15th, NAV performance has been very close, with PCI even beating out PKO. So, it appears that the bulk of the 180 bps "outperformance" is just three weeks' time between March 23 and April 15.
If PKO was able to lever up by 12.5% while PCI reduced total borrowing by 22.5%, you would have to believe that the NAV of PKO would handily beat that of PCI. The fact that it doesn't is likely a reflection of noise in the UNII report data. This is why the fiscal YTD figure is the most important factor on the UNII sheet, not 3-month coverage or UNII (at least for the taxable funds).
The next month's data sheet will provide more insights as well, since it may show a ramp-up of net investment income production from bond swaps. It is likely that the funds are much better-positioned today from an NII perspective given their ability to swap from lower-yielding short-term paper to higher-yielding non-agency MBSs and high yield paper.
From a valuation standpoint, the funds are all close to fair value. We have created a relative value swap database to help identify when to swap to "like" funds within the PIMCO fund complex. That will be unveiled on June 1.
Over on the muni side, we are nearing the end of the high UNII bucket funds. For example, the PIMCO California Municipal Income Fund (PCQ) has just 10 cents left in its UNII bucket, down from 33 cents April 2019. The other high UNII fund, the PIMCO Municipal Income Fund II (PML), has just 8 cents left, down from 20 cents last April. This despite both funds cutting the distributions in January.
All PIMCO muni CEFs lost UNII in April from 1 to 3 cents. Most are now negative, except those two funds mentioned previously. Coverage ratios are now very low, with most in the mid-to-high 80% range, down from near 100% just two months ago. These funds are all going to cut again. It's just a matter of when. It may be a few months away, but it is coming. And knowing PIMCO, they won't cut by 5%. They will cut big to make sure they don't have to cut again for some time. The last cuts were 10-25%.
The PIMCO national munis all have very high leverage - currently up near the top of the limit. This is why they have some of the highest yields in the muni CEF space. A combination of more leverage (by more than 10% against most national muni CEFs) plus lower leverage costs from their ability to borrow cheaply equates to a higher yield.
We would be trimming/selling PIMCO muni CEFs in favor of other holdings on our conviction lists. We can rebuy funds after they trim the distribution and investors sell off the shares.
The new UNII report was weaker than expected, though not a game changer by any means. The coverage ratio below shows that the data tends to vary for a few months with higher coverage and then lower (green for a few months and then red a few). In early 2019 (the right side of the below chart), you can see the red where PCI's coverage fell to the low 80s and PDI's to the low 70s. Other funds like PFL and PKO had coverage ratios in the 50s! In October 2019, PCI's coverage ratio was below 38%. Did the fund cut its distribution? No.
We do not think PCI and PTY, or other funds with lower coverage ratios, will cut this time either. The coverage ratio ebbs and flows over time and with variations in the market and different interest rate environments. The fiscal YTD coverage ratios suggest that no cut is in store for PCI or PTY. At most, we may see cuts for PHK and PGP, and perhaps even RCS.
PIMCO is the best of the best for a reason. Their brand is what it is because they continue to outperform the competition with the best managers in the bond market. Period. Are they infallible and will never make a mistake? Of course not. But their brand and the people that make their brand tend to do far more right than wrong. In this case, they have the name brand and the taste!
To reiterate, we think the distributions of PCI, PDI, PKO, PTY, PCN, and PCM are safe for now, and we see no reason to sell or swap. Still, I am committing incremental dollars to PKO, simply to hedge, even though the changes in borrowing are not likely to make a material impact on net investment income production or the future NAV performance compared to PCI or PDI.
Since the writing of this report, PIMCO has announced June distributions, which included three distribution cuts. Those three cuts were to PHK, PGP, and RCS - the very three funds we speculated could see cuts above. The cuts were not small, ranging from 16% to 22%.
We also recently issued an update on those three funds, including at what price we think they become interesting. Distribution cuts are a part of life with these funds, so it is imperative to getting them at good prices.
The PIMCO NAVs continue to be "on fire," recovering a lot of what was lost in the last few months. They have a way to go still, but the trend and momentum is on your side currently.
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This article was written by
Alpha Gen Capital is a former financial advisor and his analysis is meant to provide a relatively safer income stream with CEFs and mutual funds. He has been writing about investing on Seeking Alpha for the past decade and he aims to help investors better understand how to properly construct a portfolio.Alpha Gen Capital leads the investing group Yield Hunting: Alt Inc Opps, where along with his team of analysts, he focuses on closed-end funds and getting yield from bonds to complement dividend portfolios. The service is dedicated to income investors who are searching for yield without the high risk of the equity market. Additionally, they provide 4 actively managed portfolios. Learn more.
Analyst’s Disclosure: I am/we are long PCI, PDI, PKO. 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.
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