PKO: Allocation, Valuation And Earnings Tailwinds
Summary
- Thursday saw serious weakness across the CEF market both in underlying asset prices and especially in sharp discount widening.
- The sector allocation profile of the PIMCO taxable suite matches well our sector stance of high-yield and external EM bonds as well as non-agency RMBS.
- Within the taxable suite we highlight PKO - a fund that has been able to add assets through the drawdown and improve its earnings profile.
- PKO has not yet been rewarded for this development and its discount valuation remains very attractive relative to other PIMCO CEFs.
- Looking for a portfolio of ideas like this one? Members of Systematic Income get exclusive access to our model portfolio. Get started today »
Over the last few weeks we have discussed a number of dry powder options for investors to deploy if the market were to run into the wall of reality. On Thursday we may have met that wall - the S&P 500 fell nearly 6% and the Down nearly 7%.
In this article we take a look at the reaction of PIMCO taxable CEFs and the opportunities the sell-off presents for investors. The asset allocation profile of these funds across the high-yield, external EM debt and non-agency RMBS jives well with our sector stance. Thursday's weakness in premiums has also pushed these fund valuations to attractive levels. Together, this combination makes for a compelling investment opportunity.
Within the taxable suite we highlight the Income Opportunity Fund (PKO) as one deserving a closer look. The fund has been able to acquire assets through the drawdown and improve its earnings and coverage profile. The fund has not been rewarded for this by the market. We expect this to change as its coverage and earnings profile outperforms in the months ahead.
Action In PIMCO Funds
The chart below shows the composition of PIMCO CEF Thursday's returns.
Source: Systematic Income, Tiingo
The chart shows a couple of interesting things. First, we see a clear difference in NAV performance between muni (highlighted in purple) and taxable funds with munis registering a small NAV increase and taxable funds all showing negative NAV returns.
Secondly, we see a large discrepancy between NAV and discount moves, particularly in the taxable funds. For example, the average NAV return of the taxable funds was -1.4% while the average premium fell about 6%. In other words, the average price sharply underperformed the NAV.
Thirdly, the performance of the three RMBS-heavy funds (highlighted in orange) was particularly stark. These three funds registered the smallest NAV drops among the taxable funds and some of the largest drops in premiums.
All of this is to say that the day's moves were fairly unusual outside of a small number of extreme episodes.
In terms of overall valuation, the average premium of the taxable funds fell to 10% - a level that is in the lower part of the 5-year range which makes the valuation of the fund suite relatively attractive in aggregate.
Source: Systematic Income, Tiingo
A Sector Perspective
When choosing individual fund allocations, it is important to take a sector-based perspective. The taxable funds are overweight two main sectors: high-yield assets (bonds and loans) and non-agency RMBS. These two sectors make up 45-65% of the composition of taxable funds. Another 5-10% is made up of emerging-market bonds.
On our Sector Rating Framework on the service we are overweight all three of these sectors. We like high-yield bonds in aggregate because of current valuations - spreads are twice their pre-drawdown levels - as well as their long-duration profile. We like the legacy non-agency RMBS sector due to the high LTVs of the underlying securities. and we like the external EM bond sector due to its stronger fundamentals relative to similarly-rated US bonds.
Source: Systematic Income
If we take a look at how these three sectors performed on Thursday we can see that the NAV drops of these sectors were fairly muted. This suggests that these sectors are more likely to remain resilient if we see an extension of this drawdown.
Source: Systematic Income
The fact that the PIMCO funds are composed predominantly from these sectors alongside the much more attractive premium valuation picture suggests that these funds are worth a look. The key question is which fund to go for?
PKO
In this section we take a look at PKO. The fund closed Thursday at a 2.49% premium and a 10.65% current yield.
In terms of sector allocation PKO is fairly similar to five other PIMCO taxable funds - highlighted in orange in the chart below. Other taxable funds have different allocation profiles, particularly with respect to RMBS, agency and equity allocations. Within its group of 6 similar funds PKO features a below-average allocation to govies and a higher allocation to non-agency RMBS. In our view, this should support the earnings of the fund given the low yields on offer on US government securities - both agencies and Treasuries.
Source: Systematic Income
In terms of both current yield and distribution coverage, PKO is roughly in the middle of the pack of the taxable fund suite.
Source: Systematic Income
In terms of fund discounts/premiums, the following chart shows both the fund discounts as well as 5-year discount percentiles across the PIMCO CEFs. The chart labels are generic - so a positive figure refers to what we would normally call a premium rather than a discount.
The most attractive funds are those with lower premiums and lower premium percentiles. There are only four taxable funds with premium percentiles below 50%. In other words, only 4 funds boast premiums in the lower half of their historic distribution. Three of these four funds are funds that have just recently cut their distribution so this is a not a surprise. The fact that the premiums of these funds are on the lower side makes absolute sense given their distributions have just moved lower. PKO is the only fund that still features an attractive premium percentile but has not cut its distribution.
Source: Systematic Income
Recent Leverage Dynamics
An important part of our relative value analysis is the recent leverage dynamic. This is because a fund that has had to cut its borrowings will tend to see its portfolio earnings fall resulting in lower distribution coverage and a possible eventual distribution cut. Most PIMCO CEFs have had to cut their borrowings since February due to the need to keep their leverage in check as a result of sharply lower asset prices.
PKO is a stand-out on this metric - unlike most PIMCO CEFs it was able to add the most to its borrowings since the start of the drawdown. This is the case for two main reasons. First, the fund entered the crisis at a relatively low level of leverage which ensured that it was under less pressure to unwind its borrowings and sell assets. And secondly, PKO is one of a handful of funds having a soft leverage cap of 50%. Those CEFs with hard leverage caps have not been able to acquire assets at the same pace because of the need to maintain a more conservative leverage stance.
Source: Systematic Income
With its recent increase in leverage, the fund has been able to move from a medium-leverage tier of funds to a higher-leverage tier of funds.
Source: Systematic Income, Tiingo
This increase in new assets is what has allowed PKO, in our view, to outperform other funds in earnings growth. The chart below compares the most recent monthly earnings figure relative to the previous three months.
Source: Systematic Income
We can also see this dynamic in the fund's distribution coverage which has jumped the most of the taxable funds. We expect this trend to continue.
Source: Systematic Income
To get a more intuitive sense of the impact of relative leverage shifts since February we can calculate the marginal impact on the NAV yield due solely to the change in borrowings. We assume a 6% underlying portfolio yield, 1% fee on total assets and 1% leverage cost for all funds. Obviously, the actual figures of the individual funds are different but we keep everything the same in order to isolate the effect of the change in borrowings on NAV yield of the funds which we plot below.
Source: Systematic Income, PIMCO
In our view the market has not yet recognized the fact that PKO will be able to drive stronger earnings from here on and has not rewarded it with a stronger premium in absolute and relative terms. This offers an opportunity for investors.
In terms of its leverage composition PKO is a bit unusual within its group as it has no ARPS. Historically, having ARPS as a leverage instrument has been advantageous. The picture is a bit more complicated now since the max rates across various ARPS series are both very different and either below or above the prevailing rates on repos. The cheapest ARPS series are still offering rates a full 1% below prevailing repo rates. However these same funds also feature very high premiums which more than offsets their leverage cost advantage.
In terms of relative fees, the management fee of PKO is on the high side at 1.06% on total assets versus 0.93% average, however, the fund's premium is currently one of the most attractive relative to its fair-value. In other words, this higher-fee is more than priced into the fund's current premium.
Conclusion
The overall sector composition of PIMCO taxable funds jives well with our current sector overweights of high-yield bonds, non-agency RMBS and external EM debt. The recent sharp drop in PIMCO fund premiums makes them relatively attractive in historic terms. And although we expect some more weakness in the medium term given the difficult macro, market and political environment we think starting to add risk at current levels makes sense both in terms of discount and underlying asset valuation levels. Within the PIMCO suite we currently favor PKO which has been able to acquire assets through the drawdown and improve its earnings and coverage profile. The fund has not been rewarded by the market, however, we expect this to change as its coverage and earnings profile outperforms in the months ahead.
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This article was written by
At Systematic Income our aim is to build robust Income Portfolios with mid-to-high single digit yields and provide investors with unique Interactive Tools to cut through the wealth of different investment options across BDCs, CEFs, ETFs, mutual funds, preferred stocks and more. Join us on our Marketplace service Systematic Income.
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PKO over 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.
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.
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