PCM: A Premium Price But A Stable Yield

Nov. 17, 2020 1:29 PM ETPCM Fund (PCM)18 Comments

Summary

  • PCM remains a reasonable option for a long-term hold, with a steady yield and a portfolio primarily made up of mortgage debt.
  • At current levels, the fund seems a bit expensive, so investors want to be cautious with new buys. The premium to NAV sits over 11%.
  • Income metrics are strong, and American homeowners remain in good financial shape to remain current on their housing obligations.

Main Thesis

The purpose of this article is to evaluate the PCM Fund (NYSE:PCM) as an investment option at its current market price. PCM has been a fund I have been cautious on for a while, and that caution had some merit in 2020. However, despite some ups and downs, PCM has been a constant income provider, delivering a high distribution rate without the income cuts that plague some of its peers. Looking ahead, I see this story continuing, as PCM has some of the highest income metrics in the PIMCO CEF family. Further, the fund's underlying holdings are performing well, as evidenced by a rising NAV. With mortgage delinquencies in both the residential and commercial spaces raising a concern, investors may want to be cautious, but as the economy improves, these figures should revert back to historical norms.

Background

First, a little about PCM. It is a closed-end fund whose investment objective is "to seek high current income by investing in a portfolio comprised primarily of commercial mortgage-backed securities". Currently, the fund is trading at $10.01 and pays a monthly distribution of $.08/share, which translates to an annual yield of 9.59%. I covered PCM back in June and reiterated a neutral rating on the fund. In hindsight, I feel this call was vindicated by PCM's performance. While it has posted a reasonable gain, the market as a whole has been on fire since that time:

Source: Seeking Alpha

As we near the end of 2020, I felt it was time to take another look at PCM to see if I should change my outlook. After review, I feel a "neutral" rating on the fund remains appropriate, and I will explain why in detail below.

Premium Has Come Down, NAV Up Nicely

Similar to my review over the summer, my hesitation with being bullish on PCM sits primarily with the fund's valuation. On the plus side, the premium has come down since then, which is good news for those looking to make a purchase now. The bad news is the fund is still quite pricey, with a double-digit premium to NAV. This is typically the point where I am reluctant to buy any CEF product, and PCM is not an exception to this rule. To put the current valuation in perspective, consider the chart below:

Current Premium 11.1%
Premium in June Review 14.3%
Year-To-Date Premium High 18.4%
Year-To-Date Premium Low (23.3%)

Source: PIMCO

As you can see, PCM's premium means this fund is certainly not cheap, and it should give investors pause. However, it is worth pointing out that, despite the fund's positive gain since June, the premium to buy-in is actually lower than it was back then. Further, it is about 50% less than its high for the year. Both of these facts suggest PCM does have upside potential from its current price.

At this point, investors may be wondering how PCM could be trading at a lower premium when its total return is up almost 7%. Fortunately, the answer to this question is quite positive, and points to the increasing value of the underlying holdings of the fund. This is great news for current investors, and actually reversed a worrying trend we saw in the first half of the year, as the table below illustrates:

NAV 1/1/20 NAV 6/17/20 NAV Change
$10.03/share $8.51/share (15.2%)
NAV 6/18/20 NAV 11/16/20 NAV Change
$8.49/share $9.01/share 6.1%

Source: PIMCO

My takeaway here is PCM clearly has held the right underlying assets for our current environment. Despite a rather volatile summer, the fund has seen a 6% gain to its underlying value, in addition to paying out distributions that account for an annual yield near 10%. While the current 11% premium does not indicate this fund is a screaming buy to me, its underlying appreciation is a positive sign, and the fund's history of trading at more expensive levels tells me a bearish outlook on this fund is not appropriate either. Therefore, I feel this valuation story supports my neutral view.

UNII Report - Income Metrics Remain Strong

My second point is roundly positive, and relates to the fund's income potential. Again, PCM has impressed me by improving its value proposition in this regard, since my last review. Back in June, I felt the fund's distribution was safe, and pointed to its relatively strong income metrics. Based on PIMCO's most recent UNII report, these figures have also improved through the summer, and suggest PCM is over-earning what it needs to keep its income level constant. To illustrate, consider the fund's UNII report shown below:

Source: PIMCO

The primary takeaway is PCM's coverage ratios are very healthy, and this should give investors plenty of confidence in the distribution. While other PIMCO CEFs have struggled in recent months, the same story has not played out with PCM, with coverage ratios well over 100%, and a positive UNII balance to drawn on in case there is a hiccup. This signals the income stream remains safe, and supports the thesis that PCM will remain a reasonable option for investors seeking an above-average income stream.

MBS A Good Choice, But Commercial Delinquencies Remain On The Rise

I now want to shift the focus to the underlying assets of PCM. This particular fund used to hold assets that differed from the rest of its PIMCO CEF peers, but that has changed this year. For the past six months or so, PCM has focused on MBS, primarily in the non-agency sector. I highlighted this change back in June, and the portfolio has been fairly consistent since that time. The only noticeable difference is that PCM has shifted a few percentage points out of non-agency MBS and into agency MBS, but non-agency MBS remains the primary focus, as illustrated in the chart below:

Source: PIMCO

Clearly, this is an area of critical importance for PCM, and its fortunes are now more in-line with many of the alternative PIMCO CEFs that have a similar make-up. However, there is one primary difference for PCM, in that the fund holds quite a bit of commercial non-agency MBS, as opposed to residential, which is the bulk of some of the other PIMCO funds I cover. In fairness, PCM does hold plenty of residential MBS as well, so investors should consider both when evaluating the fund.

The good news is that commercial properties, while declining in value due to COVID-19, have not seen the wave of delinquencies (up this point) that they saw during the 2008-09 recession. Landlords have been reluctant to sell, seeing the pandemic as temporary, and that has helped keep a lid on prices and prevented mass selling or foreclosures. However, this does not mean the sector has been completely untouched. Delinquencies, while still low, have been rising. In fact, Q2 delinquencies in the commercial MBS space rose from Q1 by .1%, as shown in the two respective graphs below:

Source: St. Louis Fed

My take on this is that commercial non-agency MBS have been resilient, and this is positive for PCM. The only point of concern is that delinquencies, while low, have been rising consistently in the past few quarters. If the economy's progress is halted, due to the climbing COVID-19 cases or other reasons, these delinquency figures could rise further. Therefore, investors will want to keep an eye on this sector, but for now there is not any cause for real concern.

Residential MBS - Homeowners In A Good Spot

Expanding on the MBS sector, I will now shift to residential MBS, the other critical area for PCM. This sector has seen a bit more volatility than the commercial space, with delinquencies rising throughout 2020. However, actual foreclosures were prevented by federal programs that allowed homeowners to defer payments without moving into foreclosure proceedings or incurring other penalties. As a result, some homeowners entered those programs voluntarily, simply to defer payment, and have now been exiting the programs and making good on their obligations. Ultimately, this has kept income flowing to residential MBS investors, and should only be a concern if macro-conditions deteriorate substantially from here.

Looking ahead, I see merit to remaining long in this space. While jobless claims are up and stimulus measures have stalled, American homeowners are in better shape than the rest of the country. The impact of the COVID-19 crisis has largely impacted those in the lower income ladders, who are less likely to own homes. This means many homeowners have seen their incomes remain constant, and likely have seen their net worth rise due to the market's resurgence. Further, record low interest rates have allowed a surge of refinancing and new mortgage applications, allowing homeowners to lock in record low borrowing costs. As incomes have not fluctuated much, this has resulted in a sharp drop in the mortgage debt service ratio, as seen below:

Source: Bloomberg

This is a measure of a household's ability to pay its mortgage obligations, and the lower ratio indicates households are spending less of their income (as a percentage) on mortgage debt. The conclusion here would be that mortgage holders are in a better shape financially, as their housing costs are becoming a smaller slice of the pie. This is good news for both homeowners and investors, and suggests PCM will continue to benefit from its MBS exposure.

High Yield Spreads Suggest Limited Upside

My final point looks at the high yield credit sector, which is relevant to PCM because it represents almost 19% of total fund assets. This is an area I have a lukewarm outlook on, as I believe the macro-pressures on the economy will continue into 2021, hurting those highly leverage and riskier companies. While investors will undoubtedly be drawn to the higher income stream, I would emphasize this is a sector that is likely not appropriate for the risk averse.

On this note, PCM's high yield exposure is a key reason why I am neutral, rather than bullish on the fund. In fairness, these assets will outperform if the economy recovers more strongly than expected, and offers investors the potential for more return, along with more risk. So there is merit to owning them. However, current spreads have narrowed considerably since March and April, when they spiked dramatically, as shown below:

Source: S&P Global

My point here is that investors buying in now are quite late in the cycle. Spreads could narrow further, that is true, especially since they are still above pre-crisis levels. However, the economy is nowhere near where it was pre-crisis, with corporate revenues and profits down substantially in high yield space. This suggests limited upside from here, and I personally feel this sector could be a drag on PCM's total return for the next few months.

Bottom line

PCM continues to pump out a reliable income stream, so yield-starved investors may want to consider this fund. With MBS assets performing reasonably well, I expect PCM to register modest gains in the months ahead. However, my outlook is tempered by the reality that PCM charges a premium price to own, with a market price over 11% the fund's NAV. Further, PCM's high yield assets do increase the inherent risk of the fund, so caution is warranted for those who are more risk averse. The end result is the positive attributes are balanced out by the risk, supporting my neutral view. Thus, I suggest investors be very selective about entry points at this time.

This article was written by

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