PCN: Another Strong Performer With A Persistent Premium
Summary
- PCN continues to deliver strong returns, coupled with an improving macro picture and the persistence of a high premium to NAV.
- Credit risk is not my primary concern for the high-yield sector, considering all the new cash that was raised under very low interest rates. However, duration risk is a key concern.
- The fund's income metrics are not very encouraging. Further, the availability of cheaper options from PIMCO makes this one hard to justify at current valuations.
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Main Thesis
The purpose of this article is to evaluate the PIMCO Corporate & Income Strategy Fund (NYSE:PCN) as an investment option. This is a fund I was cautious on last summer, but continued to rise despite my expectations. Looking ahead, there is a chance this bullish momentum could continue. As the macro-economic picture keeps improving, PCN may still attract investors for a "risk-on" play.
However, I continue to have concerns about new entry points. While PCN has proved it is able to sustain a very high premium over time, that does not mean this will always be the case. Its current level is beyond my comfort zone, regardless of its individual trading history. Further, the fund's income metrics are not very strong, which is always a sore point for me. Finally, the rise in longer-term yields is pressuring the fixed-income sector as a whole, and PCN is not immune to this risk.
Background
First, a little about PCN. It is a closed-end fund with a primary objective "to seek high current income, with a secondary objective of capital preservation and appreciation." Currently, the fund is trading at $17.23/share and pays a monthly distribution of $.1125/share, yielding 7.85% annually. PCN is a fund I am often reluctant to recommend because of the high premium that it often trades at. In fairness, the persistence of this premium makes my reluctance seem overly cautious, as investors seem willing to pay up for this CEF. In fact, my caution last summer would not have been rewarded, as PCN has seen strong gains since that review:
Source: Seeking Alpha
Importantly, once we consider distributions, PCN has seen a 13-14% return in just over six months. With this in mind, I thought another look at the fund was timely. However, despite this bullish momentum, I am still turned off by the expensive buy-in price of this fund. While I see the potential for more upside, this is balanced out by the downside risk if the market turns against it. Therefore, I am sticking with my "neutral" rating, and I will explain why below.
I'm Not As Worried About Credit Risk As I Was Before
To begin, I want to take a look at the high-yield credit sector, with specific attention to how the macro-environment has improved. This is an important consideration for PCN, because, while the fund is well-diversified, high yield credit is still the largest sector by weighting. In fact, it makes up almost one-third of total assets, as shown below:
Source: PIMCO
This portfolio make-up is a key reason why I was cautious on PCN for a while, especially in 2020. I will admit my caution, in both equities and high yield, was not rewarded in the second half of last year, minus a few short-term blips in September and October. Ultimately, the equity and credit markets were roundly optimistic about the future, overlooking Covid-19 challenges, high debt levels, and an uncertain outlook for employment figures. As a result, risk-on assets have been winning quite consistently, helping to explain PCN's strong performance since my last review.
With this in mind, has my outlook for high yield credit changed? In fairness, I am still generally cautious about the sector. However, the reason for my caution has shifted. Last year, I was concerned about credit quality, as corporate revenues and earnings were dropping due to economic lock-downs and reluctant consumers. While some sectors, namely travel, hospitality, and energy fared pretty poorly, credit markets as a whole actually performed quite well. This was driven by government support, improving consumer sentiment as the year went on, and ultra-low interest rates.
The third attribute, low interest rates, spurred a binge in new borrowing and cash-raising for both high yield and investment grade issuers alike. The end result has been an improvement in current/short-term assets on corporate balance sheets. While there are longer-term challenges related to corporate debt loads, in the short-term there is much less risk of actual credit default, given the amount of cash that was raised. For perspective, consider the rise in cash and cash equivalents across the high yield space as 2020 went on:
Source: Guggenheim
Now, my point here is not to dive into high yield credit. Defaults are still occurring, and the broader economy faces a host of challenges. Further, there are other risks to consider beyond credit risk, which I will get to next. However, it is worth noting that my outlook has improved since mid-last year. I was surprised by the level of government support, and the ability of issuers to raise large amounts of cash, despite the pandemic, puts to bed the risk of wide-scale defaults, even in the high yield sector. As a result, I am less concerned than I was six months ago, which improves my outlook for PCN.
Interest Rate Risk Is My Primary Concern
Now, the bad news. While I noted that credit risk is less of a concern for me, the downside is that interest rate risk is now more of a concern. This balances out some of the optimism I discussed above, helping to support my view on a neutral rating for this fund.
To understand why, consider that PCN is certainly exposed to interest rate risk. While PIMCO uses a diversified approach to manage this risk, PCN still has a duration of over 6.5 years. This means the fund will see its underlying value fall by roughly 6.5% for every 1% rise in interest rates, as seen below:
Source: PIMCO
This is important, and helps to explain why PCN saw some weakness over the past few days, because longer-term yields are indeed rising:
Source: Charles Schwab
While central bank benchmark rates (in the U.S. and elsewhere) have been mostly unchanged, the result of rising longer-term yields is pressuring the fixed-income world, including PCN:
Source: Seeking Alpha
My takeaway here is investors need to be careful. If yield pressure eases, which has been happening so far this week, then interest rate risk becomes less of an immediate concern. But, as the yield graph above showed, we are now only approaching pre-crisis levels. Those levels were still low historically. This means if economic growth and/or expectations keep rising in 2021, then yields have the potential to rise much higher. If that does happen, then funds with high durations, such as PCN, will certainly come under pressure.
Valuation Too High For Comfort
At this point, my take on PCN has been fairly balanced. There are some pros and cons, but the fund does have bullish momentum, which could push prices higher still. However, my next few points touch on why I am still unwilling to recommend positions at this point in time. The first does not relate to the fund's underlying structure or performance, but considers the price investors must pay to own this asset. PCN is a CEF that historically has a large premium, and that is absolutely the case right now.
Importantly, PCN's premium has come down slightly since my August review. This means the fund's underlying value has risen substantially. Given how PCN's market price has increased, the premium declining means that underlying performance has outpaced market performance. That is certainly good news that owners of PCN want to hear.
The downside to that story is, despite the premium declining modestly, it is still very high. To illustrate, see the chart below:
| Current Premium | 19.2% |
| Premium in Last Review | 20.8% |
Source: PIMCO
The point here is PCN is nowhere near "cheap," not by any stretch of imagination. The premium of almost 20% on the surface is high, but it is true PCN has been able to maintain this level for a while. That is a key reason why I am not "bearish" on the fund, but simply cautious. Yes, the high premium indicates a sharp correction in share price could occur, but PCN's history suggests that is not an immediate concern. However, its premium is rarely sustainable if it goes much higher than current levels.
This, in my opinion, limits the upside potential going forward. Further, PIMCO CEF investors have multiple options to choose from, and PCN's current premium is well above many of those options. All things considered, this indicates PCN is a bit too richly priced, which forces me to leave my prior rating intact.
Income Metrics Show Some Weakness
My next point again supports a neutral view. While PCN's yield is quite attractive on the surface, investors need to consider its sustainability as well. Importantly, I have been impressed with PCN, and the majority of PIMCO CEFs, for their ability to maintain their distributions during a very challenging year. However, when we look at current income figures, we see there is some inherent weakness. In fact, PCN's coverage ratios are well below the 100% level, and the fund's UNII balance is negative, as shown below:
Source: PIMCO
My takeaway here is that investors will want to monitor these figures very closely. In fairness, PCN's distribution is attractive enough that it could withstand an income cut, and I would still find the current yield attractive. Further, PCN has been able to maintain its distribution for a long time, so I do not believe a cut will be forthcoming any time soon. Yet, these figures also do not inspire confidence, and the negative UNII balance is worth more than a full month of distributions. This leaves little room for error going forward. Ultimately, I question the logic of paying a 20% premium for a CEF with these figures, and would wait to see if they improve in the months ahead.
Bottom line
PCN's performance in 2020 through to 2021 has been impressive. This alone may pique investor interest but, unfortunately, it is still one I am cautious on. While an improving macro-picture and a rising NAV for PCN is all good news, there are risks to consider. One, the fund's income metrics are weak. Two, duration risk is notable, and contributed to the recent weakness in the fund. Three, the premium to own PCN is much too high, in my view, and ignores the risk profile of the high-yield sector. Therefore, I continue to hold a neutral rating on PCN, and suggest investors approach positions carefully at this time.
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This article was written by
Dividend Seeker began his career in financial services in 2008, at the height of the market crash. This experience shaped his investment strategy. He has worked in the Insurance industry in funds management, as a junior equity and currency analyst, and is currently working for one of the largest banks in the world.
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.Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
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Comments (14)
Uncle
Nice write-up
