- We have been capitalizing on the COVID panic, buying a lot of underpriced opportunities.
- One sector that remains undervalued is non-agency mortgage-backed securities.
- The housing market is on fire and new mortgages have very low yields.
- PCI is one of the best ways to capitalize on this opportunity.
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The unknown forms both risk and opportunity for investors. The fear of the unknown frequently causes investments to be priced lower than the actual risk calls for, which makes it a great buying opportunity.
One such opportunity is in legacy mortgages. Mortgage rates today are near all-time lows. Houses are flying off the market as fast as people can list them. House prices surged 14% in January, even as volume was up over 20%. The market is so hot, you might consider selling your house - except for the issue of where will you live? Owning mortgages is a great way to participate in this opportunity while keeping a roof over your head. Such a strong housing market should be excellent news for older mortgages, yet many continue to trade at a discount to par value.
We will be shedding light today on an elite stock that has a generous 9.4% dividend yield paid monthly. This CEF is PIMCO Dynamic Credit and Mortgage Income Fund (PCI).
PCI has a broad array of investments, is managed by a world-class manager, and many of the investments are a type that a retail investor cannot easily trade. PCI is an actively managed fund that takes advantage of market opportunities while keeping your money safe in good hands.
PCI: A Clear Winner based on Performance
PCI is managed by PIMCO, an elite management team that invests in the debt markets. PIMCO has a well-earned reputation as a world-class manager, and that is reflected in the values of their funds. PCI has been going strong, handily beating the market for the past five years before COVID-19 took the wind out of its sails. This downfall was recorded by the majority of securities listed on the market.
PCI's decline in price was primarily due to the falling prices in several of PCI's major allocations. Mortgages, high-yield credit, bank loans, and emerging market debt all suffered with the market assuming that default rates would spike.
This phenomenon is quite common during times of economic chaos. When there is fear and a lot of unknowns, institutional money exits out of credit risk investments and runs to "safety" such as US Treasuries. One thing that COVID-19 created was tons of uncertainty. Institutions were blindly selling credit risk and running to treasuries or cash.
PCI was one of the rare funds that went the other way - selling off investment grade and government debt to deleverage, while buying more mortgages. PIMCO was betting that the Armageddon of mass defaults wouldn't happen. And they were right.
A great mitigating factor has been the Fed's intervention by pumping liquidity in the system, and government assistance to overcome the financial impact of job losses. The stimulus amounts at the federal level was unprecedented, and the Federal Reserve's willingness to ensure liquidity meant that lenders were more than willing to provide forbearance and other relief to borrowers who were impacted by COVID.
Worth Every Penny
PCI is currently trading at a 7.6% premium to NAV, and that premium is worth every penny. In fact, by PIMCO standards, PCI's premium is very small compared to many PIMCO funds that trade at 20%+ premiums, for example PIMCO Corporate & Income Opportunity Fund (PTY). Even PCI's sister fund PIMCO Dynamic Income Fund (NYSE:PDI), which has very similar assets, is trading at an 13% premium and has previously traded at premiums in excess of 20%. PCI could easily reach a much higher premium in 2021.
Not only does PCI provide a leading administration, but this CEF also invests in areas that are very hard for retail investors to get in. The bulk of their holdings are RMBS (residential mortgage-backed securities) meaning that they are packaged together and the rights to collect the principal and interest payments are sold off to investors.
Mortgages Are Still Underpriced
PCI's main holding is on mortgages, "non-agency mortgage-backed securities" is their core stake. MBS are securitized mortgages, which help lenders who issue numerous mortgages preserve liquidity to be able to initiate loans in the future. As an alternative to waiting for 30-years for the borrower to make payments, they sell the loan to PCI and other investors. Investors can either profit from the regular interest payments or they can profit from trading them by selling high and buying low.
Source: PIMCO (Market Value / Duration Weighted Exposure)
Since last March, non-agency MBS has seen a substantial rally but continues to trade below pre-COVID prices. This despite the fact that the mortgages are safer today than they were before COVID.
In fact, throughout 2020 we saw the housing market strengthening. Housing prices are going up, homes listed for sale are selling extremely fast and the fundamentals are stronger than ever. For the older mortgages that PCI owns, which were primarily originated before 2009, this means that the collateral underlying the mortgage is substantially more valuable than the amount owed. Meanwhile, new mortgages are being originated at interest rates of 3% or even lower. It is a bit silly that older mortgages with 4%+ interest rates and are easily below 60% loan-to-value are trading at a discount to face value.
A Healthy Mortgage Market
Back in 2008-2009, as foreclosures erupted, the market was flooded with houses for sale, causing residential real estate to crumble and lenders were overwhelmed by the sheer volume of defaulted mortgages. Even MBS investments that were considered safe and had AAA ratings from agencies collapsed.
During the March collapse, investors believed that the same event will happen, however, the indications show that mortgages and housing markets are much healthier nowadays and are supported by strong fundamentals as seen below.
Source: First American
In addition, the number of existing mortgages that were underwater - meaning that the amount they owed exceeded the estimated home value - declined 18.3% in Q3 of 2020. As well as only 366k mortgages were underwater, representing 3.3% of all mortgages.
In 2008, the supply of houses for sale exceeded demand and many mortgages were underwater, so foreclosures could not easily be sold and the sale prices were often less than the amount owed. Today, the opposite is true - demand for buying houses exceeds the supply and most mortgages are for materially less than the house is worth on the open market.
For MBS owners, this is positive on two fronts:
- First, a borrower is likely to at least attempt to sell their house if they can get more money than is owed on the mortgages. This saves the borrower's credit rating while also providing them cash if they can sell the house for more than they owe. In this market, that is a strong possibility.
- Second, if a house does go all the way to foreclosure, selling into a hot market will result in a better recovery.
MBS prices crashed like there already was a foreclosure crisis, and that was a huge buying opportunity to buy at a discount. While others were selling, PIMCO was buying. As MBS prices continue to recover, we will see that upside show up in NAV.
Exponential Growth in a Bull Market
PCI maintains leverage of around 40% of gross assets. PCI's leverage is primarily "repurchase agreements" which is debt that is secured by the asset that it is used to buy. This debt is non-recourse, so PCI always has the option to surrender the collateral, limiting the risk to the rest of their portfolio.
Compared to other participants in the mortgage space like mREITs, PIMCO uses very conservative leverage in a sector that frequently uses very high leverage levels. During the March crash, this meant that PCI was able to buy more at very cheap prices while others were forced to sell to deleverage. PCI's selling occurred in their investment-grade and government holdings, where prices did not fall as much.
Strong Track Record of Dividend Payments
PCI has an excellent dividend record, raising its monthly dividend from $0.1491 in 2013 to the current $0.174/month. In addition to that, PCI has had several special dividends along the way including an extra $0.45 in December of 2019. Unsurprisingly, PIMCO did not distribute the "bonus" dividend in 2020 due to the Covid situation.
This extra dividend which is usually paid in December is not counted in the 9.4% yield as it is an end-of-year gift by PIMCO. With 2021 likely to be a substantial recovery year, a special dividend at year-end is a possibility.
When prices fall, the natural reaction is to worry about it. Investors wonder if prices will come back again, they often panic, they will sell to "cut their losses". Wise investors go against the grain, they recognize that the fear almost always exaggerates the real risk. When the market panics, they hit the "on" switch and start buying.
This is what PIMCO does in the very complex bond sector. Today, you can get yields of +9.4% and enjoy the capital gains as the mortgage market continues its recovery. Just like in 2010-2012, PIMCO will be there, already owning when the rest of the market is rushing in with the fear of missing out.
PCI is an excellent way for investors to gain exposure to this undervalued part of the market. Their portfolio is heavily weighted toward 10+ year-old MBS, they have the necessary liquidity to avoid losing any assets in margin calls and it's directed by a world-class team that knows this section of the market very well.
The future is bright for PCI due to higher U.S. home prices (now the medium price is at all-time highs), and increased demand for housing as a result of low interest rates. PCI is a great way to gain exposure to the red-hot real estate market without renting a U-haul and finding a new place to live.
As income investors, our aim is to create a high level of current income through dividends. These monthly payments provide the flexibility to redirect the income into other profitable investments, as well as they are used by many as retirement income.
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