PIMCO Income Strategy Fund - Take Some Risk Off
Summary
- PFL is trading at a high premium to net asset value not seen in nearly 10 years.
- High-yield bond spreads vs. Treasuries are approaching lows touched in 2007 and 2014 - historically bad entry points for PFL.
- The fund is covering about 75% of distributions with investment income - doable if NAV is also increasing, but a problem if it is declining.
- PDO is a newly-issued fund trading closer to NAV. It also invests in riskier fixed-income sectors, but has shorter average maturity and lower leverage.
- I recently sold PFL and bought a smaller amount of PDO.
Introduction
I last wrote about PIMCO Income Strategy Fund (NYSE:PFL) in December 2020. At that time I noted how this closed end fund has been a strong performer over the long term but was subject to big drawdowns during market turmoil such as the 2007-2009 financial crisis or the March 2020 COVID crash. The fund also has underperformed during other periods of rising high yield bond spreads such as 2014-2016. I mentioned in December that high yield spreads had a little further to fall, but they are now approaching levels seen only in 2007 before the financial crisis and in 2014, just before the oil price crash. Also, the fund's premium to net asset value was around 7% at the time of my last article. It has now reached over 14%, which is the highest level seen since 2011.
PFL also continues to have negative UNII, meaning distributions have exceeded investment income. This is not always a problem; for example, if the fund's NAV continues to grow due to unrealized gains, they can eventually become realized and count as part of net investment income. However, if the fund's holdings start to decrease in value and are not replaced by higher yielding securities, it will either have to cut the distribution of count some of it as a return of capital. PIMCO has mostly avoided this scenario, but a rising rate environment could make it more likely.
In this environment, PFL could face a period of negative total return, even with its 9% yield. Now is a good time to consider swapping out of PFL for a lower-risk option. For investors who want to remain with PIMCO, the newly-issued PIMCO Dynamic Income Opportunities Fund (PDO) is a possibility. At a lower annualized yield of 7.1% based on the first payment, market sentiment toward PDO has been muted. PDO only trades at a 1% premium to NAV. It also has lower average maturity and less leverage than PFL, although at two months since IPO, it may not be at its target allocations yet. This could allow PIMCO to average into new holdings for PDO at lower costs if spreads widen.
While some high yield analysts on Seeking Alpha focus mostly on the income with little regard for the share price movements, I believe these funds can be treated like stocks that can be sold when their price gets ahead of the fundamentals. I recently sold my PFL and started a smaller position in PDO.
High Yield Spreads Approaching Historic Lows
High yield corporate bonds make up the largest allocation within PFL, as the fund's web site shows as of 2/28/2021.
Source: PIMCO
PFL NAV and market price therefore tend to correlate with the high yield spread, even though PIMCO earns its 1.2% expense ratio (before interest expense) to mitigate the spread widening impact through sector allocation, security selection, and hedging. The high yield spread, as measured by the ICE B of A High Yield Index vs. the 10-year US Treasury is now at a level only observed two other times during the life of the fund: in June 2007 prior to the financial crisis and in June 2014 prior to the oil price crash that impacted high yield bonds especially in the energy sector.
Data Source: FRED - St. Louis Fed Economic Data
Note that the 2014-2016 spread widening was about the same magnitude as the March 2020 COVID crash, although it occurred over a longer time frame. Nevertheless, the impact on PFL NAV and share price were considerable.
Data Source: PIMCO
Over this time frame, from 6/1/2014 to 2/11/2016, PFL market price declined 27.9%. The fund did continue to maintain its $0.09 monthly dividend for a return of 14.7% based on starting price. That makes the total return over this period a negative -13.2%.
Fund returns during the financial crisis and COVID crash were much worse, but I am not including them here because I wanted to show that fund performance can be poor during a spread widening period even if the general economy is doing fairly well. If a new high yield spread widening period is now beginning, investors should keep this historical performance in mind whether it is because of general inflationary concerns or industry-specific credit issues like we saw with the energy industry in 2014-16.
Historically High Premiums
In the chart above, we see that market price began trading at a discount to NAV in 2015 which persisted until early 2017 and marked a great buying period for the fund. Today's conditions are the opposite. Since my December 2020 article when the fund was trading at more of a long-term average 7% premium to NAV, the premium has increased to over 14%. This is a level not seen since 2011.
Data Source: PIMCO
Further, the market price has continued to trend up while the NAV has been basically flat.
Data Source: PIMCO
I'm not that concerned about a flat NAV for a fund whose main purpose is to deliver income. In fact, it provides some reassurance that the fund's monthly distribution has been sustainable even though it continues to report an over-distribution of net investment income. The UNII report for all PIMCO closed end funds shows that only 53% of the dividends paid out by PFL since 8/1/2020 have come from realized income. This is fine as long as we expect the fund's holdings to maintain their unrealized gains until they mature or are closed out. However, if we really are going into a spread widening period, there is increased likelihood that this may not be the case. In that scenario, we can expect NAV to come down, and market price may come down faster as the market begins to see the worsening fundamentals. The fund can maintain its distribution of $0.09 per month but it is likely that some of it will be considered a return of capital. In the worst case, if PIMCO thinks the distribution can't be covered for an extended period, a dividend cut might be implemented.
These concerns have led me to sell PFL and reduce my overall allocation to high-yield CEFs. Still, since I may be wrong, I never like to make too big of a move. My new closed-end CEF position is about 60% of the size of my former PFL position and it is now in the PIMCO Dynamic Income Opportunities Fund (PDO).
PDO - A New Offering Trading Closer To NAV
PDO was a new offering from PIMCO in January 2021. The initial information about fund holdings as of 2/28/2021 show allocations that are not hugely different from PFL with a few exceptions.
Source: PIMCO
PDO is even longer high yield and less long investment grade credit than PFL, so the risk discussion above about spread widening still applies. However note that PDO still has 11.65% allocated to short duration instruments and almost no US government related exposure. PFL has a short position in other short duration and 10.3% in US government exposure. This may be an artifact of PDO not being fully invested just one month after its IPO, but that works to the fund's advantage in a spread widening environment. PIMCO can slowly scale into positions as prices fall and yields increase.
Similarly, PDO's leverage was only 9.5% as of 2/28, all coming from credit default swaps. PFL's leverage was 33.8% at that time. I would expect the leverage to increase in the coming months but PIMCO can do this at their own pace as conditions warrant. PIMCO did not disclose a duration for PDO as of 2/28, but the average maturity was 9.7 years compared to 12.4 years for PFL.
PDO's initial dividend payout of $0.1184 represents a yield of 7.1% if maintained for a full year. This is lower than PFL and most taxable PIMCO CEFs. The market seemed to be disappointed with this as the fund fell back to the $20 level from $20.80 before the 3/1 announcement. The good news is that this is only 1% over NAV. The lower yield and premium should make PDO less susceptible to a dividend cut or big price decline in a rising spread environment compared to PFL.
A final point on PDO is that PIMCO intends to dissolve the fund after 12 years, or on 1/27/2033, subject to extensions of up to 18 months. The dissolution date may also be eliminated if the fund conducts a tender offer and fewer than a threshold number of shares decide to tender. Investors should consult the prospectus for more details. The defined life span of PDO may serve to keep the market price closer to NAV than funds with no termination date.
Conclusion
Investors should consider their outlook on high yield spreads when deciding how much to allocate toward high yield closed end funds. Chasing yield could be a bad decision in a widening spread environment. With spreads touching levels only seen in 2007 and 2014, PFL and most taxable PIMCO CEFs have become riskier. Based on PFL's performance after the last HY spread bottoming in 2014 and its 10-year high premium to NAV, I have sold PFL.
PIMCO's newest offering PDO is also susceptible to widening high yield spreads, but its lower leverage and higher allocation to short duration instruments give management greater flexibility in a spread widening environment. The fund also trades only 1% above NAV and pays a lower yield than PFL making it less vulnerable to dividend cuts or drops in premium. I am now long PDO but only at 60% of my former PFL position size.
This article was written by
Analyst’s Disclosure: I am/we are long PDO. 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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