PIMCO CEF February Update
Summary
- We discuss the leverage and distribution coverage figures of PIMCO CEFs for February.
- We also highlight the interest-rate positioning in the taxable suite, which, in large part, is responsible for the performance of the taxable funds in this rising rate environment.
- We continue to favor PHK in our allocation due to its modest leverage, low fees and yield curve steepener profile which have allowed the fund to continue outperforming.
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This article was originally released to Systematic Income subscribers on 23-Mar.
In this article, we provide a February update on the PIMCO fixed-income CEF suite, focusing on coverage and leverage changes for the month. We also highlight the interest-rate dynamics of the taxable suite which, in large part, determines how the funds have responded to the shifting interest rate environment. We continue to favor the PIMCO High Income Fund (PHK) in our allocation due to its modest leverage, low fees and yield curve steepener profile which have allowed the fund to perform very well within the suite.
Leverage Update
PIMCO taxable CEFs added borrowings, in aggregate, over the month of February.
Source: Systematic Income
However, leverage ticked down very slightly as NAV gains outpaced borrowings.
Source: Systematic Income
The leverage picture that is starting to emerge here is that of PIMCO funds raising leverage levels from May into September when underlying credit valuations were attractive, then tapering leverage through December as assets became close to fully valued. Since November the average leverage level has been little changed reflecting range-bound underlying valuations. Unless we see a significant move in assets one way or another we don't expect leverage levels to move sharply from their current levels.
Individual fund leverage changes were mixed with the two idiosyncratic funds, PIMCO Strategic Income Fund (RCS) and PIMCO Global StocksPLUS & Income Fund (PGP), cutting leverage while a number of fixed-income multi-sector funds added leverage.
Source: Systematic Income
There have been no changes in borrowings for tax-exempt funds since their initial deleveraging in the first half of the year. The main reason for this is that the muni fund NAVs have been much more under pressure due to their higher-quality allocation and a longer duration at more than 2x that of the taxable funds. This inability to grow net assets means that there is no room to add borrowings as leverage is already at elevated levels in the low 40s.
Source: Systematic Income
Coverage Update
Muni fund coverage mostly reversed the modest drops of the previous months.
Source: Systematic Income
Going forward, muni coverage is unlikely to improve strongly from current levels as low leverage costs are fully baked in and are at their floored levels while low risk-free rates, high leverage levels and low Treasury ratios mean funds will struggle to grow income, particularly as bonds will continue to be redeemed apace. At the same time, it is our view that commentators make too much of muni redemptions and their potential impact on fund income. This is because tax-exempt bond coupons, unlike their corporate counterparts, are typically not set according to the prevailing yield levels which mitigates the impact of funds having to find new bonds for their cash.
This dynamic often surprises investors who are used to getting well-covered 4-5% distribution rates on tax-exempt CEFs that allocate primarily to AA/A rated bonds and who assume that this high distribution rate reflects the actual fund portfolio yields. As an example, consider that Illinois just recently issued a 25-year GO bond (rated BBB-) with a 5% coupon and a 2.75% yield. This discrepancy between coupons on bonds and their actual yields means that the impact of refinancing at lower yields is muted than if coupons were set at prevailing yields. This suggests that even if redemption activity remains elevated we wouldn't expect muni coverage to collapse in the near term.
Coverage metrics within the three muni sub-sectors (California, New York and National) highlight a persistent feature of PIMCO CEFs which is that one of three funds in each sub-sector (e.g. PIMCO Municipal Income Fund II (PML) in the National sub-sector, PIMCO California Municipal Income Fund (PCQ) in the California sub-sector) will tend to have a significantly higher NAV distribution rate versus its two other sub-sector counterparts for no apparent reason. This higher distribution rate is treated by some investors as a sign that that particular fund in the sub-sector "has the magic" while the other two don't. It's not clear why some investors think that one of three funds in the sub-sector could be earning a significantly higher income level despite being run by the same managers with, broadly speaking, the same portfolio and the same management fees. For example, PCQ which has a higher NAV distribution rate than PIMCO California Municipal Income Fund II (PCK) and PIMCO California Municipal Income Fund III (PZC) by more than 1% for which it is rewarded with a 29% premium while its counterparts enjoy low-to-mid single digit premiums.
If PCQ were indeed earning a level of income that was 1% higher than its 2 sister funds, then it should have made its way into higher longer-term NAV returns. However, the fund's 5-year NAV return is right at the average of its two sister funds. A quick glance at coverage also shows that the higher distribution rate of PCQ translates into the lowest coverage of the three funds.
Source: Systematic Income CEF Tool
Net net, the end result is that the PCQ covered yield - what we call the NII yield on price - is by far the lowest of the California trio. In other words, investors appear to be favoring a fund that delivers them the lowest earning yield on price. In addition, PCQ represents the worst risk/reward in the sub-sector as it is most likely to be forced to adjust its distribution in line with the other two funds. This would be followed with a sharp deflation of its premium, delivering outsized losses to investors. The divergent UNII trajectories of PCQ versus the other two funds show that this could very well happen sooner rather than later.
Source: Systematic Income CEF Tool
There is a very similar dynamic in the National tax-exempt sub-sector (PML, PIMCO Municipal Income Fund III (PMX), PIMCO Municipal Income Fund (PMF)) as well and it remains a peculiar, though far from unique, feature of PIMCO CEFs.
In the taxable space, the coverage of the three non-agency RMBS overweight funds was mixed. The unusually high coverage of PCM in the suite, despite its middling leverage and mid-level fees is really a function of its higher allocation to the RMBS sector, in our view. There are two features of non-agency RMBS assets that optically boost the fund's coverage which is often misinterpreted as a sign of superior portfolio yield. First, there is the usual MBS asset dynamic where the principal is repaid over time, boosting coupons by borrowing from principal and making them behave more like annuities (the point here is that the distribution rate of an annuity is significantly higher than its actual yield). And secondly, the legacy RMBS asset prices are further depressed through historic and future defaults which further boosts income yields in excess of actual portfolio yields.
Source: Systematic Income CEF Tool
The coverage of the other taxable funds bounced back from bad readings in the prior month to end up at to the highest levels over the last six months or so. The USD index rallied for both January and February, so it's not clear this is (or ever was) a good predictive factor for coverage.
Source: Systematic Income CEF Tool
The tax-exempt UNII picture is marked by convergence across the funds as well as their relative resilience as all are in at zero or in the green.
Source: Systematic Income CEF Tool
The taxable UNII picture is less serene with funds continuing their downward trajectories.
Source: Systematic Income CEF Tool
We are less concerned about this development and its potential impact on distributions simply because of our view that being able to generate sustainable yields of 8-11% is basically impossible in the current credit market, outside of CLO Equity (which has its own issues), unless the fund is 1) almost entirely in CCC-rated bonds and 2) run at a very high leverage level. Because the credit profile of the PIMCO taxable funds is certainly not at the CCC level, we shouldn't expect them to boast portfolios with yields that match high distribution rates. What that means with respect to potential distribution cuts is hard to say as these events happen so infrequently.
The majority of the taxable funds are now underwater from a net NAV (ex-distributions) perspective. This can be a useful metric for investors who view coverage in the context of the fund's total return rather than just its net investment income. In other words, most of the taxable funds have failed to "cover" their distributions through the combination of coupons and NAV returns.
Source: Systematic Income CEF Tool
Interest Rate Sensitivity
As we discussed elsewhere, investors who are concerned about the impact of rising rates on their fund holdings have to distinguish between two different scenarios. One is a reflationary scenario where rates rise gradually on the back of an improving macro picture and stronger growth. And the second scenario is a much faster and messier spike in rates due to a monetary policy or inflation surprise. The key difference between the two scenarios is that the former tends to be risk-on while the latter tends to be risk-off. In other words, while risk-free rates can end up in the same place for both scenarios, risk assets can end up in very different places due to their individual risk stance.
Investors who would like to gauge PIMCO fund performance can use the following proxies as rough guides. To proxy the first scenario of a steady grind higher in rates amid a pro-growth and pro-risk outlook we simply take a look at the performance of funds since the start of the year. A repeat of the same outcome should favor the leading funds in the chart.
Source: Systematic Income
This is how the same picture looks for the tax-exempt suite.
Source: Systematic Income
To proxy the second scenario of a risk-off rate spike we average the NAV performance across 4 days this year that saw an average double-digit rise in 10-year Treasury yields along with weaker risk assets.
Source: Systematic Income
And this is the tax-exempt version.
Source: Systematic Income
Taxable funds that should do well in the risk-on reflationary scenario are higher-leveraged, lower-quality funds. And funds that should do well in the risk-off surprise scenario are lower-leveraged, higher-quality funds. It would be unusual for one fund that be able to do well across both scenarios, unless it is doing something clever.
That said, what is striking across the two taxable charts is that PHK is in the top two funds across both scenario proxies. In other words, the fund has performed well during a broader risk-on environment as well as on risk-off days. What's going on here?
In short, the fund runs at one of the lowest leverage levels in the suite which makes it relatively defensive, allowing it to outperform on risk-off rate spike days. At the same time, PHK has an outsized yield curve steepener position in the taxable suite - discussed in more detail below - which allows it to perform well during risk-on periods of rising rates despite its under-powered exposure to risky assets.
Does this make PHK the "best" fund in the suite? Our approach to fund analysis has been to avoid such terms since it ignores individual investor utility functions. It also, at best, dumbs down the investment process and, at worst, is highly misleading. Ultimately, funds exist in a competitive ecology of experienced professionals who all have access to the same products and strategies. This means that the key performance differentiators tend to be economic decisions or tilts which the funds make. These decisions have their pros and cons (since if they worked across all types of environments - all managers would use them and there would be no difference across funds).
This is even more true for PIMCO funds which are run under the same umbrella. To go back to PHK, an environment which is less conducive to PHK performance is one where rates are falling and risky assets do well. In this environment, the fund's steepener will not be of much help and its modest leverage will cause it to lag other funds. That this kind of environment is less likely, in our view (outside of long secular trends, rates tend not to fall when risky assets do well) is what makes the fund fairly attractive to us. This is why PHK has been our sole pick in the suite since Q3 of last year.
To break down the fund's interest-rate stance we need to first look at PIMCO's broader approach to interest rate positioning. More specifically, taxable PIMCO funds use two main interest rate hedging strategies. First, they tend to maintain a yield curve steepener. The chart below shows that fund tend to received (i.e. long bonds) the front-end and belly of the curve and paid (i.e. short bonds) the long-end of the curve. In other words, the funds make money when interest rates up to about the 10-year point fall and when rates around the 30-year point rise. The units are normalized across the funds by their net assets. Here, we can see that PHK stands out for its larger mismatch between the 10y and 30y rate sensitivity. This means the fund has a larger than normal 10s30s yield curve steeper on than other funds as well as a smaller 5y position.
Source: Systematic Income
PIMCO CEFs have carried the yield curve steepener position for years and it is particularly appealing now for a couple of reasons. First, longer-end rates provide a cheaper way to short / pay a unit of duration than short-end rates, providing more bang for the buck if rates rise in roughly parallel fashion. And secondly, because the front-end of the yield curve is well anchored by the Fed, given their guidance that they will remain on hold at least through 2023, it means that the yield curve will tend to see longer-end rates rise faster than shorter-end rates. This is pretty much what happened this year as 5y Treasury yields have risen 0.51% while 10y and 30y yields have risen 0.76% and 0.72%, respectively.
The second interest-rate hedging strategy the PIMCO CEFs use is to use non-USD rates. Though all CEFs except for PCM have some foreign-currency interest rate exposure PHK stands out for its use of the strategy, particularly in EUR.
Source: Systematic Income
One reason why this strategy has been attractive is due to the low absolute level of EUR interest rates as well as a relatively flat yield curve which minimized the carry on a paid-rates position.
The upshot of this type of interest rate positioning is that PHK has been able to take advantage of the recent steepening of the yield curve which has made up for its relatively modest risk stance.
Takeaways
Leverage across the PIMCO suite remained stable in February while coverage bounced back, marking a decent February for the suite. However, rising rates and tight underlying valuations of credit assets have begun to take a toll on fund NAVs so that a majority of taxable fund NAVs are now below their level at the start of the year. Our view remains that the combination of low management fees, modest leverage level and a yield curve steepener position continues to make PHK an attractive choice.
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This article was written by
ADS Analytics is a team of analysts with experience in research and trading departments at several industry-leading global investment banks. They focus on generating income ideas from a range of security types including: CEFs, ETFs and mutual funds, BDCs as well as individual preferred stocks and baby bonds.
ADS Analytics runs the investing group 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.
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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Comments (8)
Time to buckle up...
Looking at the financial highlights section of the semi- for the 1/31 funds, I note that in the half-year PTY had NII = 66c, 154c in realized and unrealized gains, but then reports 78c in regular distributions ALL FROM NII. Notably, PCN, PFL and PFN follow the same pattern. (Only PHK reported NII equal to its distribution.)
How are we supposed to explain the reported coverage of distributions by clearly DEFICIENT NII with no mention of a contribution from realized gains? And (additionally), why does this appear out of synch with monthly reports of UNII and earnings? Can you shedsome light on this?
Regards, Dick
seekingalpha.com/...
ADS
Your monthly review is always enlightening and appreciated.