PTY, PFL And PFN: It Is Only A Flesh Wound, So Far
Summary
- PIMCO Funds have a history of exceptional performance.
- Three funds just announced distribution cuts.
- We examine this event in light of our thesis to avoid these like the bubonic plague.
- I do much more than just articles at Conservative Income Portfolio: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
When we last covered the PIMCO Income Strategy Fund (NYSE:PFL) and PIMCO Corporate & Income Opportunity Fund (NYSE:PTY), we had a clear message for investors. The setup could not be worse.
Source: Seeking Alpha
Now, the call was not based on an immediate distribution cut. We did not like the idea of going long for a multitude of other reasons. This morning though, we did get a distribution cut across these two and a third PIMCO fund. We examine this event and tell you what is the best way to play it.
Who Moved My Cheese?
PIMCO Income Strategy Fund II (NYSE:PFN) joined PTY and PFL in cutting the distribution. On a slightly surprising note, PIMCO Dynamic Credit and Mortgage Income Fund (PCI) held the line.
Source: PIMCO
The cuts are rather modest with the highest one being just 10.25%. But even that sized cut is problematic when there is a cult-like status around these funds. As of September 1, 2021 close, PTY was trading at a 41.41% premium to NAV with PFL and PFN just holding over the 20% mark.
The numbers were glaringly dangerous and were more than twice the average premium over the last 5 years for each of these funds. At 41.41% for PTY you were paying about 5.4 years of the old distribution as a premium. Assuming that you would pay at least 20% in taxes on these distributions over the course of your holding, you would need 7 years just to breakeven. Now implied in all of these calculations is that at some point this trades at NAV and you land up literally paying for that premium. While that may sound far-fetched, do note that these funds have traded at a discount on multiple occasions in just the last 5 years. The market has perhaps woken up to this.
More Cuts Are Very Likely
The environment to make money in the fixed income space is probably the most hostile that we have ever seen. By that we mean that securities have been bid up so relentlessly and credit spreads compressed so markedly that even the skills and expertise of PIMCO are likely to come up short. This makes it possible (if not highly probable) to consider the unthinkable. That being that these funds have a poor streak.
It does not even have to be a rather long period. Just a year where they struggle to find opportunities to deliver those 10% plus returns on NAV. Can you imagine what will happen to that premium if they deliver 1 year with a 3% NAV return? Can investors honestly say that under those circumstances these three funds won't cut again and that they all won't trade at a discount to NAV?
When Should You Buy?
Opportunities to buy good funds and sane prices are not that common these days. We hear investors saying that "we need income today". Well we understand that, but the solution is hardly to go chasing the most expensive bubble (fixed income) at the most ludicrous valuations and bet that there will never be a mean reversion. But if you are looking for an entry point, watch the High Yield CCC Option Adjusted Spread. When this meter blows up and we will likely get it in the next 12-24 months, it will go sailing past 10%. When that happens you can bet you will get all these funds at a discount to NAV.
What Are Great Alternatives Today?
Yields as high as these three funds are rare in the market today and most carry the risk of being cut. This is despite the fact that three funds today dropped less than their distributions were cut. In other words their yields are now lower than they were before the cut. Even that lowered bar is hard to jump over. There are no high yielding CEFs or ETFs that we see today that fit a risk profile that would make us go long. We personally prefer to use option income to generate yields in the double digit range while reducing risks. In those cases the risk profile is very easy to adjust as you can lower your yield by choosing a more defensive strike. A good example is what we did with Brookfield Renewable Partners LP. (BEP) Since we heavily disliked the price at the time, we were happy to sell the cash secured put for $30 strikes for November 2021. 
Source: Interactive Brokers May 12, 2021
It offered us a 10.44% annualized yield with about a $5.00 price buffer.
Source: Author's App
We ultimately landed up closing this out at an even better annualized yield.
Source: Author's Other App
The key thing we want to emphasize here is that the option setup allowed us to not compromise our valuation call on the company. BEP was expensive at $35 and is even more expensive today. But we made the yield by choosing the terms we wanted to engage that stock at. That same discipline needs to be exhibited on these funds. But only when things moderate on the discount fund. Investors who did not heed this discipline lost out 4 years of distributions in six months on this closed end fund.
Conclusion
The PIMCO funds may bounce back from these cuts and the crowd may go wild and cheer that this was all "priced in". The cut may appear to be only a flesh wound. The hard look at the raw numbers above suggest quite the opposite. If you do get the bounce back (and even if you do not), thank your lucky stars and make a dash for cash. Total return outlook for all three funds, especially PTY, looks abysmal on every time horizon. With yield spreads at all-time lows, premiums at all-time highs alongside a very substantial dose of leverage, this is about as bad as it can get. Caveat Emptor.
Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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This article was written by
Conservative Income Portfolio is designed for investors who want reliable income with the lowest volatility.
High Valuations have distorted the investing landscape and investors are poised for exceptionally low forward returns. Using cash secured puts and covered calls to harvest income off value income stocks is the best way forward. We "lock-in" high yields when volatility is high and capture multiple years of dividends in advance to reach the goal of producing 7-9% yields with the lowest volatility.
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