RCS: It Has Dropped Almost 20%, And It's Still Not Cheap
- RCS has been a very poor performer over the past few months. This pain could make for a contrarian buy signal.
- Despite a drop over 18%, the fund is still not "cheap", when we compare its market price to the underlying value. This makes me reluctant to be a buyer here.
- Agency MBS remain well supported by fundamentals in terms of credit risk. Housing prices are rising and delinquencies are low. Yet, there is plenty of risk with Fed tapering.
- RCS' duration is not low enough to really generate my interest, as inflation remains red hot and the Fed has turned less hawkish.
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »
Main Thesis / Background
The purpose of this article is to evaluate the PIMCO Strategic Income Fund (NYSE:RCS) as an investment option at its current market price. RCS is a closed-end fund whose objective is "to generate a level of income that's higher than that generated by high-quality, intermediate-term U.S. debt securities. Its secondary objective is capital appreciation". I cover RCS regularly, but have not been a buyer from some time. I reiterated this caution back in November, when I last looked at it. In hindsight, I was right to avoid this CEF, but I should absolutely have been more bearish. This is because the fund has dropped by just under 19% in the past four months, which is startling poor:
Given all the volatility we have seen recently, I thought it was appropriate to give RCS another look. Despite this drop, there are just too many concerns I have regarding the product as a whole to be a buyer. Yes, this drop makes for an interesting "value" opportunity - if we look at short-term performance. But the fund is still richly priced, there is plenty of macro-headwinds facing debt as an asset class, and I don't tend to buy PIMCO CEFs for trading opportunities (preferring them for longer term positions). Therefore, my "hold" rating will remain in place, and I will explain why in more detail below.
Premium Price Hard To Ignore
I will start with a quick look at the fund's valuation, which has been the sore spot for RCS (in my view) for a very long time. The good news for starting a position now, whether in RCS or one of its sister funds, is that PIMCO premiums have shrunk measurably across the board. RCS has definitely been on the front-line of this trend as well, which explains a good amount of the drop we have seen since early November. At the time of that article, RCS had a premium in the 16% range. Today, that premium has shrunk in half:
The takeaway here is simple so I won't go in to too much detail. RCS is much cheaper than it was a short while ago. Yet, the fund is not even close to what I would describe as "cheap". Does an 8% premium signal a buy opportunity for RCS? Not to me, although there are plenty of PIMCO investors who would disagree. The fund's next move here could go either direction, and investing at below average premiums can often be a winning play in isolation. In fairness, I don't expect to see RCS' valuation compress too much further, which is why I kept a "hold" rating, as opposed to a "sell" rating. Yet, I can't get behind a major upside thesis with the fund nearing a double-digit premium. This valuation story is a subjective argument, but for me it signals one to pass.
Income Metrics Are Mixed
My next point looks at the fund's income metrics. With interest rates set to rise in the U.S. in the very near term, evaluating a fund's distribution yield is extremely important. Fortunately, on the surface RCS has a very attractive yield over 10%. This means that the Fed's funds rate can move substantially higher and RCS will still have an income stream investors are going to want. Further, coverage metrics are improving in the short-term, which is bullish:
The downside is that RCS has a history of distribution cuts, and its negative UNII balance remains a concern for me. In fairness, I believe the income story right now is solid enough to support current valuations. But the already present premium price, coupled with a negative UNII balance, registers to me that future gains could be modest. This is because investors may be unwilling to bid back up a fund with a mixed history, especially at a time of such broader market volatility. This push-pull story again supports my neutral outlook.
Agency MBS - Some Good, Some Bad
As with most of PIMCO's products, investing in RCS means investors are getting a wide range of debt exposure. This CEFs are filled with credit from different sectors - whether it is high yield, IG, munis, or short term lending products. This is a benefit of PIMCO products, investors are able to get a diversified portfolio through one ticker symbol. This is true for RCS as well, although readers should note the fund has a heavy reliance on mortgage debt, with over one-quarter of assets in the agency MBS sector alone:
As a result, a look at the housing market and MBS in particular is especially relevant when evaluating RCS.
The good news is that the U.S. housing market remains extremely strong. Perhaps too strong, but that is good news for investors who hold the debt in the underlying assets. What I mean is, home sales remain competitive. Supply is tight, home values are rising, and this story has continued in 2022, helping to keep prices at elevated levels:
For investors in MBS, and RCS by extension, these are the types of trends they want to see. Lower supply means that housing prices go up and available debt on the open market is limited. These factors support MBS prices (boosting RCS's underlying value) and also work to keep delinquencies at a minimal level. After all, who wants to default on a home that keeps rising in value? With this backdrop, it makes investing in agency MBS seem like a sure thing.
Expanding on the positives, readers should also be aware that mortgage rates have been rising recently across the country. The upside here is that this limits the attractiveness of refinancing. The fewer loans that are refinanced, the more stable income streams can be from funds like RCS. Further, with rates ticking up, that means new issues will offer more attractive yields as well:
With all these positive attributes, readers have got to be asking - what is the problem?
The problem unfortunately is the Fed. After having propped up the treasury and MBS markets for a long time during the pandemic, those days are coming gradually to an end. What started as a $120 billion/month buying spree has been reduced substantially to the current levels shown below:
As of now, the Fed has hinted that this buying could cease all together as early as March. More worryingly (for investors in MBS), the Fed has stated that:
MBS sales could be something the Committee considers down the road to satisfy our balance sheet principles long run goal of holding primarily Treasury securities"
Source: Federal Reserve
How does this all tie together? Well, it means that Fed buying of agency MBS has been substantially reduced, and is likely to be reduced even further over the next few months, if not sooner. For RCS this removes a key party that had been the source of buying demand for debt that makes up over 25% of its total assets. This reduction in Fed buying has got to account for some of RCS' decline over the past four months. With no signal to suggest this trend is going to reverse in 2022, it is difficult to be bullish on this fund now.
Duration Risk A Bit Too High For Comfort
My next take is on the fund's interest rate sensitivity. This is a critical element for any CEF investor right now, given the Fed has indicated it will begin raising its benchmark rate this month. For those interested in RCS, they should acknowledge that this fund is quite sensitive to changes in rates. While the fund's duration is not overly high, it is not low either, at just under 7 years:
As I have been highlighting in pretty much all my reviews over the last twelve months, duration risk should be top of mind for any investor. Inflation has been red hot for a year, and 2022 has proven that trend is not going anywhere fast:
Clearly, energy prices are driving a large percentage of the inflation metric. While this could cool with time, the current situation in Eastern Europe suggest high energy prices are going to be with us for a least a while longer. Their force behind the inflation story being what it is, we should conclude inflation is not going to tame itself in the near term. If that is the case, the Fed is going to have to act, and RCS' net asset value is sure to come under pressure.
Again, I don't want to be overly alarmist. The inflation risk is well known at this point, and RCS' decline has clearly built some of this headwind in already. Further, the Russian invasion of Ukraine has prompted the Fed to become a little less hawkish in its interest rate outlook. While inflation is going to force the Fed's hand to some degree, it can be less bold given the uncertainty caused by this geo-political crisis. In fact, while investors have begun to price in a .50 basis point move by the Fed in the March meeting, the futures market is now extremely confident in a .25 basis point move. This is largely due to the unraveling situation in Europe:
The overall conclusion here is not to panic, but to be mindful that rates are still going to increase and investors need to manage their duration exposure. If one already has a limited amount of credit and growth stocks, they can probably afford to take on some additional interest rate risk. But for those, like myself, who already own plenty of assets that will see pressure from rising rates, adding a fund like RCS just doesn't make sense at this time.
The market's volatile and broad decline has me looking for value. I have been a buyer on down days, and will continue to be, wherever the opportunity presents itself. Broadly speaking, equities tend to perform extremely well after geo-political events, so that is primarily where I will be looking. But I also have found some value in the credit space, with plenty of muni CEFs hitting wide discount levels and even some PIMCO CEFs have breached discount territory. This has allowed me to put some cash to work.
Unfortunately, RCS does not fit in well with this mindset. The fund is still richly priced, albeit at a lower premium that where it has traded for most of the past twelve months. While that does limit further downside and suggest there is some value in positions here, I have not found long-term success buying funds near double-digit premiums. Further, the fund is exposed to Fed tapering in the MBS space, and it has plenty of interest rate risk that makes me cautious. As a result, I will keep a "hold" rating on RCS in place, and suggest readers approach this fund very selectively at this time.
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This article was written by
I've been in the Financial Services sector since 2008, which unsurprisingly gives me an invaluable insight in how markets can turn. I was a D1 athlete in college (men's tennis), where I studied Finance. I also have my MBA in Finance.
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