PDO: Revisiting A Mistake I Made Last Year

Summary

• Last year I moved into a newly created PDO. The fund had seen some weakness and had a relatively reasonable valuation.
• Despite being cheaper than most of the PIMCO CEF family, PDO has failed to deliver.
• While most of the fixed-income world has been hurting in 2022, PDO's discount to NAV has not offered any shelter.
• Despite the continued poor performance of this CEF, I have been reluctant to unload. The fund's distribution is attractive, and the discount to NAV has widened to near double-digits.
• Ultimately, this remains a fund for those who can withstand further losses while collecting generous income. I do believe a turnaround is in the cards, so I don't want to miss it, but it could be a while before that happens.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

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Main Thesis & Background

The purpose of this article is to evaluate the PIMCO Dynamic Income Opportunities Fund (NYSE:PDO) as an investment option at its current market price. This is a closed-end fund whose objective is "current income as a primary objective and capital appreciation as a secondary objective".

I covered PDO for the first time back in October 2021, when the fund was quite new. It had seen some weakness, and I was reluctant to buy competing PIMCO CEFs because the premiums were getting out of hand. At the time, PDO had a modest premium, and PKO and PCI were going to be absorbed by PIMCO Dynamic Income Fund (PDI). Therefore, I thought the fund's valuation advantage would draw in some PKO and PCI investors who were concerned about the merger. While that may have happened, my thesis did not pan out as planned. Simply, PDO has done nothing but go down since that review, and holding it has turned out to be one of my biggest mistakes since last year:

Fund Performance (Seeking Alpha)

With this backdrop, I have been torn over just divesting this fund and moving on or adding to dollar cost average. Fortunately, I have held off on adding, which would have ended up costing me more. But rather than divest, I was continuously hoping for a turnover that never came.

Looking ahead, I continue to believe hold is the right outlook for this fund. While I may continue down the sucker's course on this mistake, I think bailing now is not going to be well timed. The fund's discount has widened to a lever that is very attractive, and the income metrics give me assurance the yield is safe. While I continue to have concerns, and I am not going to add more at this juncture because I don't want to compound my losses, I see potential for gains going forward. As such, I am going to wait for the expected rebound, and will explain why in detail below.

Fixed Income Has Been Hit Hard By Inflation

To start, I want to take a moment to reflect on how we got here. While PDO's performance since my last review has been a disaster, it is important to recognize this poor showing is not as bad as it looks in isolation. The broader macro-story has been difficult for fixed-income. Starting at the end of last year, investors finally began to wake up to the fact that inflation was not going way. Compounding this reality in Q1 of 2022 was a more hawkish tone out of the Fed and other central banks. As a result, fixed-income saw one of the worst quarters on record, impacting sectors across the board:

Fixed Income Returns (Vanguard)

Just as importantly, this backdrop has stretched beyond PDO and has impacted the entire PIMCO family (including muni funds). When looking at PIMCO's similar funds, we see a wave of red for the calendar year so far:

PIMCO CEF YTD Performance (Google Finance)

There are two primary takeaways for me when I look at this graphic. One, PDO has done very poorly, but investors would have lost money going with a multitude of PIMCO CEF options. So we can't simply say PDO is a bad fund. But, two, it illustrates an interesting concept. One of the reasons I looked up PDO last year was because its valuation was, on the surface, much more attractive. Yet, that has not saved it. In fact, it has performed worse than the funds with much loftier premiums. So therein lies the rub - premiums and discount, or valuations more broadly, are an important tool but have its limits. One would have thought PDO's cheaper price would have protected it when compared to the other funds, but the opposite was true.

So, this begs the question - why? On this point I can only guess, but I believe it stems from the relative newness of the fund. Investors do not have a track record to fall back on - in regards to income stability or capital gain performance. With respect to the other PIMCO CEFs, investors in those funds may have held them for years since they have been around longer, and were therefore more reluctant to sell. PDO, being newer, may have had investors bail as performance started to suffer because they had less skin in the game in terms of time invested. This selling would have exacerbated the downward price moves, and could explain the under-performance from this fund.

Wrapping this all together presents a difficult dilemma, and supports my continued caution on this fund, as opposed to a more bullish outlook. If investors did bail on PDO more aggressively because it was a newer fund, that story has not shifted. It is still less than a year and a half old so we cannot expect investor sentiment to have moved that much. That presents a challenging forward outlook, if we can't rely on investor stability to the same degree as its sister fund.

Furthermore, one of the primary roadblocks to fixed-income gains has been inflation. This again is not a headwind that is going way. CPI and CPE metrics have kept coming in strong, and there are other metrics we can look at to affirm that inflation is not slowing down, but continues to accelerate. We see this in the cost of employment index, which is impacted by rising wages and input costs that companies are coping with:

Cost of Employment Index (Yahoo Finance)

To tie this back to PDO, what I want to make clear here is that PDO still faces some of the same challenges it has faced since inception. I will get to the positive points in the following paragraphs, but I want to manage expectations and explain why I am not overly bullish on this CEF. While the fund gets a lot of positive coverage on Seeking Alpha, we must be cognizant that its relative newness and the inflation headwind will continue to make strong performance a difficult proposition in the short-term.

So, What's The Good News? Discount to NAV is One

Now that I have given my word of caution, I want to shift the conversation to the positive attributes. After all, I am not bearish on this fund, and I am hopeful that gains are on the way because, after all, I own it.

One of the top reasons for not divesting it is the fund's valuation. Back in October I started a small position because the fund had a small premium to NAV. While I prefer funds at discounts, I was trying to front-run what I hoped was some investor interest in a new PIMCO fund, especially since there was concern about the PDI/PKO/PCI merger. While that prediction did not bear fruit, the reality now is that PDO's sliding price has widened the discount significantly. In fact, it is nearing double-digit territory, as shown below:

PDO Valuation (PIMCO)

Simply put, this does not seem like the time to sell this fund. A discount nearing 10% is rare for a PIMCO CEF, so this is a fund that certainly warrants quite a bit of attention. I expect this will limit downside risk going forward, and is especially attractive when we consider many other PIMCO CEFs are still trading at expensive premiums:

PIMCO CEF Premiums (PIMCO)

My thought here is simple. Many alternative funds remain at premiums, and some at quite large premiums. PDO's steep discount is likely to bring in investors eventually, it is just a matter of time.

Income Metrics Are Very Strong

Another very attractive aspect to PDO is the fund's distribution. The yield is nearing on 9% and investors can take comfort in knowing this is currently well supported. While the leverage of the fund has me concerned as short-term rates rise and the yield curve inverts, for now we see PDO's income story is robustly strong. In fact, the fund's coverage metrics are most impressive, and this is coupled with a UNII balance that should make up any shortfalls:

Income Metrics (PIMCO)

The takeaway here is straightforward. For income investors, PDO has a lot to desire when it comes to a high yield and a supported income stream. While the share price drop has wiped out any total return gains for this option, I am hopeful that will reverse with time. When it comes, this income stream is going to look even more attractive.

Yields Are Up, But Investors Need More Than Treasuries Can Offer

Looking at the backdrop for credit more broadly, the market has been rattled by rising yields and the potential for Fed rate hiking. While this is certainly a legitimate concern, I do believe the market is overreacting a bit. While treasury yields are indeed up, inflation is making those yields unattractive in my view. In fact, even those the 10-year has seen a spike in its yield in 2022, with inflation it is barely in "real" positive territory:

10-Year Real Yield (Bloomberg)

Of course, this is good news in isolation for those buying treasuries, especially compared to the real yield one would have gotten since 2020. But a real yield barely above zero is not especially enticing. This is going to remain a catalyst for investors to look beyond the safest of assets and into more aggressive sectors to earn higher income. Enter PDO, along with the rest of the PIMCO CEF family. With a diversified holdings list in many higher yielding areas, I expect PDO is going to find buyers even as Treasury yields grind higher:

PDO Holdings List (PIMCO)

Of course, when investors reach for yield, they are taking on more risk. PDO in particular has a lot of exposure in the high yield credit sector. This helps boost the distribution, but readers need to recognize this is a more volatile and riskier sector.

While I would stress this is not an option for the risk averse, there have been some developments that reduce the risk somewhat. For example, as corporations locked in lower yielding debt and benefited from a broad economic recovery, their balance sheets have strengthened. This is true of the high yield sector as well as IG, and helps to reduce the probability of defaults in the months ahead:

Corporate Balance Sheet Metrics (Schroders)

This reality has allowed credit ratings agencies to publish rather favorable outlooks. In fact, Fitch Ratings published a report a few weeks ago which predicts the high yield default rate will finish the year at around 1%:

High Yield Default Rate (Forecast) (Fitch Ratings)

This suggests high yield credit is set to hold up reasonably well for the next few quarters. While duration risk is certainly a big concern, it looks like credit risk isn't something to stress too much about at the moment.

PDO Lacks Agency MBS - This Is A Good Thing With The Fed Unwinding

My final point on why I will keep holding PDO here has to do with a sector PDO does not hold a lot of. As my followers know, for years I had promoted agency MBS as a strong play. This was a core holding of many PIMCO CEFs, and I viewed it positively as home values were rising, the Fed was supporting the sector, and delinquencies remained rare. Fast forward to today, as this is a sector I am very cautious on. Fortunately, as the graphic showing PDO's holdings breakdown shows, this CEF has just over 1% exposure to this asset class.

So, why do I feel this is a positive? In fairness, agency MBS remain a very stable asset class in terms of credit risk. The backdrop of U.S. housing is strong, and the agency backing virtually guarantees investors will get their money back. However, with the Fed looking to unwind its holdings, agency MBS is not really where I want to be. The reason is simple - the Fed holds a tremendous amount of agency MBS and is now looking to sell them:

Fed Holdings (Yahoo Finance)

As you can see, the Fed's balance sheet contains roughly $3 trillion in agency MBS and is looking to begin unloading those assets in the months ahead. PDO's lack of exposure in this area is another reason I remain long this fund.

Bottom line

Buying PDO was a mistake, I am the first to admit that. The fund's performance has been extremely disappointing and the chances of an immediate turnaround seem slim. Inflation remains red-hot, PDO has zero positive momentum, and the Fed is planning on hiking interest rates continuously. All of these factors are against PDO.

However, there are some reasons to consider the fund, which is why this is such a balancing act. PDO has a wide discount, which hopefully limits downside and will draw value-oriented investors. The income metrics are very comforting, and the high yield exposure is nothing to be worried about at present. As a result, I will keep on holding PDO and hoping for the best, but I would caution readers to be selective in entry points for this fund at this time.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of PDO either through stock ownership, options, or other derivatives. 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.