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- We have put together a Guide To PIMCO CEFs from some of the existing as well as new material which will hopefully provide a useful reference for investors.
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PIMCO CEFs have been and remain one of the most compelling income investments. We have discussed these funds in many of our articles this year, offering views on how these funds have managed their leverage, their use of ARPs, their distribution coverage, our picks in the sector, recent changes in distributions and more.
In our dialogue with readers we continue to be asked similar questions so we thought we would put together a primer on these funds for investors to use as a reference. It should be a good starting point for investors new to PIMCO CEFs and will, hopefully, provide some information to those who already hold these funds.
To read the guide please take a no-obligation 2-week free trial of the service. Below is an extract from the guide. This section talks about some of the key features of PIMCO CEFs that have allowed them to perform as well as they have.
Extract From Our Guide To PIMCO CEFs
Cracking Open the PIMCO Black Box
So what makes PIMCO funds different from other more typical CEFs? We can divide the main differences into structural and operational features.
First, let’s take a look at the structural differences.
A typical fixed-income fund, let’s say a high-yield bond CEF, is structured in a straightforward way. It holds a portfolio of high-yield bonds, leveraged through borrowings – typically in the form of a bank credit facility.
Taxable PIMCO funds have a number of structural differences versus this more straight-forward structure:
- They hold a variety of leverage instruments such as repos of various terms and with various counterparties and ARPS of different series
- They have a significant allocation to legacy non-agency RMBS
- They hold a variety of different types of assets rather than single-sector assets
- They overlay the securities portfolio with different types of derivatives such as FX, CDS and Interest Rate Swaps
The following illustration compares the more typical CEF structure to the PIMCO taxable CEF structure.
Typical High-Yield Bond CEF Structure
Typical PIMCO Taxable Fund Structure
Municipal PIMCO funds have a number of structural differences as well – they hold an overweight in revenue municipal bonds and they are significant users of ARPS. Sections below go into more detail about ARPS as well as non-agency RMBS and how they generate value for PIMCO CEFs.
Auction-Rate Preferred Securities
ARPS, along with repurchase agreements, tender option bonds, bank credit agreements and senior securities are a form of leverage financing for CEFs. ARPS are a type of preferred securities with floating interest rates – their rates are calculated based on a pre-agreed formula linked to other short-term market instruments such as Libor or Commercial Paper.
Generally speaking, CEFs have two financing options: short-term financing which has a lower rate (is cheaper) but resets more frequently and longer-term financing which has a higher rate (assuming a normal upward-sloping yield curve) and a longer term. ARPS were designed to square the circle in a sense – to minimize the interest rate but have a longer term profile. Their structure is designed in such a way as to have a perpetual term but enjoy low cost of financing due to a liquidity mechanism provided by periodic auctions (hence the name).
The role of the auctions is to reset the rate on the ARPS and allow holders to sell their positions. Prior to the financial crisis the auctions attracted sufficient bids and offers for the market to clear. Often, the ARPS underwriter (a bank) stepped in to provide bids for investors looking to exit their ARPS positions, despite having no obligation to support the auction. During the crisis, however, banks stepped away from the market, auctions began to fail and ARPS holders were not able to exit their positions. When ARPS auctions fail their holders can get locked into a below-market rate for perpetuity.
Various brokerage firms that pitched ARPS as a liquid and higher-yield alternative to money market instruments were blindsided and threatened to sue both fund issuers as well as banks. It's not clear whether this worked or whether funds wanted to be seen as responsible market participants but they began to buy back the ARPS, albeit at a discount. PIMCO remained one of the few holdouts in this market, continuing to benefit from this low cost of financing, effectively subsidizing shareholders of their funds via ARPS holders.
Most fund managers have already redeemed their ARPS. The chart below shows the level of redemptions. Total ARPS outstanding has fallen from $60bn to less than $5bn as of 2020.
There are two ways in which ARPS can generate value for PIMCO funds. First, is that many ARPS enjoy interest rates that are below other types of leverage instruments such as repos or credit facilities, allowing PIMCO to source leverage at significantly cheaper levels than other funds.
In the first quarter of 2020 short-term interest rates fell sharply due to swift cuts by the Fed designed to stabilize markets. This caused many ARPS series to shift to very low interest rates, according to their complex formulas. As of June 2020 the ARPS interest rates ranged from 0.14% to 1.61%. This illustrates an important point – not all ARPS are the same. Interest rates can vary widely depending on the individual series and its rating. For example, in 2020 a number of ARPS issued by PIMCO funds were downgraded from AAA which caused a rise in their interest rates.
Funds that have ARPS at the lower end of this range enjoy an enormous advantage. The best that CEFs can do on repos and credit facilities as of mid-2020 is in the range of about 1%, so paying just a small fraction of that provides a huge advantage.
The funds that benefitted the most from this dynamic are those funds that hold a larger proportion of ARPS in their leverage stack and those series whose interest rates fell the most. The chart below shows the composition of fund borrowings according to type. For taxable funds, “Preferreds” refer only to ARPS. For municipal funds they can refer to both ARPS and Variable-rate Municipal Term Preferreds (VMTPs).
If we look across taxable funds we see a large divergence in borrowing costs. The biggest driver of the differential is the proportion of ARPS in the leverage stack and the interest rate on the individual series. Taxable funds also use repos as a leverage instrument, however, unlike ARPS, the rates that the funds pay on repos are very similar. PIMCO publish ARPS rates on a weekly basis on the fund websites.
The picture for municipal funds is broadly similar and somewhat simpler. Unlike their taxable counterparts all municipal CEFs boasted the same interest rate on their ARPS. In addition to ARPS, municipal CEFs also hold tender option bonds (TOBs) and Variable-rate Municipal Term Preferreds (VMTPs). As of mid-2020, the following chart illustrates the average interest rates on these instruments.
The following chart shows the composition of the leverage stack for each fund. Those funds boasting the highest proportion of ARPS enjoys the lowest cost of leverage.
The second way that PIMCO funds can add value via ARPS is by holding tender offers. Because ARPS auctions have failed continuously since the financial crisis, the holders of ARPs do not have an easy way to get rid of these securities. The only way of doing so is via tender offers where PIMCO effectively buy back the ARPS. Of course, PIMCO is running their CEFs in the interests of fund shareholders which means that if they can buy back their ARPS at a discount they will certainly try it. Historically, PIMCO has been able to buy back various series at discounts of 5-20%. Because PIMCO hold the ARPS at their full principal value on their balance sheet, buying them back at a discount is accretive to NAV. For example, one of these tender offers that the company ran in 2019 generated 1-2% of NAV returns depending on the fund.
An Overweight in Non-Agency RMBS
Prior to the financial crisis a number of factors drove the creation of a large private-label mortgage security market such as sharp housing price appreciation, new securitization technology, a lax regulatory and rating agency approach as well as high investor demand for investment-grade assets.
As house price appreciation slowed down due to Fed rate rises and lower economic activity, some homeowners and speculators faced difficulties servicing their mortgages or finding demand for their properties. MBS securities began seeing higher than expected losses which caused a wave of downgrades and forced selling by rating-constrained investors.
MBS prices fell below fundamental values in many instances which opened up an opportunity for active unconstrained investors like PIMCO and others to take advantage. The chart below shows the price of ABX.HE indices which track a set number of RMBS tranches with the same original rating. AAA indices fell more than 70% during the crisis and have since rebounded somewhat, stabilizing in 2015-2016 at what appears to be fully-valued levels.
New issuance essentially stopped for several years after the crisis and the size of the sector decreased through defaults and paydowns. More recently, however, issuance has been increasing and has offset the maturing legacy assets so that the size of the sector has begun to grow again. New issuance rose to $24 billion in the third quarter of 2019.
A big part of the “magic” in the PIMCO taxable funds has to do with this prescient choice made in the early part of the last decade. That PIMCO saw a big opportunity in non-agency RMBS assets was not in itself so unusual – many other fund managers saw the same opportunity. What is fairly unusual is that PIMCO pushed this asset class into so many of its CEFs rather than creating a single focused-fund, something which other fund managers like Nuveen and Western Asset did.
If we look at the annual performance of a CEF like DMO which also was heavily overweight non-agency RMBS we see that DMO did a pretty good job keeping up with PDI – in fact it outperformed PDI in 4 out of the last 8 years.
A Variety of Assets
A third structural difference between PIMCO and other CEFs is that nearly all PIMCO taxable funds hold Multi-Sector portfolios. This is quite unusual – other fund managers follow a different model. Rather than running a group of Multi-Sector funds, fund companies like BlackRock, Nuveen and Eaton Vance have a set of funds covering individual sectors. Having a broader mandate does have its advantages, however. It allows PIMCO to reach across a larger set of assets in order to generate value and find attractive opportunities.
For the municipal CEFs, PIMCO is constrained to allocating to tax-exempt bonds. However, even within this sector its reach is relatively broad: across the rating spectrum as well as both revenue and GO securities.
The rest of this section in the Guide talks about derivative overlays, the use of leverage, dynamic portfolios, exotic positioning, at-the-market offerings and more.
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