Welcome to another weekend blog post from Systematic Income.
In this post we highlight a debate that has come up recently on the service having to do with what drives PIMCO CEF earnings and coverage.
There is a view that has been offered on our service that PIMCO CEF coverage is driven by the dollar - specifically, that poor coverage numbers are driven by dollar weakness.
Let's take a look at the US Dollar Index chart below - we highlighted 2 months with moves lower in the dollar.
If the theory that PIMCO CEF income falls during months of weaker dollar is true then we should see monthly earnings for the highlighted months fall as well.
These two months are highlighted in the monthly CEF earnings in the table below. As we can see fund earnings for these months are just fine - in fact, for some funds the monthly earnings are outstanding.
On the other hand August was an especially poor month for fund earnings and hence coverage (4 funds even had negative earnings!), however, if we refer back to the Dollar Index chart, August was very close to unchanged in the dollar. So the evidence that it is moves in the dollar that drive fund earnings is, as they say, everywhere except in the data.
A few other points we've made in the discussion on the service that are worth highlighting briefly.
First, the quantum of the fund income change is way out of proportion to what it should be if the FX theory were true. If we just do a sense-check and assume that foreign-currency bonds make up about 10% of a given fund's security portfolio then a relatively big move in the dollar over a month of 2-3% would make an impact of 0.2-0.3% of the fund's overall income. However, we are looking at months where income changes by 20-50%. That's two orders of magnitude larger than could be explained by FX moves alone.
Secondly, what makes us somewhat skeptical about the theory is that it referres to "FX swaps". Investors familiar with how FX products actually work will know that FX swaps are not used to hedge FX risk because they don't have any. Rather FX swaps are used to hedge short-term interest rates in foreign currencies. They do this by having an initial and final exchange that are nearly offsetting (the interest rate is baked into the small differential in the final exchange relative to the initial exchange, something known as "points"). So, why would PIMCO use FX swaps to hedge foreign-currency bonds whose primary risk is FX risk? We suspect that what PIMCO actually uses to hedge foreign-currency bonds are FX forwards which no person experienced with fixed-income markets would confuse with FX swaps.
All of this is not to say that FX derivatives have no impact on fund cashflows but that neither the argument nor the evidence for the case actually hold up under basic scrutiny. Let us know if you think otherwise in the comments.
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