Contributor Since 2009
On 10/6/12 Barron's came out with an article discussing the huge premiums some investors pay to own a few closed end funds (CEF) in order to enjoy their very high distributions:
Today, Morningstar came out with its own piece on the subject examining this phenomena and justly observing that the huge premiums are detrimental to shareholders value not just in terms of heightened risk of capital loss but also because there is a distortion to the funds risk/return trade off when one examines how they earn their income.
Suffice to say that PHK is high on both articles as the poster child of high premium/high risk and inability to earn its current distribution rate based on its portfolio.
The details are in this link :
Over the past 18-30 months PHK has lost value on NAV basis and lagged dramatically other alternatives both on price and NAV basis (see FHY for example) due to the facts mentioned in both articles and in my previous Blogposts here on SA.
Not only do peer funds trade at much better values (closer to their NAV's), but they also actually EARN their full distributions and have reserve cushions (in the form of UNII) to serve as buffer in times of market distress.
The give up in yield of about 3% a year (it has been less than that when PHK was trading higher and FHY was trading lower) has been well worth it if you examine the total return difference between PHK and FHY , for example:
1 year (October 14 2011- October15 2012):
PHK +13.6% FHY+ 44.3% - a difference of 30.7% !
JNK a HY ETF which is NOT leveraged at all produced a 16.3% return over that period of time so where is the vaunted Pimco management premium (that many of PHK's holders cite) coming from?
18 months (April 15 2011 - Oct. 15 2012):
PHK +3.2% FHY +41.2% - a difference of 38% !!
Again, JNK, the HY ETF managed a total return well in excess of PHK at +12.3% for those 18 months.
24 months ( October 15 2010 - October 15 2012:
PHK + 15.88% FHY + 46.11% a difference of 30.81% !!
Once again JNK return better than PHK at 19.56% !
It gets only uglier for PHK if we go back 30 months (27.5% vs 67% on FHY a 39.5% difference in 30 months - that is about 1.3% a month)
The facts speak for themselves:
PHK buyers/holders have given up a LOT of performance over the past 30 months due to the premiums they were willing to pay in order to get higher income streams.
Those premiums, coupled with VERY weak NAV performance in 2011 combined to produce a very bad risk-adjusted trade in PHK vs. its peers.
People bought PHK for its rich stable distributions but forgot about the volatility and risks associated with paying a premium for that distribution as well as owning a fund that MUST resort to very risky strategies involving derivatives like swaps options and futures to try and make up for the missing income from its core bond portfolio.
2011 illustrated that it is not possible to be always right in gambling on Macro issues and PHK ended that year at the very bottom of its peer group in terms of NAV performance (and 84th percentile price wise).
2012 has so far been very good for PHK in terms of NAV performance, less so in terms of market price vs. peers) but over the past 11 months the fund issued 10 Section 19 notices declaring that parts of its distributions were from return of Capital (ROC):
While the fund can opt to characterize these notices not as ROC at the end of the year, the fact that the fund has been issuing them almost every month (save April 2012) for the past 11 months speaks volumes of the fact that the fund finds it harder and harder to earn its distribution rate from the income earned on its investment portfolio.
I can't recall another such period in the fund's history where such ROC notices had been published with such consistency and frequency - does this mean we are getting closer and closer to the day of reckoning within Pimco's management when they will consider more seriously to reduce distributions to a more manageable rate (or better yet, earnable rate)?
I think the answer is a resounding YES!
While Pimco and Bill Gross probably pride themselves in keeping the distribution rate on PHK intact since inception and all through the financial crisis, the realities of today's marketplace are such that there is no way for them to earn the 17.6% on their portfolio required to pay that rate without dipping into the principle.
So Pimco has 2 choices now:
1) Keep paying this unrealistic distribution in hopes something would happen that would enable them to earn it in the future (sort of Pimco's version of kicking the can down the road)
2)Cutting the distribution rate soon to reflect current market conditions and prevent long term erosion of NAV and shareholders value.
Obviously option 2 is the more responsible thing to do as a fund manager but would cause an immediate crash in PHK's price (to probably below NAV levels).
However, option 1 has NOT been working for Pimco either after the rise from the depth of the financial crisis (see above performance relative peers for the past 12-18-24-30 months) and subjects the PHK price to more and more frequent "Flash Crashes" like we have seen over the past 10 days.
Regardless of which option Pimco and Gross opt for, I expect PHK to continue lagging vs. more attractively priced peers who can actually earn their dividends and do not trade at huge premiums to their NAV.
Disclosure: I am short PHK.