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PHK - The Odds Of A Distribution (Or Dividend) Cut Just Got Stronger!

|Includes: FHY, FSD, PIMCO High Income Fund (PHK)


You could hear the PHK bubble burst and the hot air leaving it over the past month and a half as it caused A LOT of pain to the holders and buyers who ignored common sense and history.

The staunch holders and buyers of PHK (both retail and institutional investors) found many excuses to try and justify the huge premiums and chose to ignore the reality of the markets.

PHK still distributes a rate which cannot be sustainable long term:

It needs to earn some 17.6% a year on its NAV (a metric I use as a benchmark to compare it to other leveraged funds).

Some people choose to compute the rate based on total assets given the fact that today's ZIRP environment enables PHK (and other funds as well) to finance its leverage at close to zero cost.

Even at that metric, PHK must earn about 13% a year on its leveraged total assets.

With a portfolio of bonds with average coupons around 7.50% and with most bonds in the portfolio trading around par (with many at premiums) - this becomes an impossible task BET the house on leveraged derivative swaps, futures or options.

As anyone with experience in the financial markets would be leery of the odds to be right all the time with derivative trades and will be cognizant of the high risks involved (remember Warren Buffet's comment on derivatives as "financial weapons of mass destructions"?).

To wit, Bill Gross himself has shown us how wrong one can be as he bet on US rates going higher during 2011 only to be faced with the opposite result.

The result was that PHK (and to some extent, other funds managed by Pimco) suffered badly as its NAV performance rang in dead last within the HY category in 2011.

That, of course, did not dissuade the "religious" following of PHK from bidding up the shares to even more ridiculous premiums.

The negative premium effect on total return performance showed its ugly side in earnest during the past 2-3 years - as PHK's NAV went higher the total return of its market price under-performed relative to its peers which started at much better entry points (discounts to NAV or slight premiums).

I have covered PHK relative under-performance in a few instablogs here on Seekeing Alpha, for anyone who might be interested to read them.

While I recognize that PHK might derive some of its distributions from derivative trades, the frequency of its Section 19 notices (for Return of Capital - ROC) has increased dramatically and from a very rare incidence we can see how Section 19 notices have become the norm over the past 12 months.

About a year ago I covered this emerging trend in an Instablog post, for your reference:

This suggests to me that PHK is struggling to earn its distributions and thus, with hardly any UNII cushion , may be force to cut its distributions sooner rather than later.

With the implosion of the premium in PHK from 70%+ to about 22% now, the decision to cut the distribution rate is, paradoxically, easier now than before for Pimco management.

No doubt, Pimco had been reluctant to cut the distribution rate knowing full well that a cut would cause PHK's market price to collapse spectacularly.

The current meltdown in PHK's price has made that issue almost moot and can enable Pimco to do the right thing and adjust the distribution rate to a more sustainable and more importantly "earnable" rate.

My estimate is that a rate of 7.5 to 8 cents a share per months is probably the right range for the current market environment.

The longer Pimco delays their decision the more pain would be inflicted on shareholders over the long term because of PHK's inability to earn the required 12.1875 cents per share per month.

The past few days' carnage in most leveraged Closed End funds has uncovered numerous competitive opportunities to own peer funds at nice discounts to their NAV.

I have added to my positions in FHY and FSD in the HY arena (and a few other positions) today and covered about 50% of my PHK shorts below $10 for a very nice profit.

I will be on the lookout to add to my short position if PHK jumps to around $12 again and still has a target for it to be trading BELOW its NAV like most CEF's historically have done.

In the mean time, I point you to my end of 2011 Instablog entry, which reviewed PHK's performance vs. its peers and called for it to give another sub-par year in 2012 due to the huge premium it carried.

Even at 22% premium to NAV (the lowes in quite a few years but still abnormal in historical perspective) - I expect PHK to lag its peers which trade today at DISCOUNTS to NAV of 7-10%.

Disclosure: I am short PHK.