This article was first released to Systematic Income subscribers and free trials on Mar. 9
PIMCO taxable CEFs remain popular choices for income investors, particularly as the recent volatility has caused a compression in premiums in the suite. In this article, we discuss the latest semi-annual shareholder report, specifically focusing on any insights relating to income. The shareholder report provides a different perspective on the popular monthly income releases.
The big picture is that, after a pause in 2020 due to a drop in leverage costs, aggregate NII in the suite resumed its slide. This trend should accelerate once the Fed kicks off its hikes in earnest, pushing leverage costs higher. Some of the direct impact will be offset by the funds’ floating-rate assets and swaps positions. Overall, we continue to find value in PDO, remain cautious on PDI and looking for attractive entry points in PHK and PFL.
The funds covered in the latest shareholder report are:
- PCM Fund (PCM)
- Global StocksPLUS&Income Fund (PGP)
- Strategic Income Fund (RCS)
- Dynamic Income Fund (PDI)
- Dynamic Income Opportunities Fund (PDO)
We don’t include PCI and PKO as they have been merged into PDI. Some charts don’t include PDO because this was the first full income period for the fund.
An obvious question is why do we need to look at the shareholder report when PIMCO provides income numbers on a monthly basis, particularly since 1) the report is usually lagging – the recently released report only covers the semi-annual period ending in December, whereas PIMCO has already provided January income numbers in their monthly reporting and 2) the report is less granular than the monthly figures since it only covers semi-annual periods.
The short answer is that the income figures reported monthly are different from the figures reported in the reports. The reports post “final” numbers while the monthly reports are “estimated”.
The second reason why the report figures are useful is that they provide numbers across a longer period – the report we discuss today goes from 2017 (with earlier periods available in previous iterations) while the monthly reports only include the last 6 months. Of course, some investors have been diligently saving the monthly reports for years but the vast majority probably haven’t.
Apart from the reports and the monthly releases, some investors find value in just looking for a Section 19 – a filing required to be made by CEFs if the fund is distributing anything else but net investment income. The thing about Section 19, however, is that PIMCO base them on its own internal accounting practices rather than GAAP (see discussion of this on Page 107 of the report). What this means is that, as PIMCO readily admits, a lack of Section 19 doesn’t really mean a whole lot. The treatment difference applies especially to interest rate swaps and, as many investors are well aware, PIMCO taxable funds are heavy users of swaps.
Another reason we like to check in on the report figures is that the monthly PIMCO coverage figures are often comically volatile as the chart below shows.
For example, PDI 6-month rolling coverage was 98% in October, 125% in November, 84% in December and 119% in January. RCS coverage was 52% in September, 100% in October, 121% in November, 61% in December and 113% in January. These variations are way larger than anything we see in other fund families such as BlackRock, Nuveen, Eaton Vance or others that also disclose monthly coverage numbers. The reason we like to use 6-month rolling figures (rather than 3-month or fiscal-year-to-date numbers) is because it provides the least noisy figures since most bonds pay coupons semi-annually. However, even the 6-month rolling figures are extraordinarily volatile. The report figures are much less volatile which makes them a bit more useful, in our view.
A final thing that’s good to be aware of is the fact that the reported NII is actually different from distributions marked as NII. For example, as the table below highlights PCM earned $0.39 of NII per share in the second half of 2021 but distributed $0.48 from NII over the same period. This seeming NII manna from heaven appears to be due to a different treatment of distributions versus NII, i.e., GAAP for NII vs. tax for distributions. This is not something we see from other CEFs, so checking in on GAAP NII gives investors a better apples-to-apples comparison versus the broader CEF space.
With that out of the way, let’s check in on how the funds did.
The chart below shows the NII per share history of the funds. The chart shows that there has been a general downward trajectory in NII.
The chart below shows the change in monthly NII/share from the most recent period (Jul-Dec 21) versus the previous period (Jul-20 to Jun-21). Three funds saw drops in NII while PDI saw a bump in NII.
We are assuming that PIMCO did their math correctly on a weighted-average share basis since PDI now carries a much larger amount of assets after its merger closed in December.
If we normalize NII across the funds, we see that the average NII profile has moved lower in 2021 after a bump in 2020. The bump in NII was very likely due to the sharp drop in leverage costs as the Fed moves the policy rate to a near-zero level.
This highlights two key dynamics going forward. First, we are likely to see the opposite of the 2020 bump in NII as the Fed begins to move the policy rate back to its pre-COVID level.
The second interesting dynamic is that NII tends to fall in the absence of a boost from a drop in leverage costs. For example, the latest semi-annual period shows a drop in NII of about 30% relative to 2016 levels, despite leverage costs being roughly equal in these two periods as the Fed policy rate was near zero in both times. Once we put these together, it suggests that NII is likely to fall in aggregate across the taxable space. NII may not move in a straight line period to period, but the trajectory looks clear.
One potential saving grace is that if yields continue to rise, it may allow the funds to rotate into higher-yielding assets over time. However, this is not something that will happen immediately, particularly as the yield curve is likely to continue to flatten. This is because in a flat yield curve environment, as assets roll down the yield curve, there is less of an opportunity to enhance yield by terming out holdings. A continued rise in yields is also something that will hurt NAVs, so this rotation may not be particularly pleasant for investors if it happens since the future rise in income will come at the expense of today’s NAVs.
What can PIMCO funds do to counteract the negative impact of rising leverage costs? They can boost income by either moving lower in quality, switching their swaps portfolios or by adding borrowings. With average leverage around 40% (as of January), there is not a ton of additional borrowing capacity, but there is some. It’s also important to note that NAVs have fallen since January which would have caused leverage to rise, further reducing additional borrowing capacity.
Let’s turn to net investment income yields of this fund population. The chart below shows price NII yields (blue bars) and NAV NII yields (orange bars). This chart is useful because it shows NII yields across the same group as well as the difference between price and NAV yields – the difference between the two is due to the fund’s discount. It is interesting that PCM has the lowest NAV NII yield in the group despite its highest premium. This is likely due to the stability of its income and coverage based on the monthly releases. We will compare the monthly release and semi-annual report income numbers later.
If we zero in on the difference between price and NAV yields – something we call the yield “tax or boost”, we get the chart below. The chart shows that investors are willing to leave 1.44% on the table by holding PCM while investors earn an additional 0.34% by holding PDO. It should be said that some differences can make sense, especially for funds with different management fees or unusual holdings (arguably, PCM fits the bill here). However, in our view, the 1.44% yield tax for PCM, due to its 20% premium, looks excessive, as does the yield tax differential of more than 1% between PDI and PDO, which have the same management fee.
It’s also interesting to simply compare the July-Dec 2021 NII from the semi-annual report to the NII from monthly releases for the same period versus the distribution. The NII from the report we call the GAAP NII in the chart (blue bars) and the NII from the monthly coverage/UNII statements we call Tax NII. Grey bars are distributions. The GAAP NII is below its Tax version for three of the five funds. It should be said that because Tax NII is very volatile (as highlighted above), these comparisons will shift over time. For PGP and PDO, both GAAP and Tax NII are above their distribution levels while the picture is mixed for the other 3 funds.
This chart shows the same thing but in ratio terms. This chart makes clear that whenever we want to talk about PIMCO coverage levels, we should be clear whether we are talking about GAAP or Tax terms.
Outside of the reports, we like to check in on the change in NAVs over periods of roughly stable credit yields. This gives us a sense of whether or not funds are overdistributing relative to their actual portfolio yields. Recall that just because a fund has distribution coverage of 100% doesn’t mean it’s not overdistributing relative to its portfolio yield. The best example of what we are talking about are municipal bonds which are issued at coupons well above their yields-to-call or yields-to-maturity (creating a strong negative pull-to-par given their high premium starting prices). And although PIMCO taxable funds don’t hold much munis, this dynamic does appear in other fixed-income sectors, though to a lesser extent.
Let’s have a look at how the PIMCO fund NAVs have fared since 23-AUG-2019. The reason we pick this date is because the high-yield corporate bond yield was the same then as it is now. Of course, PIMCO funds don’t just hold corporate bonds and the corporate bonds they do hold don’t necessarily resemble the high-yield index, however, it’s a reasonable enough proxy for the credit-sensitive portfolios of these funds. RCS and PGP are clear exceptions due to their agency MBS (in the case of RCS) and equity (in the case of PGP) allocations.
What the chart shows is that all funds have delivered NAV decreases since that date which does suggest some level of overdistribution. It is also interesting that PDI has underperformed here, which is probably not a coincidence given its highest NAV distribution rate in the suite. Ultimately, a consistent drop in NAVs will force funds to cut their borrowings to prevent leverage from exceeding 50%, which will have an obvious impact of a lower NII, all else equal.
Tracking PIMCO shareholder reports is a useful task for the taxable suite, particularly despite the availability of higher-frequency income disclosures. These disclosures don’t use the same accounting rules and are notoriously volatile, making it difficult to extract a longer-term signal from the data.
The latest shareholder report showed that, after a 2020 boost to NII – likely as a result of lower leverage costs, income levels across 3 of 4 funds continued their decline. We expect further declines in the year ahead, with higher leverage costs being a key drag on income levels. These will be partially, though likely not fully, offset through floating-rate holdings such as non-agency MBS and loans. If yields continue to rise, it will help these funds to eventually increase their NII, but this process will be extended and painful for NAVs.
A glimpse of the potential impact is shown in the chart below which highlights how fund NAVs have been sliding over the past 6 months or so with RCS performing particularly badly, despite its “safer” label. It’s a fund we have never found appealing.
In terms of our fund selection, we remain cautious on PDI given its NAV trajectory and highest NAV distribution rate – a potential warning sign. We continue to watch PHK and PFL – two funds that have approached attractive entry points over the past couple of weeks. The funds have an attractive combination of lowish fees, attractive historic returns and, occasionally, attractive valuations.
The average valuation of the taxable suite has fallen significantly and is close to the lowest premium outside of exceptional periods such as the GFC, the energy crash of 2015 and the COVID crash. It should be said, however, that much of this premium deflation is a direct result of a continued drip of distribution cuts in the suite.
We have recently marginally added to PDO at a high single-digit discount. However, we have not gone “all-in” to PIMCO CEFs for the simple reason that underlying credit spreads remain fairly expensive. The chart below shows a long-term history of HY corporate credit spreads, highlighting that the current level is about 1% below the median. Allocating to funds strictly based on discounts while ignoring the valuation of underlying assets is not a sensible long-term strategy in our view.