PIMCO CEF Update: What Is Driving The Funds' Performance?

Summary

The May PIMCO UNII report card showed strong coverage improvement on most of the taxable funds.

Muni funds continued their same trend of slow erosion on both coverage and UNII levels.

We do believe distribution cuts to some of the munis are coming relatively soon.

Taxable PIMCO CEFs have higher risk than many believe, but the funds we like to focus on have unique underlying investments that are hard to find elsewhere.

On the 15th of the month, PIMCO released their monthly UNII report card. The May results were very favorable as coverage and UNII both jumped significantly. It was about this time last summer that many SA writers were talking about distribution cuts and the end of the great funds' run.

The increase in coverage effectively puts to rest the notion that the larger and newer funds, PIMCO Dynamic Income (PDI) and PIMCO Dynamic Credit and Mortgage (PCI) will need to cut the income payment. UNIIs went well over zero for both funds this past month.

For example, PCI UNII increased from -10 cents to +19 cents. PDI went from +11 cents to +42 cents. 3-month stacks (Most recent 3-month coverage compared to the 3-month coverage 3 months ago) were up 29% for those funds. PTY and PCN were also up nicely rising 10 cents and 12 cents, respectively.

The other taxable funds didn't see the same UNII bounce with PKO rising 6 cents, PFN up 8 cents, and PFL up 5 cents. The table is below:

 

Coverage ratios also looked very strong on the taxables producing those UNII increases.

 

Moving to munis, we continue to see the same trends that we've seen for many months in the PIMCOs. UNIIs continue to bleed lower by a penny or two per month. The large muni UNII bucket funds, PML and PCQ, saw coverage fall further during the month. PML is now at 81.1%, down 50 bps from the month before and losing another penny on UNII to 28. PCQ coverage fell by a significant 410 bps to 82.4% with UNII dropping 2 cents to 52.

Most of these distributions are likely safe for the time being simply due to those large UNII buckets. However, eventually they will need to be cut. (We will be releasing an update to members very soon on which funds may cut as early as July 1) Every single PIMCO muni fund saw coverage fall in the month of May with all UNIIs staying flat or falling as well.

Long-time members know that we like to look at the NAV for clues to positioning and distribution coverage on these funds. Sticking with the munis, May was a 'good' month with NAV all UP more than the distribution. But we saw that trend reverse in June.

The chart below shows the NAV movements over the last month and a half. The last two columns show the variance from different starting dates. The second to last column shows the NAV from April 30th through June 14th. Included in that movement are TWO distributions. Its clear that in May that the muni funds covered the distributions and then some but that is reversing to lesser degree in the first half of June.

 

We are seeing some pause also in the taxables in terms of covering their distributions. For PCI, the NAV is down about 5 cents (-0.20%) over the trailing 30 days. Over the last two months, NAV is down 6 cents. We see these "pauses" every once in awhile with the non-agency funds like PCI, PDI, and PKO/PFN/PFL. We do not think this means that there is something fundamentally wrong with them.

Our contention is that they are "pausing" for two reasons:

  1. The lack of 3-month libor continuing its rise recently
  2. The dollar also ceasing its rise in the last month

 

 

3-Month LIBOR based on US Dollar data by YCharts

 

At the same time, the price has closed the discount gap since February, we believe driven mainly by the strengthening dollar. The discount had closed to within an earshot of the NAV recently but starting around the second week of June the price began to fall back. It appears there was general selling by a large holder of all PIMCO funds. We've seen this several times before where we see significant selling across the fund complex with the higher premium funds being affected the most.

 

PIMCO Corporate & Income (PTY) is a poster child for managing risk and watching premiums. PTYs premium started rising in February and didn't stop for four months. The premium hit 29% a couple of weeks ago, when the long-term average was around 10%. The premium was at just 9% in mid-February. Last week, the premium fell sharply falling over 6% in one day. This is the risk of large premium funds, even well-run and high-quality one's from PIMCO. This may be the start of another "hiccup" (phraseology that we use to describe the sharp price drops and discount widening evident in the chart above which tend to fall around ex-distribution dates or on the first of the month).

Lastly, on the muni funds, many of our members ask why they do not hedge the interest rate risk. It is primarily because it would mean an immediate and significant cut to the distribution due to the cost. Additionally, PIMCOs house view is that interest rates are not likely to rise much more from here. 3.25% on the 10-year is likely to be near the top. Thus, they see munis as a good buy here for the risk.

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PCI and PDI have different financing vehicles than PKO, PTY and the others simply because they were launched after the financial crisis in a post-auction rate preferred security world. Currently, over 60% (by our calculation) of the holdings are floating rate meaning that the are positively correlated to interest rates. Both funds continue to add to the non-agency bucket to gain exposure and offset maturing or called positions. Most of the new purchases are coming from banks and insurance companies who are de-risking their balance sheets and raising capital to meet stress tests and stricter capital requirements placed on them by central banks.

But the main issue for many closed-end funds has been the rising leverage costs eating away at the earnings. As the yield curve flattens, the spread between what they earn and what they must pay to lever shrinks, placing pressure on the distributions. PIMCO, with some degree of foresight, initiated substantial interest rates swaps primarily on the short-end of the curve. This allows them to offset increases in 3-month libor (a proxy for taxable CEF leverage costs).

While we remain very bullish on the non-agency MBS sector, the NAV has indeed paused a bit recently. As we noted above, 3-month libor has paused, preventing further appreciation in a large chunk of the underlying holdings. Given that the Fed has essentially said four rate hikes are in the cards, 3-month libor almost has to rise from here.

The non-agency positions contain optionality meaning the upside is skewed by some sort of special situation event. This is why PDI does an at-the-money offering and PIMCO would almost assuredly do one on PCI if it were at a premium. These types of plays include lawsuit type payoffs, remodifications, and securitizations that might benefit from a whole-loan format. Some are zero-coupon which would need a refinancing to get a big bump in price. Given the move in mortgage rates recently, we do think homeowners finally refinanced some of this pre-recession subprime debt.

The uncertainty of the flows due to some "event" being needed makes them cheaper. It's similar to a closed-end fund that has a variable distribution versus a fixed one. The fixed one traditionally trades "richer" (less of a discount or greater premium) because investors know what they are going to get.

The coverage ratios are highly volatile primarily because of the currency swaps and movements. There is a mismatch in the liquidity of the underlying and the hedge in place. In other words, they buy a GBP-denominated (British pound) bond and hedge with currency swap. The swap is marked-to-market daily while the locally denominated bond may not trade for days or weeks or even longer to reflect the movement in the currency given the low liquidity.

Overall, the PIMCO funds remain healthy and a centerpiece of our investment strategy. These are higher-yielding, but of course, risky, investments that we think provide the best opportunity to reach our objective.

The question is, are these funds are solid buy today?

We released to members our "PIMCO Actionable Takeaways" report highlighting each fund and going through our rating on it and why. That said, we would be cautious of the high premium funds as well as some munis that we believe could be affected by distribution cuts. There may even be a cut to a taxable fund in the not too distant future. These funds are highly levered so watching the NAV and calculating "all in" distribution coverage is a key.

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