NRGX: Get A 5.8% Yield From This Unique PIMCO Fund
Summary
This is a unique fund for the energy and natural resource space giving investors a bit of a reduced risk exposure to MLPs, energy companies, and utilities.
They have a host of underlying strategies going on in the fund including options writing, futures exposure, swaps, and MLPs/energy names.
The fund has performed well on a NAV basis as energy has recovered but also because the fund reduced the quarterly distribution.
We think it could be time to invest as the NAV momentum is very strong and borrowing is on the increase.
We like the fund for a near-term holding (3-6 months) on the expectation of the discount closing with the catalyst being a distribution increase and NAV momentum.
(This report was issued to members of Yield Hunting on May 17. All data herein is from that date. Since our original publication the share price is up 16 cents and the discount tighter by 2.5%.)
This is a report on a fund in a space that many of you know that I despise. But I'm always open to changing my mind if the research supports it. We are in a cyclical and value upswing. In this phase of the cycle, we want to have exposure to the best areas of the market that should benefit from the market's rotation and a lower dollar.
The energy sector is one of those areas that should benefit from the early-to-mid cycle and value resurgence. Essentially, energy, materials, industrials, commodities, and financials are the best sectors to be involved in at the moment- while selling health care and consumer staples.
We have been highlighting many of the securities we think would benefit, most recently highlighting Barings Short Duration High Yield (BGH) which has larger than average energy exposure.
We have also done fund focuses on:
Vanguard Small Cap 600 Value (VIOV)
Schwab Fundamental Int'l Large Company (FNDF)
Virtus NFJ International Value (AFJAX)
SPDR S&P Regional Banking ETF (KRE)
SPDR S&P Global Natural Resources (GNR)
iShares North American Natural Resources (IGE)
This report is on PIMCO Energy and Tactical Credit Opportunities Fund (NRGX), one of the newer funds from the PIMCO CEF complex and one of the larger. With a duration of under 1, this one is insulated from higher rates and is exposed to areas of the market likely to outperform. Despite the large rise since November, I think this one has more room to run.
What Does This Fund Invest In?
As the name hints at, the fund is a credit fund whereas most of the energy closed-end funds ("CEFs") often invest in energy names via the common shares (equity). This is a big distinction to make. One of the reasons we like BGH is simply because it gains you access to the energy/natural resource space without being in the common.
NRGX has a very flexible strategy with the prospectus noting: "focusing on investments across the full value chain, capital structure and liquidity spectrum of the energy markets to pursue its primary objective of total return as well as its secondary objective of seeking to provide high current income."
At least 66% of the fund's net assets have to be invested in energy investments. This can include MLPs which are equity investments. But they are limited in their exposure to MLPs to 25% so that the fund can qualify as a regulated investment company ("RIC") for US federal income tax purposes.
So the fund is a mix of equity, MLPs, and bonds.
(Source: PIMCO)
You can see in the above image that just over half of the fund is invested in pipelines. But the fund has 63% invested in equities (so this fund does NOT belong in your bond allocation). In the latest holdings report, the fund had only 10.8% in MLPs. But the majority of their equity exposure is invested in pipeline companies. In other words, they are not heavily invested in the MLPs themselves but the pipeline companies through their common shares. This includes:
Cheniere Energy
Diamondback Energy
Targa Resources Corp
Venture Global
Hess Midstream LP A
Plains GP
The fund also has a lot of derivatives exposure, which is typical PIMCO. They like to take positions in some small issues or exposures through swaps and futures in order to maintain liquidity and possibly get out of a position quickly if need be.
Some articles on the fund note that the fund has a large treasury position (currently at 23%) as "dry powder" or other reasons. But in fact, that treasury position is margin for all of their derivative positions. When the fund takes a position in a futures contract (let's say for oil), the exchange makes them put 20% of the notional value down and the rest can be invested. In this case, PIMCO is placing the rest in treasuries to earn something. Let's go through those high level so I don't lose your interest in the fund.
First, they have long and short futures on natural gas, Brent crude, and a few other commodities like gold (smaller position). Futures contracts are synthetic exposure to an underlying assets. In NRGX, the vast majority of that exposure is to natural gas.
Second, they have some exchange traded options. These are written options meaning they sold the option, collected the premium, and would owe the buyer the spread above the strike price on the underlying. They sold both put and call options on NYMEX Crude. That option spread means that they expect the price of oil to stay fairly flat (meaning not move higher or lower). They also have a small written call option on the Alerian MLP ETF.
Third, they have a bunch of total return swaps on a bunch of individual names. Most of the positions they are receiving the underlying reference rate and paying the 1-month LIBOR (which is almost at zero). So they generate some decent cash flow at the moment taking advantage of the spread.
Lastly, they hedge out the currency risk as over 20% of the assets are foreign and held in another currency other than the US dollar.
Fund Characteristics
Total Net Assets: $683M
Effective Leverage: 18.8%
Interest expense on Leverage: 0.76%
Leveraged Adjusted Duration: 0.71 yrs
Distribution: $0.17 (quarterly)
Last Change: October 2020 (-57.5%)
Distribution Yield: 6.13% (managed)
Number of holdings: 135
Avg Daily Volume: 228K
Avg Daily Volume $: 1.85mm
Management Fee: 1.85%
Total Expenses with Interest Expense: 2.61%
Inception Date: 2/1/2019
The fund intends to terminate on January 29, 2031 which is part of the trend towards launching new funds with a term structure. There needs to be a 75% majority vote by the board.
Distribution
Remember to think of this fund as part of your equity allocation. As such, equity-type investments should be thought of as a total return play, not an income play. While the quarterly yield is nice the fund is never going to earn that distribution fully over long periods of time given the lower portfolio yields.
The fund cut the distribution back in October. That was not a surprise given NRGX had to de-lever last year during the Covid crisis and the fund was seeing large amount of roc in the distribution (as opposed to gains). If we go back to the start of 2020, the fund had total managed assets of $1.2B, compared to the $683M today. That's a decline of 43% despite the rise in the NAV since October of 75%! So the distribution had to be cut.
I'm not a huge fan of the quarterly distribution payment structure but that is typical with equity-focused funds. Most of the underlying only pay quarterly so it makes it difficult to smooth the distributions out.
With the NAV rising nicely in the last six months, the managed distribution policy intends to pay all net investment income ("NII"), short-term gains and long-term gains each year. The NAV has risen from $8.00 per share to nearly $14, an increase of 75% since October. With that amount of NAV gains, the leverage ratio has fallen down but they have been adding more recently.
As the fund adds borrowing to keep the effective leverage stable, it is producing more income. That could eventually lead to a re-raising of the distribution down the road.
But I want to throw out something that may be heresy to some- the actual distribution payment doesn't matter. This is a total return play to gain you exposure to energy and credit sectors that NRGX focuses on.
Lastly, in 2019, they distributed a short-term capital gain. I think that is likely in 2021 given the gains produced in such a quick manner. For those very tax-sensitive, you may want to be cautious around the 19a's.
Valuation
One of the things that I like to see is NAV momentum and a wide discount - i.e. the price is having a hard time keeping up with a fast moving (higher) NAV. The discount is largely a function of the lower yield. The CEF market tends to ignore the underlying and simply look at yields. At 6.1%, the market is likely thinking that they can invest in other CEFs that yield more.
But this is a total return type of fund. The distribution was slashed and with the NAV up 75% since they cut it, I wouldn't be surprised if they raise this distribution in the next month or two. If they do, in typical PIMCO fashion, it would likely be double-digits. I could see them going to at least $0.21 and perhaps more.
If they do increase the distribution, I think the discount would close significantly. Assuming a 25% increase, the new yield at the current price is 7.6%. I think that would be compelling to a lot of investors.
Add in the fact that the discount is currently at -16.4% which is far wider than most of the CEF space. Newbie CEF investors are flocking in and looking for two things: wide discounts and higher yields. The distribution increase would take care of the former and the discount would also likely draw in some investors.
We also have some nice insider purchases into the fund.
(Source: Fidelity)
Concluding Thoughts
My mind hasn't changed all that much but given the current CEF market, this one appears to be a decent option. Just remember what I discussed earlier. This is an EQUITY fund that does not own high-quality, stable, large cap names but volatile commodity-linked securities. As such, the fund can be whipsawed frequently.
It would not be unheard of to be up or down 5% in a week in this fund. (Movements are all on paper, not realized gains or losses.) But I do think the fund can represent a place in the portfolio for the next 3-6 months minimum. Near-term we are playing the higher than average potential for a distribution increase, discount closing, and NAV momentum.
Some larger risks include oil prices cratering again - perhaps from a resurgence of the virus from the Indian variant. Longer-term risks include a shift away from oil-based products which appears to be happening at an accelerated rate. This fund is a bit outside of PIMCO's wheelhouse and has had a spectacular fall in the past. Could it occur again?
I actually bought my first lot in this fund at $10.05 towards the end of March. I added more in mid-April in the $10.40s and added more recently right at $11.00. It's a bit of a desperation play as the entirety of the CEF space looks so rich. This is one of those rare exceptions and it's odd it's a PIMCO name. Keep positioning small. I think anything wider than a -13% discount looks compelling here. The fund fits better in a non-qualified account as so much of the distribution is from return of capital (gains and capital).
This one checks all the boxes we are looking for in this market: NAV momentum, distribution stability, and a favorable time to enter. The next distribution date is June 1. We think there's a possibility that they raise the payment which could cause a rally in the shares.
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