Guest Post: Why Do PIMCO Muni CEFs Consistently Trade At Premiums Over NAV? | George Spritzer

Here is the next installment of George's guest posts for our marketplace.

You can find the last one here.

--------------------

I was recently doing a one year NAV performance screen on all muni bond closed-end funds. Here are the top ten performers sorted by one year NAV return:

(Source: cefanalyzer 4/4/2019)

Note that five out of the top ten NAV performers are Pimco funds. Two of the funds (PNI, PCK) are state muni funds from New York and California. Three of the funds are national muni funds with high premiums over NAV and high distribution rates- (PML), (PMX) and (PMF). Note that the market returns over the last year are quite a bit higher than the NAV returns and also considerably higher than for the non-Pimco funds. Pimco appears to have beaten most of the competition. This is partially because the premiums on the Pimco funds have expanded considerably over the last year, but the NAV performance is also quite impressive.

One question many investors may ask is: What is Pimco's secret sauce? Is it simply that Pimco has more skilled portfolio managers or are there other factors at work? In this article, I will discuss some potential factors may explain how Pimco CEFs can continue to trade at a premium. I will also discuss some lower risk Pimco alternatives (mutual funds, interval fund) that may be suitable for risk-averse investors who are afraid that the high premiums may suddenly go away at some point due to a "black swan" event.

Reason For Premium- #1: Ability to Sell New Shares Above NAV

When a closed-end fund trades at a big premium and issues new shares at a premium over NAV, it gives an immediate boost to the NAV performance. Let's first work through a hypothetical example to see how this works.

Suppose a fund has 1 million shares outstanding with an NAV of $10 a share. So the total NAV is $10 million. Let us also assume the fund is trading at a 55% premium over NAV or at $15.50 a share. Now assume the fund issues 1 million new shares at a 50% premium over NAV (subtract expenses from an at-the-money offering or apply 5% discount due to the DRIP plan). Let's assume the actual fund performance is flat during the period when the new shares are offered,

Let's compute the new NAV:

Original shares 1,000,000 @ $10 $10,000,000

New shares 1,000,000 @ $15 $15,000,000

Total= 2,000,000 @$12.50 $25,000,000

Note that by just doing a little bit of financial engineering, the fund's NAV has appreciated by 25%!

This is a win-win-win situation for everyone.

WIn #1: Jones Trading or the DRIP plan administrator earns some fees.

Win #2: Pimco grows the fund assets under management earning higher management fees in the future.

Win #3: The Pimco portfolio manager looks great and gets a reputation as a bond guru, even though the actual fund portfolio investment performance may have been flat if there were no new shares offered.

WIn #4: Investors get a nice pop in NAV. Assuming the premium remains around 50% they also get a nice bounce in market performance.

Pimco often issues new shares of some of their funds trading at a premium. They have hired Jones Trading and pay a commission (usually around 2%) to sell the new shares in the secondary market with "at-the-money" offerings. Here are some recent at-the-money offerings that Jone Trading has done for Pimco. I haven't seen any recent at-the-money offerings for Pimco's muni CEFs, but they may use this technique in the future if the premiums remain high.

Some Recent Pimco At-The-Money Offerings

Another way that Pimco issues new shares above NAV is with their DIvidend Reinvestment Plan. Here is how their plan works when a fund is trading at a premium over NAV:

"3. MARKET PREMIUM ISSUANCES. .."The number of Additional Common Shares to be credited shall be determined by dividing the dollar amount of the Distribution by the greater of (I) the net asset value per Common Share on the payment date, or (II) 95% of the market price per Common Share on the payment date."

So if a Pimco CEF is trading at a 20% premium and they issue a monthly distribution, new shares are created at a premium of about 15% over NAV for all investors who participate in the DRIP plan. I checked the 2018 DRIP plan participation for PML, PMF and PMX:

Dividend Reinvestment Participation- 2018

Total Distr.(000) DRIP(000) # new shares issued

PML $48,454 $4,267 347,000

PMF $18,413 $882 71,000

PMX $25,618 $1,171 109,000

Note that the participation rate in the DRIP plan is well under 10% for these funds, so the NAV accretion from new shares issued above NAV has been fairly small. This data shows how the closed-end market is not very efficient. Over 90% of the investors (or their advisors) are passing up the chance to reinvest their fund distributions at a 5% discount to the market price.

Reason For Premium- #2: Low Cost Leverage From Auction Rate Preferreds

Pimco is one of the few closed-end fund management firms that has retained a lot of auction rate preferred financing. Here is a sampling of some recent ARP interest rates paid on by some popular Pimco CEFs. While this leverage is no longer available at zero cost like a few years ago, the ARP financing is still quite attractive, especially for the muni bond CEFs.

Muni Bond Funds Taxable Funds (as of March 29, 2019)

PMF 2.74% PCN 3.60%

PML 2.74% PTY 4.80%

PMX 2.74% PHK 3.84%

At some periods over the last ten years, the ARP financing rates were close to zero and provided a real edge. More recently, there have been other forms of financing that are comparable. Some of the Nuveen muni CEFs have also recently reported leverage costs in the 2.60%-2.70% range. But Pimco has generally been quite opportunistic in managing their leverage costs, and if we ever reach a point where the ARP financing is not as advantageous, they would likely conduct tender offers at a discount. Here is a link to an article describing a tender offer in July, 2018 when Pimco conducted a a voluntary tender offer to repurchase ARPs at 85% of par- https://www.marketwatch.com/press-release/pimco-municipal-closed-end-funds-announce-intention-to-conduct-tender-offers-for-auction-rate-preferred-shares-2018-07-20

These tender offers are favorable for fund shareholders since they are accretive to NAV.

Reason For Premium- Factor #3: Tax "Handcuffs"

Nearly all investors who own Pimco muni bond CEFs are in higher tax brackets, and they almost always hold them in taxable account. Because of this, it rarely pays to sell a position with a large unrealized capital gain. Any investor who bought the Pimco muni funds in late 2008 or early 2009 still have significant capital gains and and therefore have "tax handcuffs". Selling the funds now, would require sharing too much money with Uncle Sam.

Reason For Premium- Factor #4: Rare Infrequent Dividend Cuts

The Pimco muni funds consistently rank near the top in distribution yield. Part of the reason this may occur is because of Reasons #1 and #2 above- favorable leverage costs and the ability to boost performance with sales of new shares above NAV. I suspect many of the investors who buy Pimco muni CEFs are not necessarily aware of all the factors involved (discount/premium, leverage cost etc.) and just buy them for the high tax free consistent distribution yield regardless of the premium. A lot of investors are willing to "pay up" for stable high yields. Some of these high yielding bonds may be hard to refinance so they are also more resistant to call risk.

Reason For Premium- Factor #5: Very Difficult To Sell Short

Sometimes when the premium over NAV gets too big, professional investors look sell them short and perhaps hedge with ETFs or other CEFs trading at a discount. But it is quite expensive to short the Pimco muni funds. Here are the short borrowing costs for 4/04/2019 reported on the iborrowdesk.com web site which come from Interactive Brokers:

PML 16.0%

PMX 31.0%

PMF 27.8%

One reason for the scarcity of shares to borrow is because shares participating in the DRIP plan cannot be lent out. But a bigger issue is that when shares are lent out to a short seller, the interest earned is considered "interest in lieu of dividends" which is not tax exempt. Most retail investors would never lend their shares unless the broker compensated them for the taxes they would have to pay on the "interest in lieu of dividends".

Reason For Premium- Factor #6: Better Research Into Lesser Known Unrated Bonds

Pimco takes the trouble to seek out low and unrated bonds with high yields that are still fairly safe. But investors should keep in mind that Pimco funds may be riskier than some of their peers if we ever get another "black swan" event like the credit crisis in 2008.

What If You Have Unrealized Tax Losses Available and Want to Sell or Trim Your Position in Pimco Muni CEFs?

Some investors may have access to tax losses from other investments and may want to sell or trim their Pimco CEF holdings because they are afraid of a rapid drop in the premium. Assuming you want to stay invested with Pimco, I've listed two possible swap candidates below:

Swap Option #1: PFMIX or PMLAX Open-End Mutual Funds

David Hammer is the lead portfolio manager of PML, PMF and PMX which all trade at double digit premiums. But Mr. Hammer is also the lead manager of PFMIX which is an unleveraged open-end mutual fund. The expense ratio for this institutional class fund is very reasonable at 0.48%, but you need $1 million minimum to buy this from Pimco directly. But the fund is also available with no minimum at some brokers like Charles Schwab as long as you pay a transaction fee. At Schwab you can also purchase Class A fund PMLAX (NTF fund) which holds the same portfolio, but the expense ratio is higher at 0.79%.

Swap Option #2: PMFLX Interval Fund

PMFLX is a new municipal bond interval fund that is also lead managed by David Hammer. The fund seeks to opportunistically exploit structural illiquidity in the municipal market. Its interval fund structure, which offers periodic repurchases rather than providing daily liquidity, gives the fund the flexibility to play offense to try to capitalize on dislocations in periods of municipal market stress by executing investment strategies that may be less liquid and more suited to longer holding periods.

As an interval fund, PMFLX currently expects to offer to repurchase 10% of the fund's outstanding shares at NAV on a pro rata basis if participation is over 10%. PMFLX will use leverage, so in many ways it is similar to the Pimco closed-end funds, except if offers a partial exit every quarter at NAV. It is important to keep in mind that unlike the Pimco CEFs, PMFLX does not trade on an exchange and does not offer daily liquidity. So it is a fund designed more for buy and hold investors who need some liquidity, but not for active traders.

If you have any questions or concerns, please post in the comment section below.  

Best,

George Spritzer, CFA