Co-produced with Beyond Saving and PendragonY for High Dividend Opportunities.
Introduction
For income investors, the fixed income space can be one of the most defensive and conservative ways to gain exposure to high yield at low risk. Some fixed income products can be more secure, less volatile and provide stable recurring income compared to common shares. In 2018, bonds, fixed income closed-end funds, and preferred shares experienced declining prices due to fears of rising interest rates. Of course, rising interest rates are a big negative for fixed income as prices of fixed income securities are inversely related to interest rates.
Today the situation is very different. We are seeing slowing economic growth across the globe with inflation remaining stubbornly low. This has prompted central bankers across most developed nations to halt interest rate hikes and with some central bankers re-activating quantitative easing. We believe that we are on track to start seeing declining interest rates again, and therefore we are very bullish on fixed income products. At High Dividend Opportunities we have been writing a series of reports to our members to highlight some of the best fixed income CEFs, preferred stocks and bonds to benefit from this new trend. In fact, we have been increasing the allocation of our model portfolio to high-yield preferred stocks and bonds while still being able to achieve an overall yield of +9%.
In our report today, we highlight one of the best fixed income CEFs the Dynamic Credit and Mortgage Income Fund (PCI).
About PCI
Pacific Investment Management Company LLC (PIMCO) is a well-known and very large global investment manager with $1.66 trillion in assets under management. Launched in 1971 with only $12 million in assets, PIMCO has earned its reputation as a premier investment manager.
There are a variety of great investments that can be made through PIMCO, but one of our favorites is their Dynamic Credit and Mortgage Income Fund (PCI).
The objective of this fund is "to seek current income as a primary objective and capital appreciation as a secondary objective." The fund pays a regular monthly dividend of $0.1641, which is higher than its initial dividend of $0.1563/month. Then, depending on annual performance, the fund may or may not pay a special dividend. In 2018, the special dividend was $0.35. At current prices, that is a yield of approximately 8.4% with potential for upside depending on the special dividend.
We believe that PCI is an excellent way for retail investors to gain exposure to types of investments that are not otherwise available to them and receive a stable, steady stream of income from a well-managed fund.
Closed-End Fund
PCI is a closed-end fund or CEF. The main feature that separates a CEF from an open-end fund ("OEF") is that the number of shares for the fund is fixed. The fund does not issue or redeem shares and capital does not come into or out of the fund. This provides the CEF the advantage of not needing to maintain liquidity for cash out requests and allows them to manage a relatively static pool of assets.
For CEFs, NAV is calculated daily and represents the net value of the assets held within the fund. Since the shares are traded in the open market, the market price will trade in relation to NAV, but it will frequently be at a discount or premium. The discount/premium will reflect the markets opinion on factors such as the growth potential of the assets, the abilities of the fund managers or a preference/aversion to leveraged investments.
Source: PIMCO
PCI has managed to provide a steady income while maintaining the NAV. While NAV will inevitably have fluctuations as values change, it's important that over the long term a CEF can maintain value to support their distributions.
Mortgages
One benefit of funds is that they allow retail investors to invest in a broad array of investments that would be impossible for a retail investor to replicate. This provides great diversity as well as the opportunity to be part of investments that are generally closed to retail investors.
Source: PIMCO
PCI's largest sector allocation is mortgage-backed securities (MBS). PCI continues to favor "non-agency" residential MBS. "Non-agency" means that these are mortgages that are not issued under the Fannie Mae or Freddie Mac programs and have no governmental guarantees.
Many investors run in panic at the mere mention of residential MBS, the type of security that played the starring role as the villain in the great recession. This fear has created an opportunity for PCI to acquire residential mortgage backed securities ('RMBS'), below par, even as industry fundamentals remain very strong.
Source: CoreLogic
This graph illustrates the monthly rate at which mortgages become 30 days late. In October of 2018, 0.8% of mortgages became 30 days late. That is down from 1.1% the previous year and significantly below the rates experienced during the "housing boom" of 2000-2006.
Naturally, declining rates of late payments have directly led to fewer significant delinquencies and foreclosures.
Source: CoreLogic
In addition to delinquencies being at or near multi-decade lows, homeowner equity has been increasing at a rapid rate.
Source: CoreLogic
This is bullish for MBS because it means that the spread between the underlying collateral covers the mortgage value better.
Despite the fundamentals being stronger than they have been in over two decades, the market remains fearful. The fundamentals are pointing to mortgages as having a very low default rate and the underlying asset values rising in relation to the mortgages.
Despite very strong fundamentals, residential mortgage backed securities are trading at a discount to par. PCI recognizes this as an opportunity where perceived risk is greater than the underlying risk.
Either the market will gradually recognize that the risk assessment is wrong and prices will rise to create a capital gain, or the perception remains wrong and PCI gets a safe return at a much lower price relative to other fixed-income investments.
PCI sees this dynamic as an excellent opportunity and we agree. Even in case we hit a recession in the future, this recession is unlikely to be anything related to the 2007-2008 one. Today, banks and financial institutions are much stronger and more regulated. They also have been much more careful in their lending practices as they are lending in amounts much lower than the value of the mortgaged properties. In case of a recession, the mortgage market is unlikely to take a large hit.
Other Investments
Source: PIMCO
In addition to their MBS and asset-backed investments, PCI invests in corporate debt spread across a variety of industries. The diversity provided by a fund like PCI is something that would be impossible to duplicate in a personal portfolio.
PCI holders get diversity among industries, but also gain some international exposure.
Source: PIMCO
Most importantly, PCI has implemented a significant amount of interest rate swaps. One significant risk of investing in fixed-income securities is changing interest rates, which can leave you trapped in an inferior investment.
Source: MorningStar
Investors researching PCI might see something like this listed under "holdings" and become quite confused about what they are investing in. All of these holdings are interest rate swaps. To mitigate the impact of interest rate changes, PCI is long and short a series of interest rate swaps in a variety of currencies.
This results in PCI's effective return being slightly smaller if interest rates remain unchanged, but it helps protect their income stream when interest rates do change. Remember, PCI's first priority is providing current income.
Dividends
While the complexity of PCI's hedging through interest rate swaps, credit default swaps, and long/short pair trades can quickly become confusing for even the most seasoned investors, the end result is straight forward.
Source: PIMCO
PCI continues to comfortably cover its dividend which currently stands at 8.3% with net investment Income. It's this kind of consistent and dependable income that makes PCI a great addition to an income portfolio. The fact that PCI pays the dividend monthly is a great plus. For each share of PCI, investors get $0.164 in dividends on a monthly basis. PCI also has been paying a special dividend at year end in 2014, 2015, 2016, and in 2018.
Valuation
Currently, PCI is trading at a slight premium to NAV. NAV is $23/share and it is trading at $23.39, a 1.7% premium. We do not believe that premium is excessive and we believe that NAV will continue to increase throughout the year. Also PCI remains one of the cheapest fixed income CEFs from PIMCO. For example:
- PIMCO Corporate and Income Opportunity Fund (PTY) trades at a 20% premium to NAV.
PIMCO Income Opportunity (PKO) trades at a 9% premium to NAV.
PIMCO Dynamic Income Fund (PDY) trades at a 16% premium to NAV.
Note as the long-term interest rate yields continue their decline trend (with 29 years of interest rate declines so far), the hunt for yield is only set to accelerate, and it would not be surprising to see all these funds from PIMCO go up in price and reach even higher NAV levels.
Below is the 10-year US Treasury Bond Yield Since 1962
From more about our views on interest rates and high yield investing, please refer to our recent report entitled: As The Global Economy Slows, The Grab For Yield Will Accelerate.
In our opinion, funds like PCI should generally be looked at through the lens of NAV rather than market price. If NAV stays strong, the market will eventually get over itself. PCI's NAV was 23.86 at IPO and their low was $19.34 in February 2016. Psychologically, the market has not gotten over the mortgage meltdown. Yet the fundamentals are extremely strong and sooner or later the market is going to get over itself and realize it's overestimating the risk. With PCI trading at a slight premium to NAV now, maybe the market is starting to realize that, but you are right, investors do need to be prepared for the potential of more volatility. We anticipate that any such volatility will be in the price, while the distributions will remain stable thanks to the underlying fundamental strength of the mortgage market. As long as the fundamentals remain strong, we suggest holding through any volatility. At the end of the day, this is an income investment and we believe the income will remain stable regardless of mispricing due to irrational anxiety in the market.
Finally, investors need to keep in mind that we were recently in an increasing interest rate environment, which is bearing for fixed income products like PCI. Starting the year 2020 or 2021, we are likely to start to be in a decreasing interest rate environment. So demand for fixed income products is set to increase significantly, and both the price of PCI should go up in price, resulting in capital gains. Historical NAV prices do not mean much in this case. I'm buying PCI here to lock in the high income now (not for the capital gains). I think the high yields that we are seeing today are unlikely to last long.
Conclusion
PIMCO has a well-earned reputation as a premier investment manager. The PCI fund, in particular, offers income investors an opportunity to diversify while providing a steady and durable stream of monthly income.
The fund primarily focuses on the residential MBS market, a sector which still has the psychological scars of the 2007 recession. The negative sentiment runs contrary to the actual fundamentals.
Fundamentally, the residential mortgage industry is extremely strong. New delinquencies are slowing down, significant delinquencies and foreclosures are at or near multi-decade lows, and the amount of equity in home prices has grown to unprecedented levels. The market is valuing mortgages below par, suggesting high risk, when in reality the risk is pretty low.
Investors are not the only ones carrying the psychological scars of the 2007 recession. The homeowners and people who knew those homeowners remember the tragedy of losing homes to foreclosure. No doubt, that social memory is part of what is encouraging consumers to pay down mortgages and increasing their equity as opposed to refinancing.
PCI has recognized this and has invested in a big way, securing a steady stream of mortgage income at below par prices. We believe that this strategy is going to continue being successful. The fundamentals are strong and will remain strong. Either the market will realize that and PCI can benefit from capital gains, or it will not and PCI can continue investing in mortgages at a discount.
We also appreciate PCI hedging both the short and long-end of the interest rate curve. This will help PCI continue to provide investors steady income regardless of how interest rates change.
PCI will continue to provide investors with a solid 8.4% yield with special dividend distributions on top. Additionally, we believe that PCI will experience an increasing NAV as the market's unreasonable fear toward residential MBS fades. This is a premium CEF for income investors.
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