PIMCO’s 14% Yield PDI: Hold For Income Only (NYSE:PDI)

When I last covered the PIMCO Dynamic Income Fund (NYSE:PDI), I rated the 14% yielding ETF a buy, on the grounds that it paid lots of income and stood to benefit from coming rate cuts. The high yield is still on offer, but the prospect of capital gains brought on by rate cuts is rapidly diminishing. At its last meeting, the Federal Reserve held its policy rate steady at 5.5%. At the start of the year, investors expected interest rate cuts to start early and continue until the end of the year. Now, many investors think there will be no cuts until September–if at all this year.

This all has bearing on the valuation of a high yield bond fund like PDI. Bonds go up in value when rates go down, because the lower interest rates go, the more valuable older bonds with high yields become. This effect is stronger on lower yield bonds because they have higher durations, but it affects high yield bonds as well. As interest rates rose in 2022 and early 2023, PDI experienced persistent losses, consistent with a fund that is sensitive to interest rate changes. We would expect the opposite to occur with interest rate cuts.

It all looked like a good setup for PDI to deliver strong capital gains in a scenario of falling rates. The problem is that rates are now looking unlikely to come down. Although treasury yields spent some months falling recently, that was largely in response to expectations of the Fed cutting its policy rate. When those expectations started to diminish, yields once again began to climb. Currently, the 10 year treasury yield (4.68%) is pretty close to the 5.5% policy rate, indicating that markets are not expecting much of a cut, if any.

This all has bearing on the valuation of a bond fund like PDI. For such a fund to deliver capital gains, it has to have some kind of a macroeconomic catalyst. PDI is so diversified, with 1,803 bonds under the hood, that no company-specific factor is going to have a big impact on its total return. To really move the needle, the fund needs something to change in the economy or the bond market, and the biggest positive change that could happen for the fund, now appears unlikely to materialize. There is no longer any kind of catalyst expected that would cause PDI or its holdings to experience a capital gain.

This isn’t to say that PDI isn’t worth owning. If its 14% yielding distribution can continue to be paid safely, then it beats the S&P 500’s historical average total return even if the price goes sideways. However, you can’t really count on a fund like this just paying its full distribution indefinitely, it has a lot of junk bonds with low credit ratings in its portfolio. For example, Wesco Aircraft Holdings, a major fund holding, recently had its credit rating lowered to D- by S&P Global (SPGI). D- is the lowest rating on SPGI’s rating scale, indicating that bankruptcy is imminent or very likely.

I do not point this out to say that the Wesco bond will default–I am not sure that it will–but to emphasize that the quality of the bonds in PDI are not the highest on average. The average rating on fund holdings is BBB. BBB is not a ‘junk’ rating, but if you have a 1,800 bond portfolio with an average rating of BBB and ratings follow a normal distribution, you’ll have several hundred bonds with sub-investment grade ratings. You would expect some defaults in such a portfolio. Indeed, there have been defaults on the portfolio historically. For example, the fund held both Credit Suisse and Silicon Valley Bank bonds when those banks failed, and those banks’ bonds defaulted.

For the reasons above, I am lowering my PDI rating to hold. Although I think that the fund will deliver high distributions for the foreseeable future, the combination of default risk and the lack of coming rate cuts means that the capital gain portion of the return will likely be either 0% or negative. For this reason I do not expect the fund’s total return to be any better than that of other CEFs investors can buy as an alternative.

Mortgage Backed Securities – A Large Proportion of PDI’s Portfolio

Although PIMCO’s Dynamic Income Fund is very diversified numerically, it is actually very concentrated in a few key sectors. About 26% of the fund’s assets are securitized instruments, meaning primarily mortgage backed securities (“MBS”).

It’s not surprising that MBS would make up an outsized proportion of PDI’s portfolio. Such securities have high yields on average, with a 5.57% yield to maturity according to S&P Global. That’s a decently high yield on the surface of it, and of course, in a pool of securities yielding 5.6% on average, you’re likely to find a few double digit yielders.

Mortgage backed securities can provide a lot of yield, it’s true. The problem is that PDI’s preferred MBS securities are among the riskiest of the bunch–non-agency MBS. These securities’ cash flows are mostly paid by individual homeowners. Their value tends to decline when interest rates go up, resulting in capital losses for funds that hold them, such as PDI. Consistent with this, mortgage backed securities experienced capital losses in 2022, when interest rates were on the rise.

On top of that, U.S. home buyers are now borrowing at higher rates than they borrowed at in past years. In 2023, a TD Bank (TD)(TD:CA) survey found that 58% of U.S. homebuyers “felt stress” as a result of their purchase, with 24% citing mortgage rates as a contributor. Interest rates on such mortgages remain elevated in 2024. In February, 500 million mortgages went into default, as the delinquency rate surged. The more homeowners default, the lesser the interest paid on mortgage backed securities. Such securities may experience capital losses if the number of defaults is too high, as well.

Hedging Strategies Are Costly

Now, PIMCO’s fund managers are well aware of the risks inherent in their high yield strategies. For this reason, they use various strategies to hedge against both interest rate risk and credit risk. In the fund’s prospectus, it outlines the following hedging instruments:

• Credit default swaps. These are used to hedge against credit risk. They pay out if the borrower defaults. Otherwise, the protection buyer simply pays a regular fixed amount to the counterparty.

• Interest rate swaps. These hedge against interest rate risk. These always have a cash flow, the long or the short party pays out depending on whether interest rates rise or fall. Sometimes they earn a return, other times they represent a cost.

• Currency swaps and forwards. These are used for much the same purpose as interest rate swaps, only to hedge against FOREX risk rather than interest rate risk.

• Protective puts. These can hedge against several risks, most notably the risk of capital losses. You have to pay a premium to enter a short trade using a put.

PDI says in its prospectus that it “may” use the hedging instruments outlined above as part of its risk management strategy. When I looked at the fund’s holding sheet I found that the fund was in fact using swaps and forwards in large quantities (see the image below for an example), but saw no indication of puts being used.

All of this hedging definitely helps protect against some of the risks in PDI’s ultra-high yield portfolio. The problem is that these strategies are very costly. PDI’s fact sheet shows a 1.1% management fee, a 1.92% total expense ratio, and sky-high 5.12% expense ratio including interest expense! These costs will rise should the hedging positions mentioned above become more expensive to enter into. This would happen if, for example, a foreign currency that PDI was net short started rising against the U.S. dollar.

Inflation Proving Stubborn

A big problem for PDI right now is the fact that inflation is proving very stubborn. The CPI remains at elevated levels, above the Fed’s target of 2%. As of this writing (April 26), a PCE inflation report was just released, showing the producer prices rose 2.8% in March, exceeding estimates by 0.1%. Jerome Powell has said many times that 2% is the Fed’s official monetary policy target. Although Powell and his team have had much success in getting inflation down from the near-double digit levels of mid-2022, the CPI is still rising above the target amount. So, Powell likely feels no specific pressure to bring rates down, and this fact is likely to limit upside on PDI’s portfolio.

Valuation

The biggest positive I can think of for PDI is the fund’s discounted cash flow valuation. The fund pays a $0.2205 fixed monthly coupon. The payout might vary by small percentages if portfolio assets default and/or pay out more than expected, but it has been remarkably consistent since 2016. Thus, I will treat PDI’s coupon as a fixed payment, and assume no growth. $0.2205 per month works out to $2.646 per year. The 10 year treasury currently yields 4.68%. Add a 6% risk premium to that, to account for the high default risk on PDI’s portfolio, and we have a 10.68% discount rate. Discount the $2.646 in annual distributions by 10.68%, and you get a $24.77 fair value estimate. Were a wave of defaults to take the annual distribution down to just $2, then the estimate would be $18.72, or about what PDI trades for today. Therefore, this fund’s cash flow stream appears worth paying for. However, for the reasons outlined elsewhere in this article, it is unlikely to experience a capital gain any time soon. So, I downgrade my rating to hold.