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PCI: High Yield (10.5%), Historic Discount (14.6%), But An Uneven Recent Record

Summary PCI is the largest CEF by market cap in the taxable income category. PCI is paying a distribution yield of 10.5% and is priced at a historically low discount. The fund has suffered along with its category over the past year. Investors might ask if there is now value here. I began this series exploring taxable income CEFs with an overview of 105 CEFs in this category where I showed that the funds had been battered by the market, often well in excess of changes in net asset values. Some funds had cut distributions and the broad data suggest that others may follow. I am following up on that overview with a look at specific funds in the category. First up was the PIMCO Dynamic Income Fund (NYSE: PDI ) which I consider to be the best in the class in today’s skewed market. With this installment, I want to look at its sibling fund, the PIMCO Dynamic Credit Income Fund (NYSE: PCI ), which like many siblings, is fundamentally similar but distinctly different. I refer to the two funds as siblings because they share a similar lineage. They are young funds (May 2012 for PDI, Jan 2013 2013 for PCI) and the most recent additions to the PIMCO CEF line. The funds have similar sounding objectives, but unlike many sibling funds, come have at their objectives quite differently although there are signs that they are coming be more alike as they weather tough times in their category. Where PDI stood out as being at or very near the upper reaches of the group for many key metrics, PCI does not fare nearly as well. This chart shows its percent rank among the funds for various market characteristics. (click to enlarge) Figure 1 . PCI percent rank among 105 taxable, fixed-income CEFs. Liquidity This is an area where PCI outscored PDI but only by minor amounts. It is the category leader for market cap and ranks 3rd of the 105 funds considered for trading volume. But either fund has as much liquidity as one is likely to find among closed end funds. Discount Discount is a second category where PCI turns in a better number than PDI, at least in terms of absolute value. Its discount (-14.64%) ranks 65 of the 105 funds which have a median discount of -13.2%. The fact that a fund can be that deep into discount territory and still be outpaced by 1//3 of the category’s funds shows how difficult times have been for taxable income CEFs. The discount/premium Z-scores show us that this discount is not only deep, it is much deeper than its average value has been over the last 3, 6 or 12 months. (click to enlarge) Figure 2 . PCI Z-Scores for PDI and median values for the category. The discount has been on an expanding trend since early in 2014. Indeed, at its current value, PCI’s discount is at an historic low for the fund. (click to enlarge) Figure 3 . PDI Premium/Discount since inception (end month values). Discounts are without question appealing, and historically low discounts can be especially appealing, but one does not — or, I should say, should not — buy a CEF on the basis of discount alone. Distributions Fixed income CEFs are designed to provide regular income to their shareholders. Most pay out a stable distribution and managers are generally reluctant to reduce those distribution. To a large extend investors value the funds on the basis of those distributions. Here again, PCI is turning in better numbers than PDI. Its distribution at NAV is 8.98% (75% percentile for the category), slightly above PDI’s 8.72%. Its deeper discount pushes the distribution to shareholders well above PDI’s. It is currently paying 10.52% on the basis of its regular distribution; PDI pays 9.53%. The regular distribution currently stands at $ 0.16406/share. It was increased for the September 2015 payment from $ 0.15625/share a value that had been constant from the fund’s inception. This is a 5% increase. PCI has also paid out a special distribution in each of its two years of operation. In 2013 it was $0.36 and for 2014 it was $0.60. If one considers the special distribution, current distribution yield through the past twelve months is 13.14% which would place PCI at the 97%tile of the category. Figure 4. PCI. Regular and special distributions since inception. Of course the difference between the regular distribution at 10.52% and the regular plus full distribution of 13.14% is considerable, but is not predictive for future yield from the fund. The special distributions are special and variable. An investor cannot count on them. One indicator of expectations for a year-end special distribution is undistributed net investment income (UNII). This is where PDI excels, but PCI falls short. Cefconnect list PCI as having -$0.0656 in UNII. Not enough to cause real concern, but it is in negative territory which would indicate that a large year-end special distribution based on excess income will not be forthcoming in 2015. Summing up the distribution situation, PCI has an exceptionally high distribution yield driven in part by its large discount. It looks sustainable at this time. On the surface it is higher than that of PDI but when one considers the history and likelihood of special distributions in the mix, PDI is returning a greater yield. The other significant aspect of UNII is that it is a predictor of distribution stability and sustainability. This is obvious from the recent fall of the PIMCO High Income Fund (NYSE: PHK ) as documented in this recent article on Seeking Alpha . If you are concerned about the stability of distributions for any CEFs you may hold or be researching, I refer you to the cases explored there. Where PDI is at the top of the category for UNII/Distribution, PCI is only at the 37%tile. This has not prevented managers from raising PCI’s distribution, so I’m not inclined to see it as an indicator that the fund’s distribution is in trouble. If I were holding PCI I would be watching this metric carefully in the coming months. Fund Performance Actual return is a interesting facet of CEFs. On one hand there is return to an investor, which is the market return. On the other there is return on NAV which is the true indicator of how a fund is performing. Premium/discount status determines the differences between the two. PCI has outperformed only 38-39% of the category’s funds for total return on market price and NAV for the past year. This is far from an encouraging performance record, particularly when one considers that it has not been a good year for fixed-income. The median fund has a total return on NAV for the trailing twelve months of -0.2% and at market price it’s -5.98%. For PCI 1yr return on price is -7.2%. These returns show make an investor wary of PCI at this time. If tough times persist in fixed income, and there is ample reason to believe they might, declines in price (both at market and NAV) may continue to erode value for the fund’s investors. Add the fact of negative UNII (slight, but negative nonetheless) and PCI’s high yield begins to look much less attractive. I’ve been focused on PCI relative to PDI and the other funds in its category. I’ll now turn attention to PCI itself. What is the fund about. PDI has been operating for a bit over 30 months (inception date: 29 Jan 2013). It has a category-leading total net assets of $2.57B and its effective leverage of 42.44% is higher than all but one fund in the taxable income category. Management fees and other expenses are 1.382% excluding interest expense and 1.501% with interest costs (data from Pimco ). Morningstar compares its performance to Barclays US Aggregate Bond Total Return and its Multisector Bond category. It lists only 2014 and 2015 (YTD) comparisons and the fund underperformed in 2014 but is doing relatively well YTD. Fund Characteristics PCI has a broad investment mandate but is somewhat more focused than PDI. From the sponsor’s website : The fund will normally invest at least 50% of its net assets in corporate income-producing securities of varying maturities issued by U.S. or foreign (non-U.S.) corporations or other business entities, including emerging market issuers. Corporate income-producing securities include fixed-, variable- and floating-rate bonds, debentures, notes and other similar types of corporate debt instruments, such as preferred shares, convertible securities, bank loans and loan participations and assignments, payment-in-kind securities, zero-coupon bonds, bank certificates of deposit, fixed time deposits and bankers’ acceptances, stressed debt securities, structured notes, and other hybrid instruments. As for types of investments: The fund will normally invest at least 80% of its net assets (plus any borrowings for investment purposes) in a portfolio of debt instruments of varying maturities. The fund will normally invest at least 25% of its total assets (i.e., concentrate) in privately issued (commonly known as “non-agency”) mortgage-related securities.: And, “The Fund may normally invest up to 40% of its total assets in securities of issuers economically tied to emerging market countries. This definition is broad and flexible. Its successes or failures will depend on the abilities of management to handle that flexibility. Most of the management team (Daniel Ivascyn, Sai S. Devabhaktuni, Mark Kiesel, Elizabeth O. MacLean and Alfred Murata) has been place since the fund’s inception. Fund documents state that the fund “will normally maintain an average portfolio duration of between zero and eight years.” This is identical to PDI and Morningstar lists effective duration at 2.27 (unadjusted) and 3.91 (adjusted for leverage) which is about a half year longer than comparable durations for PDI. No information is provided on the portfolio’s credit quality. The fund’s holding by sector allocation on market value is (from the PIMCO website): This sector breakdown varies form that of PDI in one important element; PDI has twice as much of its portfolio in mortgage securities. For PDI mortgage securities comprise 2/3 of the portfolio; for PCI it is only 1/3 but that is a substantial increase in the last four months. I last looked at the two funds in May 2015. At that time PCI held only 0.11% in mortgage-back securities. Another change since May is in the geographic distribution of the fund’s portfolio. This chart from the May article shows where PCI was positioned at that time: Figure 5 . PCI. Geographical distribution of the fund’s portfolio in May 2015 (taken from Is It Time To Sell These PIMCO Closed-End Funds? ). Compare this distribution to the current distribution shown in the table below. The current geographical breakdown of the portfolio from Morningstar is: In less than 4 months time the portfolio has been repositioned to strongly favor U.S. bonds, while U.K. and Canada exposure has dropped precipitously from 3/8 of the portfolio to less than 4%. Brazil and Ireland did not even show up in May, now they represent more than 5% of the portfolio. This comparison illustrates the dynamic nature of PCI’s portfolio management. Brazilian bonds are currently the largest holding in the portfolio. With the recent downgrading of Brazil’s sovereign debt to junk status, management’s move into the sector may have been less than timely. The fund’s top 10 holdings sorted from PIMCO’s downloadable spreadsheet are: PCI shares the same risk factors facing PDI in the coming months. Interest rate risk with the on-going anxiety over rising interest rates is primary. The meltdown in emerging markets is also a factor. Each has been weighing on the space for some time. Together they have taken their toll on the fund’s NAV returns and, more severely, on the fund’s returns to investors at market. I do not expect the inevitable uptick in interest rates to be characterized by sudden and markedly disruptive increases. Rather I expect gradual changes that a well managed fund should be able to handle. Indeed, as rates do begin to rise, I would prefer to have my fixed-income allocation positioned to emphasize proven management. PCI’s managers have decreased duration over the past year and “has an outright short on the long-end of the curve” (June 30, 2015 Quarterly Commentary). I have been holding a position in PCI. While I am confident that the fund will continue to deliver excellent income I am concerned about the declines in principal and for the near-term future of the category itself. I am not concerned about the stability or sustainability of the distribution and am encouraged in this view by the small but meaningful increase in that distribution this month. The historically low discount is only of interest to a new buyer, and a new buyer may find value there. To someone holding the fund with no inclination to add to the position, the increasingly deep discount is more of a frustration. In summary, I will continue to hold the fund but if I were considering a new position in a taxable income CEF, I would be more likely to go with PDI, its older sibling, at this time. Disclosure: I am/we are long PCI, PDI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: I remind readers that this article does not constitute investment advice. I am passing along the results of my research on the subject. Any investor who finds these results intriguing will certainly want to do all due diligence to determine if any investment mentioned here is suitable for his or her portfolio. As always I welcome your comments and critiques, particularly from those readers who have contrary opinions.

Ozymandias On The Street: The Fall Of The Mighty In Fixed-Income CEFS

Taxable fixed-income, closed-end funds have fared poorly in 2015. Highly visible distribution cuts by category leaders have been followed by sharp selloffs and price declines with very high premiums falling to discounts. There may be opportunities in taxable, fixed-income funds although one might want to wait for a decision on interest rates before taking any action. It took a long time but the market has finally decided that the PIMCO High Income Fund (NYSE: PHK ) is not worth a premium. After running a premium in the stratosphere for seven years, PHK closed below par today, just five months after running a premium of 66%. PHK was clearly a house of cards. It was earning less than 65% of its distribution. But investors stuck with the fund and even defended it vigorously long after the writing was on the wall. A distribution cut was inevitable and when it came it wiped the premium off the board. On Sept 1 the fund announced a 15% cut in its distribution. Now, two weeks later (Sept 14), what had been the second highest premium in fixed-income CEFs is gone. This chart shows PHK’s premium/discount history. What you may not realize is that the right side does not show a vertical cut-off of the mountain at the end of the chart; that’s a vertical drop to near-zero. Interestingly, if someone buys the fund at today’s discount, the yield will be 17.4% until PIMCO drops the distribution further. It was that sort of return that driving the premium, and I’d not be surprised to see that premium moving up between now the next cut. Some might argue that with that distribution there is an opportunity, but I’m certainly not among them. Continuing to deliver that distribution after September (ex-date was Sept 9) at today’s -0.43% discount, will mean PHK has to pay out 17.3% on its NAV [Distrib NAV = Distrib Price /(1-(Premium/Discount)]. So, if PHK was a house of cards, parts of that house remain standing. And inevitably they must fall. Look for another distribution cut soon. For those of us not invested in PHK, there is a lesson here. One might choose to avoid all closed end funds, especially in this time of market uncertainty. And the steady declines in fixed-income CEFs ( discussed here ) says that many may have taken that tack. To my mind there is real opportunity in this market even though returns have been dismal and discounts continue to grow. Identifying those opportunities with confidence is going to be tricky however. I’ve written several times about the PIMCO Dynamic Income Fund (NYSE: PDI ), most recently this week . It is, in my view, well poised to provide strong returns in the near- to mid-term future. One of its qualities, which so many funds in this category lack at present, is that it is earning its distribution handily. Its current undistributed net investment income or UNII as a percentage of its distribution is the highest in the category, a category where 55% of funds are failing to cover their distributions from investment income. What other funds might be attractive on this metric? Right now, the strongest subcategory looks to be mortgage bond funds. I’ll be discussing this group in detail shortly, but I’ll mention a few highlights here as preview. The Western Asset Mortgage Defined Opportunity Fund (NYSE: DMO ), the BlackRock Income Trust (NYSE: BKT ) and the First Trust Mortgage Income (NYSE: FMY ) are standouts for their positive levels of UNII. FMY’s modest market cap and volume make it somewhat problematic in terms of liquidity, which is always a consideration in CEFs. DMO and BKT fare better on liquidity metrics. DMO is paying a 10.2% distribution yield; BKT’s is 5.9%. DMO has the best 1yr return on NAV in the category and it has recently dropped to a small discount. Anyone interested might want to start with a hard look at DMO. PDI is another consideration in the mortgage space. Although not a mortgage bond fund its present portfolio (30 June 2015) comprises 66% mortgage securities, so today it is two-thirds of one. The potential advantage is that if mortgages go south, PDI’s management has the flexibility to move out as readily as they moved in. What about those with existing positions? My advice to anyone invested in fixed-income CEFs is to take a look at the NII status of their holdings to see how well the fund is earning its distribution. Negative UNII alone does not necessarily mean one should sell a fund, but a persistent negative on this metric is a most worrisome sign. It could well mean that one should start looking for a suitable exit point. Waiting until distributions are cut to bring them in line with NII can be devastating not only to income, but to the value the portfolio as well. I’ll add as an aside that the value of UNII as an indicator of a fund’s status and distribution stability does not transfer to many of the equity funds. Details are outside the scope of this discussion, but I’ll note many solid equity funds, especially those that use options (option-income or buy-write funds), routinely show negative UNII and its evil twin, Return of Capital. They can even be a part of a fund’s investment objectives as they can create tax-advantages to the shareholder. It’s not clear what the Fed will do this week, but should they finally decide to raise rates, expect a move out of many of the fixed-income funds and sharp increases in the absolute values of discount. That may well be the best buying opportunity since the infamous taper-tantrum. Time spent now searching out quality funds may be rewarded. Disclosure: I am/we are long PDI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Why TIPS Deserve A Spot In Your Portfolio

Summary TIPS represent only 10% of the Treasury market but should play a larger role in diversified portfolios. TIPS protect bond investors against unexpected inflation while capping deflation risk. Only TIPS can provide an inflation hedge, the prospect of real returns, and the safety of the backing of the U.S. Treasury. We’ve written several articles in the past about what investments and asset classes shouldn’t be in your portfolio, such as commodities , currency funds , and bank loan funds . We also wrote a few articles about asset classes that should be in your portfolio, such as international bonds . But we’ve never discussed how to assemble a comprehensive, well-diversified portfolio. It’s important to note we are talking about an investment portfolio so we will not be considering cash which would be part of someone’s savings portfolio. In this ongoing series of articles, we’ll be discussing each of the asset classes we use to assemble client portfolios. Over the next few weeks, we’ll be discussing each asset class in depth and talking about what risk and reward attributes they bring to a portfolio. For this series of articles, we’ve divided the asset classes into three conceptual categories: low risk, medium risk, and high risk. The links to previous articles are below. Low Risk Treasury Inflation Protected Securities (( OTC:TIPS )): Why TIPS Deserve a Spot in Your Portfolio Domestic Government Bonds Medium Risk High Risk Real Estate Domestic and International Stocks Summary How to Assemble a Comprehensive Investment Portfolio What are Treasury Inflation Protected Securities or TIPS? Treasury Inflation Protected Securities or TIPS are a relatively recent invention having only been issued by the U.S. Treasury since 1997. TIPS represent a small minority of the Treasury securities market, with only about a 10% market share, but we believe they could play a much bigger role in investors’ portfolios. Like the name suggests TIPS are designed to protect investors from unexpected rises in inflation by adjusting the income and principal investors receive when inflation changes. How TIPS Work TIPS function just like normal bonds but with one key difference. Like a traditional bond, a TIPS bond pays a fixed percentage coupon and the investor receives the par value of the bond back at maturity. However, TIPS protect investors against inflation by adjusting the par value of the bond upwards when inflation rises. The coupon payments also increase since they are based on the new, higher par value of the bond. Inflation data is calculated using the non-seasonally adjusted U.S. City Average All Items Consumer Price Index for All Urban Consumers (CPI-U) index published by the Bureau of Labor Statistics. The inflation data is calculated every six months when the TIPS pay interest (like most bonds, TIPS make interest payments twice per year). To see how this works, let’s look at a hypothetical TIPS bond that has a par value of $1,000 and pays a coupon of 2%, and then what happens after a year that sees 10% inflation. For simplicity’s sake, we are going to just pretend TIPS pay interest once per year while in reality they make two coupon payments each year (each one being one-half the calculated interest rate). Year Inflation/Deflation Par Value Coupon Rate Coupon Payment Initial Year n/a $1,000 2% $20 Second Year 10% inflation $1,100 2% $22 As you can see in the table, the 10% increase in inflation increases the par value of the bond by 10% or $100. The coupon is 2% of the new par value of $1,100 or $22. Now, an important thing to take note of is that this process also works in reverse. If inflation, as measured by CPI-U, is negative, then the par value of the bond will decrease. However, the value will never drop below the initial par value the bond was issued at (in this case $1,000). To see how deflation affects TIPS, let’s take the same example we used above but now add a third year where we have 5% deflation. The table below shows what will happen. Year Inflation/Deflation Par Value Coupon Rate Coupon Payment Initial Year n/a $1,000 2% $20 Second Year 10% inflation $1,100 2% $22 Third Year 5% deflation $1,045 2% $20.9 The par value of the bond is reduced from its previous value of $1,100 by 5% to $1,045. The coupon rate as always stays the same at 2% and the new coupon payment is 2% of the new par value of $1,045 or $20.90. It’s also important to note that the fluctuation of the par value of TIPS will have an effect on the taxes an investor pays. An investor will be liable for taxes on the adjustments to the par value of the bonds. Increases in the par value of the bonds are treated as interest income in the year the increases occur, even though the investor may only receive the increase in par value years in the future when the bond comes due. For example, if an investor received $2,000 in interest and the par value of the bonds rose $500, then the investor would be taxed on $2,500 of income ($2,000 in interest plus a $500 increase in par value). Likewise, decreases in the par value of the bond due to deflation are treated as reductions in interest income. For example, if an investor received $2,000 in interest payments but the par value of the bonds dropped by $500, the investor would only be taxed on $1,500 of income ($2,000 in interest minus $500 reduction in par value). What TIPS Can Add to Your Portfolio We’ve spent almost the last decade in an environment of very low to no inflation so TIPS may seem like they provide little value. In fact, we’ve basically been in a period of falling inflation and falling interest rates over the past few decades which have been great for traditional bonds. But the recent past is certainly not an indication of the future. The chart below shows the year-over-year change in the inflation measure used by TIPS (CPI-U). As you can see, inflation has been much more volatile in the past. Unexpected, high inflation is the exact type of risk that TIPS are designed to protect investors against. In periods of unexpected rising inflation, TIPS behave the opposite of normal bonds. If inflation were to rise unexpectedly, the fixed coupon payments of traditional Treasury securities would become less valuable in real terms. Investors would demand higher interest rates and the price of bonds would fall. With TIPS, both the coupon payment and the par value of the bond would be adjusted upwards to match inflation. TIPS also benefit from the fact that inflation below expectations (remember all bonds have inflation expectations built into them in the form of what interest rates investors demand) or deflation will only reduce the value of a TIPS bond down to its par value. Thus, losses due to negative inflation adjustments are effectively capped. TIPS offer investors unlimited inflation upside and limited deflation downside. It’s virtually impossible to find any other type of investment with capped downside and unlimited upside risks in respect to inflation. The Case for TIPS over Other Hedges While TIPS certainly aren’t the only type of inflation hedge out there, they are one of the best. Specific types of stocks can be good inflation hedges. Stocks of companies that have significant pricing power and strong brands, the stereotypical example of cigarette companies come to mind, can provide a powerful hedge against inflation. They also come with the higher risk and volatility that comes with all stocks. Commodities are often cited as providing a hedge against inflation. However, as we showed in two of our previous articles last year ( here and part two here ), over the long term, commodities have only provided a hedge against inflation. They offered no real return above inflation. Also, as recent events have shown, commodities can be quite volatile as well. TIPS offer investors a hedge against inflation, the opportunity for real returns, and the safety of the backing of the U.S. Treasury. No other asset class can offer that combination to investors and that is why TIPS should play an important role in any diversified portfolio. Investors can purchase TIPS directly from the U.S. Treasury or via any number of ETFs or mutual funds, a few of which are shown in the table below. Fund Name (Ticker) Expense Ratio iShares TIPS Bond ETF .20% Vanguard Inflation-Protected Securities Fund (MUTF: VIPSX ) .20% Schwab U.S. TIPS ETF (NYSEARCA: SCHP ) .07% SPDR Barclays TIPS ETF (NYSEARCA: IPE ) .15% Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks. Disclosure: I am/we are long TIP. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.