PAXS - PAXS: Investors May Be Too Optimistic About This Levered Bond Fund

2023-07-13 16:06:15 ET

Summary

• Investors are in desperate need of income today to maintain their standard of living in the current inflationary environment.
• PIMCO Access Income Fund invests in a highly leveraged portfolio of bonds to deliver a high yield to its shareholders.
• There could be a lot of downside risk here if the Federal Reserve stands firm on interest rates.
• The fund failed to cover its distributions last year but it is uncertain how it managed to perform year-to-date.
• The PAXS closed-end fund is one of the few PIMCO funds that trades at a discount to net asset value.

There can be few doubts that one of the biggest problems facing the average American today is the rapidly rising cost of living. For most of the past two years, inflation has been at the highest level that the nation has seen since the early 1980s. This is evidenced by the consumer price index, which claims to measure the cost of a basket of goods that is regularly purchased by the average person. As we can see here, the consumer price index has increased by more than the 2% rate that is considered healthy during each of the past twelve months:

While we have seen some improvements here since the middle of last year, it is important to keep in mind that inflation compounds. Thus, the 3% increase may not sound that bad, but that was on top of a 9.1% increase in June of 2022. The power of compounding works for us when it comes to investing, but it very much works against us in this case. Due to this inflation, real hourly wages in the United States have fallen from $11.41 in January 2021 to $11.03 in May 2023. As I discussed in a blog post yesterday morning, this has led many consumers to take desperate actions just to obtain the money and resources that they need to survive in the current environment. In short, people are desperate for income right now.

As investors, we are certainly not immune to this. After all, we need money to pay our bills and enjoy our lifestyles just like anyone else. Fortunately, we do have ways that we can obtain this extra money without needing to resort to taking on a second job or the other extreme measures that I discussed in the linked blog post. After all, we have the ability to put our money to work for us to earn more money that can be used to cover our expenses.

One of the best ways to do this is to purchase shares of a closed-end fund, or CEF, that specializes in the generation of income. Unfortunately, these funds are not very well followed in the investment media and many financial planners are unfamiliar with them so it is difficult to obtain the information that we want to have to make an informed decision. This is a shame because these funds offer a number of advantages over familiar open-ended and exchange-traded funds. In particular, a closed-end fund has the ability to employ certain strategies that allow it to boast higher yields than the underlying assets or indeed pretty much anything else in the market.

In this article, we will discuss the PIMCO Access Income Fund ( PAXS ), which is one fund that investors can use to earn a high level of income. This is immediately apparent in the fact that this fund yields 12.18% at the current share price. I have discussed this fund before, but a few months have passed since that time so naturally some things have changed. This article will focus specifically on these changes and provide an updated analysis of the fund's financial condition. Let us investigate and see if this fund could be a good addition to your portfolio today!

About The Fund

According to the fund's webpage , the PIMCO Access Income Fund has the stated objective of providing its investors with a high level of current income. The fund will also attempt to get capital appreciation when possible. This is not a particularly surprising objective for a PIMCO fund. As everyone reading this is likely aware, PIMCO is well known for specializing in fixed-income funds and this one is no different. As we can see here, the PIMCO Access Income Fund is almost entirely invested in bonds, although it does have some exposure to common and preferred stock:

We can also see that this fund has a negative allocation to cash. This is due to the fact that this fund employs leverage, which we will discuss later in this article. For right now, the important thing is that this is very obviously a fixed-income fund.

The fund's focus on current income is unsurprising considering the fixed-income portfolio. This is because fixed-income securities such as bonds have no net capital gains over their lifetime. An investor purchases the bond at face value when it is issued, collects a regular payment from the issuer of the security, and then gets the face value back when the security matures. Thus, the only investment return for someone that holds a bond for its entire life is the regular interest payment that the bond pays out. There are no net capital gains because a bond has no inherent link with the growth and prosperity of the issuing company or government. Pretty much any bond fund will have a current income objective for this reason.

With that said, it is possible to achieve some capital gains by trading bonds prior to their maturity date to exploit changes in bond prices. This comes from the fact that bond prices vary with interest rates. It is an inverse relationship so when interest rates rise, bond prices go down and vice versa. This is important today because of the Federal Reserve's recent monetary tightening push. Since March 2022, the Federal Reserve has been aggressively raising interest rates in an attempt to contract economic activity and reduce the inflation rate. We can see this quite clearly in the federal funds rate, which has gone from 0.08% at the start of last year to 5.08% today:

This has had the general effect of causing bond prices to fall over the period. This makes sense because bonds issued eighteen months ago will have a substantially lower interest rate than a brand-new bond so nobody will buy the existing bond unless the price on it is low enough that it delivers the same effective yield-to-maturity. As bond funds are valued based on the market price of their assets, this generally caused bond funds to decline over the period. We can see this very clearly here as the PIMCO Access Income Fund is down 7.42% over the past twelve months:

We are starting to see a rally over the past month or so, but as I mentioned in a previous article , this could be a sign of the market being overly optimistic. The market is currently predicting that the Federal Reserve will cut rates as the economy descends into a recession during the second half of the year. This is why we tend to see market rallies every time bad news hits the tickers. However, the Federal Reserve has outright stated that it will not cut. At the last meeting, officials stated that there will most likely be two more rate hikes this year and no cuts. They were steadfast in stating that lowering rates even in a recession will cause inflation to stage a comeback, and this view is probably correct. The amount of money created since 2008 has greatly exceeded actual economic growth and the Federal Government continues to run huge inflationary deficits, so the central bank needs to run a very tight monetary policy in order to keep inflation contained. If the Federal Reserve does indeed show integrity and stands by its current statements, we will almost certainly see a correction in the bond market within the next six months. That would have an adverse impact on the value of the assets held by the fund, as well as its market price.

One of the interesting characteristics of bonds is that somebody that buys them at issuance and holds them until maturity will not lose money unless the issuer defaults. As such, an investor in this category does not have to worry about interest rates as they only affect the price that you will receive if you actually try to sell the bonds. However, as individual investors, we do not have the ability to control when a fund that we are invested in buys or sells bonds for its portfolio so we will still be affected by the price swings of the bonds held by it even if the fund does not actually realize losses. This is something that is important because PIMCO funds are known for engaging in significant trading activity to capitalize on bond price fluctuations.

PAXS is an exception, however, as its annual turnover is only 16.00%, which is not particularly high for a fixed-income fund. This could be a sign that this fund is holding many of its bonds to maturity and thus minimizing its realized losses. This could be a very good thing today as Jim Grant, Founder of Grant's Rate Observer, recently stated that we could see a bear market in bonds that could last for decades. This is a lot more extreme than the viewpoint that I have on the matter (detailed above), but it still means that a fund that does minimal trading will probably perform better over the long run than one that engages in a great deal of trading and ends up locking-in capital losses. The PIMCO Access Income Fund appears to be well positioned in this respect.

Another advantage to the fact that this fund engages in minimal trading comes from the fact that it costs money to trade bonds or other assets. These expenses are billed directly to the shareholders of the fund and thus create a drag on the portfolio's performance and make the job of its management more difficult. After all, the fund's managers need to earn sufficient returns to both cover these additional expenses and provide the shareholders with a competitive return. That is a very difficult task that very few management teams manage to accomplish on a consistent basis. This is one of the reasons why many actively-managed funds end up underperforming their benchmark indices.

The PIMCO Access Income Fund has too short of history to judge it in this respect, but it did manage to outperform the Bloomberg U.S. Aggregate Bond Index ( AGG ) during the one-year period that ended on June 30, 2023. Here is the total return data for the PIMCO fund as of that date:

The Bloomberg U.S. Aggregate Bond Index delivered a total return of -0.94% over the same one-year period. The PIMCO fund's portfolio delivered a total return of -0.78% over the same period, so it managed to slightly beat the index. We can clearly see that the fund did much better in the market in terms of share price performance, though. The fact that this fund only beat the index by such a small amount could be an indicator that the market is greatly overvaluing it due to the PIMCO name, and the strong total return performance that the fund delivered was completely unjustified. We will discuss this later in this article.

Leverage

In the introduction to this article, I stated that closed-end funds such as the PIMCO Access Income Fund have to ability to employ certain strategies that have the effect of boosting their effective yields beyond that of any of the underlying assets. One of the strategies that is used by this fund to accomplish that is the use of leverage. In short, the fund borrows money and uses that borrowed money to purchase bonds and similar fixed-income assets. As long as the borrowed assets have a higher yield than the interest rate that the fund has to pay on the borrowed funds, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably higher than retail rates, that will normally be the case. With that said, though, this strategy is much less effective today with market rates above 5% than it was a year ago when rates were just barely above 0%.

However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage, since that would expose us to an outsized amount of risk. I generally do not like to see a fund's leverage exceed a third as a percentage of assets for this reason. Unfortunately, the PIMCO Access Income Fund greatly exceeds that level. As of the time of writing, the fund's levered assets account for 47.23% of the fund's portfolio. This is a substantial amount of leverage that will make the fund much more volatile than a similar fund that depends less heavily on borrowing money. As such, this fund may not be appropriate for risk-averse investors that are simply seeking a high level of income.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the PIMCO Access Income Fund is to provide its investors with a high level of current income. In order to achieve this objective, the fund purchases bonds that deliver the majority of their investment returns in the form of direct payments to the fund. It then applies a layer of leverage to artificially boost the yield of the portfolio beyond that of any of the underlying assets. As such, we might assume that the fund itself has a very high yield.

That is certainly the case here, as the PIMCO Access Income Fund pays a monthly distribution of $0.1494 per share ($1.7928 per share annually), which gives it a 12.18% yield at the current share price. This fund has a very short history, but it has generally been consistent with its distribution over its lifetime:

This is a better distribution history than that possessed by most fixed-income funds over the same period. With that said though, its inception date meant that it would not have been loading up on debt securities during 2020 and 2021 when rates were much lower. These are the securities that handed large unrealized losses to many other fixed-income funds. While the fund's history so far has been promising, it does not have enough of a history to really establish enough of a track record to appeal to someone that is looking for a stable and secure source of income to pay their bills. It certainly might become very appealing though, especially if it can maintain its distribution so let us have a look at its finances and attempt to determine if that is the case.

Unfortunately, we do not have an especially recent document that we can consult for the purposes of our analysis. The fund's most recent financial report corresponds to the six-month period that ended on December 31, 2022. As such, it will not include any information about the fund's performance so far this year. That is about six and a half months of market activity that we have no information about right now. However, 2022 was generally a more challenging market for bonds and bond funds than this year has been so far and this report will give us a good idea of how the fund handled that.

During the six-month period, the PIMCO Access Income Fund received a total of $1.078 million in dividends along with $61.162 million in interest from the investments in its portfolio. This gives the fund a total investment income of $62.240 million for the full-year period. The fund paid its expenses out of this amount, which left it with $43.395 million available for the shareholders.

That was, unfortunately, not enough to cover the $59.433 million that the fund actually paid out in distributions during the period. This is certainly concerning at first glance as we usually like fixed-income funds to be able to cover their distributions out of net investment income.

With that said, this fund does have other methods that can be employed to obtain the money that it needs to cover its distributions. For example, it might be able to earn capital gains by taking advantage of fluctuations in bond prices and distributing that money to the shareholders. Unfortunately, the fund failed to achieve that during the six-month period. It reported net realized losses of $25.578 million and had another $26.087 million net unrealized losses.

Overall, the fund's assets declined by $67.411 million during the period. PAXS thus quite clearly failed to cover the distributions that it paid out. We cannot draw any conclusions yet about how well it managed to cover the distributions this year, but it would need to improve its performance substantially for the current payout to be sustainable.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to earn a suboptimal return on that asset. The usual way that we value a closed-end fund like the PIMCO Access Income Fund is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of the fund's assets minus any outstanding debt. It is, therefore, the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to buy shares of a fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are purchasing the fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of July 12, 2023, the PIMCO Access Income Fund has a net asset value of $14.79 per share but the shares currently trade for $14.69 each. This gives the shares a 0.68% discount on the net asset value. This is a very small discount that is reasonably in line with the 0.94% discount that the shares have averaged over the past month. Thus, the current price appears to be reasonable.

Conclusion

In conclusion, the PIMCO Access Income Fund is a reasonably solid bond fund with a very short history. As the fund is so new, it is difficult to judge it, but it did manage to outperform the bond index over the past year. The biggest problem right now, though, is that the market seems to be overly optimistic towards bonds in general and if the Federal Reserve shows any integrity going forward anyone buying today will take large losses. This is a problem shared by every bond fund, though, not just this one.

The biggest problem with PIMCO Access Income Fund is that the fund failed to earn enough to cover its distribution over the course of 2022 and it is still uncertain whether or not it has corrected this problem in 2023. The fund is highly levered, too, which is another risk. The current price is reasonable, though, as this is one of the only PIMCO funds to trade at a discount.

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