PCN - PCN CEF: Possible Gains In Store For The Brave

2023-10-25 13:20:08 ET

Summary

• The PIMCO Corporate & Income Strategy Fund has experienced a significant drawdown, opening up a potential value gap.
• The fund's portfolio is diversified across various corporate sectors, presenting investors with exposure to credit risk premiums, which look set to revert to mean.
• The fund's high dividend yield and moderate premium to NAV add to our bullish outlook.
• Risks such as weakening interest coverage ratios and default rate uncertainty shouldn't be overlooked. However, our view is that the CEF's positives outweigh its negatives.

There's no doubt that fixed-income markets are in a tizzy at the moment. Realistically speaking, the yield curve's 15-year high , paired with exacerbating credit spreads, was never going to be well received by fixed-income investors, especially by those interested in investment vehicles such as the PIMCO Corporate & Income Strategy Fund ( PCN ) .

Top-down variables in the credit markets have been brass tacks to the shaky environment. Moreover, the PIMCO Corporate & Income Strategy Fund is a cyclical closed-ended fund ("CEF"), which explains its more than 15% month-over-month drawdown amid the turmoil surrounding the credit markets.

However, as investors, we need to remind ourselves that our focus should be on expected returns instead of realized returns. As such, buying into dips on the correct occasions often leads to better outcomes than buying trendy assets.

Here are a few reasons why we believe the PIMCO Corporate & Income Strategy Fund is undervalued after its recent drawdown.

Portfolio Overview & Strategy

The PIMCO Corporate & Income Strategy Fund provides investors with access to credit risk premiums via a vehicle that diversifies into most corporate sectors.

Approximately 75.52% of the vehicle's exposure is to U.S. securities, while the remainder of its notable constituents are in France, Luxembourg, and Italy. Moreover, a noteworthy consideration is that 70.54% of the vehicle's exposure is to corporate debt, communicating its cyclical attributes.

Furthermore, the PIMCO Corporate & Income Strategy Fund's portfolio has an intermediate maturity schedule with an effective duration of 7.69.

Intermediate-term bonds allow investors to participate in partial benefits from term premiums. However, note that they can be sensitive to yield and credit curvature, which are functions that tend to change abruptly.

Let's dissect the fund's strategy.

The PIMCO Corporate & Income Strategy Fund's portfolio is 51.52% short on cash & equivalents and 151.52% long on other instruments, netting out to a fully invested portfolio of 100% in net long positions.

The CEF is short on cash & equivalents because it uses reverse repurchase trades and issuances of preferred shares to leverage its long positions. It also uses other instruments to leverage; however, repo trades & issuing preferreds are its primary tools.

Therefore, it is critical to consider that interest rates play a significant part here as the fund will typically onboard liabilities on its balance sheet to invest in other debt instruments. Moreover, its liabilities are often pegged to short-term interest rates, while its investments rely on longer-term rates, meaning the yield curve's current inversion poses serious challenges.

In our view, the yield curve's inversion and the volatility embedded in today's markets add substantial risk to repo trades, which usually function better when the yield curve is stable and sloping upward. Moreover, the PIMCO Corporate & Income Strategy Fund has intermediate-term exposure, which is risky in today's uncertain interest rate environment as such an environment adds to curvature risk.

Risk Premiums & Expected Returns

More on the Yield Curve

I already mentioned the yield curve. However, let's add to the discussion that it is a critical feature of the PIMCO Corporate & Income Strategy Fund's expected returns.

The curve's inversion suggests the PIMCO Corporate & Income Strategy Fund's expected returns may be hindered. In addition, funding rates are significant, with the short-end elevated while the longer-end is in arrears. However, fortunately, market returns of fixed-income CEFs rely on implied curves instead of the realized curve.

In our view, inflation will eventually settle much lower as consumer sentiment is waning. If we happen to be correct, the curve will probably experience a lower level, concurrently presenting the PIMCO Corporate & Income Strategy Fund with more favorable funding rates.

Furthermore, disinflation, credit events, wavering consumer demand, and a stall in interest rate hikes tell us that we are potentially in an economic slowdown phase. Should a recession follow, the yield curve will steepen, lending opportunities to funds that focus on repo trades, such as the PIMCO Corporate & Income Strategy Fund. Sure, weak credit rating debt may suffer if a contraction occurs; however, the CEF's recent drawdown implies the market might've priced such risks in advance.

Credit Risk

Option-adjusted spreads are one of the most reliable ways of measuring the credit risk of tradable securities. According to OAS spreads, credit risk has re-emerged in recent months after tapering significantly since the turn of the year. Again, much of this is likely due to interest rate uncertainty, which sent a rippled effect through credit markets.

The PIMCO Corporate & Income Strategy Fund's contemporaneous drawdown suggests investors have already priced increases in credit spreads. As such, logic tells us that the emergence of increased credit spread has created a value gap.

Nevertheless, investors must be wary of the fact that additional credit spread increases may occur, given the recent increase in expected default rate forecasts illustrated in the diagram below.

Sidenote: Corporate credit risk is usually bound to default probabilities and the loss given default.

Stellar Dividends With Moderate Premium To NAV

High effective interest rates and floating-rate exposure by the PIMCO Corporate & Income Strategy Fund allow it to pay a sublime dividend with a forward yield of 12.26%.

Although a lower interest rate environment might reduce the fund's distributable income, the lowest incremental dividend yield this CEF has presented in the past ten years was 7.03% in 2020 , illustrating the sustainability of its distributions.

Is the PIMCO Corporate & Income Strategy Fund a bird-in-hand opportunity? I certainly think so.

A retrospective look at the CEF's market value versus asset value shows that it often trades at a premium. Moreover, the current premium over the fund's NAV is quite slim; as such, there isn't much reason to believe that the market will price it in.

Risks

Let's look at a few of the PIMCO Corporate & Income Strategy Fund's risks to balance the analysis.

Interest Coverage Ratios

Fitch Ratings recently downgraded North American corporate interest coverage ratios. Even though ratings agencies are often backward-looking, sustainable interest rates and slow consumer spending might cause the forecasts to realize and inflict damage to the PIMCO Corporate & Income Strategy Fund.

Sectors of Concern

I mentioned earlier in the article that credit default rates are rising. However, I wanted to emphasize the matter from a bottom-up point of view, as the sectors of concern hold similar parallels to the PIMCO Corporate & Income Strategy Fund.

Fitch Ratings selected bonds of concern on an issuer-by-issuer basis and discovered that 30% of its sampled bonds of concern belong to the healthcare sector, which is an issue to the PIMCO Corporate & Income Strategy Fund as it is overweight on healthcare assets with 7.79% portfolio exposure.

Furthermore, technology is another area of concern to Fitch, which again coincides with the PIMCO Corporate & Income Strategy Fund as its second-largest sector exposure is tech, with 7.05%.

Lastly, Fitch deems telecommunication bonds risky, which again plays into the PIMCO Corporate & Income Strategy Fund's risk profile, as wireless communication exposure is the fund's fourth-largest exposure at 4.73%.

VaR

Lastly, the PIMCO Corporate & Income Strategy Fund's value-at-risk must be considered, as the metric shows that the CEF's tail risk is more than that of the SPDR® S&P 500 ETF Trust ( SPY ), essentially meaning that the vehicle trades like a stock portfolio in down markets instead of a fixed-income portfolio. Therefore, I suggest investors do not mistake the PIMCO Corporate & Income Strategy Fund for a safe haven.

Final Word

Our analysis shows that the PIMCO Corporate & Income Strategy Fund possesses a potential value opportunity after its sharp month-over-month drawdown.

Although we deem this asset a high-risk fixed-income investment, we believe its risk factors have reached fever pitch, and reversion of such factors will likely lead to significant upside.

Lastly, despite the CEF's cyclical features, its dividend profile generally sustains throughout the economic cycle.

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