PCQ - PCQ: Not Impressed By Recent Momentum Cautious Outlook Remains

2023-07-21 08:49:47 ET

Summary

• This article evaluates the PIMCO California Municipal Income Fund as a potential investment option at its current market price.
• Despite recent gains in PCQ, the prudent course here is to remain cautious.
• California's budget and finances are more sensitive to economic trends, given its tax structure that relies heavily on high net worth individuals.

Main Thesis & Background

The purpose of this article is to evaluate the PIMCO California Municipal Income Fund ( PCQ ) as an investment option at the current market price. The fund invests primarily in California municipal bonds, and therefore, seeks to provide current income which is exempt from federal and California income tax. The fund normally invests at least 90% of its net assets in municipal bonds that pay interest that is exempt from federal and California income tax.

This is a fund I followed closely and have owned at one point. My bearish call on it at the end of last year was extremely accurate but, after that big drop, I advised that a more cautious or "hold" opinion on it became warranted. Looking back, this was a reasonable take. As the equity market has rallied and munis have also recovered, PCQ continues to post modest losses:

Generally speaking, going forward, I have a positive view on municipal bonds. This has led me to reconsider PCQ to see if this is a value opportunity and if the time is ripe for an upgrade. After review, I still believe caution is warranted and "hold" remains the right rating. I will explain why in detail below.

Munis Look Attractive, PCQ Has Momentum

To begin this review, I want to take a moment to highlight some key positives for both the muni sector and PCQ by extension. These are central to why I even considered giving this CEF a look at this juncture. The primary is that muni yields remain attractive on a historical basis. This is true for California munis but also for the broader index. On average, munis have yields well above what we have seen in the past few years:

This should at least pique investor interest, especially with inflation falling and the Fed near "peak" rates. That makes the outlook and timing for fixed-income as a whole fairly attractive. So PCQ - and many other funds - are probably popping up on the radar of retail investors.

Another attribute that is more specific to PCQ is the fund's momentum in recent weeks. Over the past month, the fund has displayed a strong gain as well as kept its distribution constant. This has been a welcome relief for current holders who are likely nursing losses from the sell-off in January:

This graphic shows me two things. One, momentum traders could be interested and two, the worst of things is probably over. PCQ has finally stabilized and is picking up steam again. After a sharp distribution cut and dramatic sell-off earlier this year, it is not too surprising this fund has been slow to rebound. But seeing these recent gains should shore up some confidence. This is key to why I am not bearish on the fund overall.

But there are a few attributes that make me reluctant to be a buyer even with these positives. I will take each in turn in the following paragraphs.

Updated Income Metrics Don't Impress

The first element I am critical of is PCQ's income story. As noted in earlier reviews, I anticipated a cut to the distribution late last year. It didn't take long for that story to pan out, and the result was disastrous for holders of the fund. That reality makes me very cautious on buying PCQ until income metrics are strong enough to put my mind at ease. With PIMCO's July UNII report out this past week, the story really isn't too great for PCQ at the moment:

As you can see, the fund is clearly under-earning what it needs to maintain its current payout. The coverage ratios are too low for my liking, and the negative UNII metric suggests there isn't much room for further error. This puts the distribution on watch for me, and that is never a buy signal in my book. Until these metrics paint a brighter picture, I will be on the sidelines.

Valuation Looks Tempting, But PCK Much Cheaper

The second attribute is a bit of a mixed bag and relates to the fund's valuation. On the surface, PCQ may look like a bargain. It sits at a discount to NAV, which is unusual for this fund over a long time frame. It often sat at a premium - and quite frankly an absurdly high premium - for most of the time it was on my watch list. That changed dramatically after the January distribution cut, when the valuation came back down to earth. The modest discount now may seem like a good value, but we have to put it in perspective.

Specifically, there are two points of concern. One, the current discount of just over 1% is not much of a change from the February valuation when the fund was just right around par value. Thus, it has seen a 3% drop in total return but only shed 1% in the market value compared to the net asset value. This exposes some underlying weaknesses in the assets. Two, PCQ has two sister funds from PIMCO and there is one that is markedly cheaper than the others:

Source: PIMCO

When evaluating California municipal CEFs one should consider more than just the PIMCO family (and municipal CEFs for any state for that matter). So this is not an all-inclusive discussion. But the takeaway for me is that if one decides they need to have PIMCO exposure to California muni bonds, it is hard to make a care to buy PCQ right now when PCK has a double-digit discount and similar exposure. Seems like a no-brainer to me and supports why I don't view PCQ as a buy at this juncture.

The Leverage Risk Hasn't Gone Away

Another topic to consider is the fund's extensive use of leverage. As CEF investors have undoubtedly felt the pain from leverage over the past year and a half, it could be easy to think the worst is over. And - quite frankly - it probably is. But that doesn't mean the risk has evaporated. While inflation has come down in a big way, it is still high based on pre-Covid measures:

This means the Fed is probably not completely done with hiking rates. And, as rates keep going up, so too does the risk of a drag on long-term growth and/or a recession. This is keeping long-term rates muted, while simultaneously sending short-term rates higher. As I have discussed in a number of reviews over the past year, this pressures CEFs that borrow and short-term rates and then reinvest at long-term rates.

This is relevant to PCQ in particular because the fund uses extensive leverage. At over 44% of fund assets, this means the risk in this particular product is elevated:

While preferred shares are not the same as borrowing directly, the dividends demanded by preferred shareholders are similar to short-term and intermediate-term interest rates. So, again, as short-term rates rise, so too does the cost of this leverage. And then PCQ uses these proceeds to invest in long-dated assets generally:

What this shows us is that PCQ's strategy is to buy longer-term bonds. With the pressure on short-term costs not being offset by rising rates on the longer end of the curve, the problem of leverage continues for now. Will this change in the months to come? Perhaps, and probably by 2024. But we need to be conscious that the headwind of leverage remains relevant to investors.

California: Not The Best Bet If We See A Recession

My final point looks at California muni bonds more broadly. As a fund that invests solely in munis from this state, the outlook for these bonds is of vital importance to anyone evaluating this fund.

One thing to keep in mind is that California depends heavily on capital gains and personal income taxes to pay for its very expensive budget. With high income taxes on top earners, the state is very reliant on the fortunes of a small percentage of people to keep the state in the black. Unfortunately, when recessions hit, income taxes and gains from investments can drop. That puts California at a distinct disadvantage compared to some other states if the economy does turn in a worse-than-expected manner:

The risk here is dependent on the future and one's personal outlook. We have been hearing the "recession" mantra for a long time. It hasn't really happened yet, and it might not for a long time. If that is the case, then the risk to California munis is minimal.

But the opposite case needs to be weighed carefully. Not that I am declaring California munis are going to default, quite the contrary. But rather if economic conditions worsen, then other state's munis may look more attractive by comparison. That could limit the gains for the underlying assets in PCQ's portfolio compared to funds that focus on other states that are not as sensitive to macro-conditions. Readers should understand this risk before buying in.

Bottom Line

PCQ has continued to come under pressure as 2023 has gone on, and I'm not sure the horizon is clear enough yet to be a buyer. California munis remain more economically sensitive than other states, the fund's income metrics are quite poor, and the risk of leverage is still a very important consideration. While I like the broader muni sector overall, I believe investors need to be especially selective for the remainder of the year. Therefore, I remain convinced that "hold" continues to be the correct rating for the fund at this time.

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