PDI - PDI: No Pain No Gain

2024-01-16 09:54:09 ET

Summary

• PIMCO Dynamic Income Fund has seen a total return of over 20% in the past three months since our call.
• Investors can expect to receive their entire investment back in dividends in ~7 years at the current yield, making it a strong income powerhouse.
• PDI has a diversified portfolio of fixed income securities and has a long history of providing a high level of income to investors.
• There is leverage and credit risk, but there are 20 years of payment history to investors.

PIMCO Dynamic Income Fund ( PDI ) is a name that we called for a buy 3 months ago in October 2023. Recall that this is a closed-end mutual fund, or CEF. PIMCO Dynamic Income fund, herein referred to as PDI in this column, seeks to provide investors in the fund with a high level of current income, but we still see the potential for capital appreciation. However, since our call, the total return is now over 20% when factoring in the 16% run in shares and the monthly dividends. While the price tag has gone up, we still see upside, but think you can wait for a pullback. As we head into earnings season, we expect some volatility, which should provide ample opportunity to acquire cheaper shares. You see, when we called for a buy near the absolute lows of the pain, we know as traders that you can have no gain without pain. You need to be unemotional and tolerate the pain.

Still, even if you buy today, you can collect a 14.2% yield . Assuming the dividend is paid at the same level over time, no cuts or raises, along with the level of special dividend being maintained, an investor can get their entire investment back in dividends in 7 years at current rates. What makes this attractive for income is that shares will definitely oscillate in value, and the nimble investor can pick their spots. Shares are unlikely to depreciate greatly, so even if there are some on paper declines in the next quarter, we see that as a buying opportunity at the low end of the trading channel. Bottom line, the payouts mean you will be guaranteed to be even in a few years if you are taking the cash.

We see 2024 as a strong year for income instruments. As rate cuts are expected later this year, income from bonds and cash are seemingly less attractive. For the long-term investor, PDI is still a strong income powerhouse. We do think you let it come down a bit if you are new to PDI, but like it in the medium and long-term for income. It trades a bit in tandem with the market just given its holdings, but has had a great run since our call:

This is how we like to invest and trade. While we do trade positive momentum and growth, we also love to find beaten down value and profit from reversals. At this juncture, we would not blame anyone for trimming some of the position if they are trading around the core position and look to redeploy lower, but from an income only standpoint, the principal on paper day to day is not always something to watch if you own it only for income. You monitor it, but will go crazy watching it for trading purposes. Think of it like a rental real estate property. Are you getting a new appraisal every day? No, you are collecting the rental income month to month. We digress.

Now, we do understand there may be those who bought much higher underwater. While we would normally suggest adding on, sometimes your cash position is not in that position to do so. Look, you can still earn 5% in a bond or money market with no risk, but taking on some risk, you can still collect nearly 3 times that with PDI. We also see upside to the $20 level. On the downside to $16. We are slightly over the higher end of that, so you can pick your spots. A good basic strategy is to add on 50 cent dips over time to build a position.

So why we do we like PDI? Well, management here we have respect for. We think they run a strong fund. We like the approach to have a blended and diversified portfolio of fixed income securities, which includes government and corporate bonds, as well as mortgage-backed securities, asset-backed securities, and other debt instruments. The fund also has the flexibility to invest across various fixed income sectors. Now there are some risks and rate sensitivity here. There is some non-agency MBS exposure here and if we see massive moves in rates, or experience a recession, that could impact cash flow. There is also leverage in the portfolio to magnify returns, but significant leverage opens up the fund to take hits of the instruments and leverage move in the wrong direction (i.e. losses). Management uses leverage to enhance potential returns. This means that the fund borrows money to invest in additional securities, and the borrowing rates are still expensive. However, we like the for management to make active and swift moves to adjust to market conditions. Still, the company does have over 1800 holdings, here is the look at the top 10 as of 11/30:

While there are many diverse holdings, the above gives you an idea of the major holdings. As you can see, there is heavy investment in debt obligations and other income-producing securities.

There is also investment grade, and high-yield corporate debt, as well as in both developed and emerging markets' corporate and sovereign bonds. There is approximately $4.9 billion in assets under management at the time of this writing. So why did PDI fall so much in 2022-2023? It was a result of the changing and increasing rate environment. There is concern that if rates are rapidly cut that it could impact MBS holdings, or returns on debt. In our opinion, it is not so much where rates are (it is a factor) but the change in rates. If there is a slow and orderly cut to rates over the next few years, we think it will be well managed. But if the cuts are significant and swift, it will have an impact. However, the one offsetting fact is that lower rates means lower returns on buying treasuries or sitting in cash/money markets, which could generate buying power for income names like PDI.

So PDI has a rough midpoint portfolio maturity ranging from zero to eight years. So as we saw with the rapid surge in rates, the impact to principal for bonds, there has been pressure on the holdings, and as such, the value of the fund. Still, right now, we have very little concern over the bountiful payout. The investments made by the fund result in strong returns, which is why you get a bountiful monthly dividend and special dividends over time. While we have a 20% return here, more income is on the way.

This is a largely unprecedented time in history, but PDI has a long history of providing its investors with a very high level of income. In the short-term, there will be volatility, but in the grand scheme of trading this is still a good price. The fund has paid a monthly dividend for over 20 years now, and as we mentioned, it has also paid special dividends. The yield is nearly three times that of sitting in cash. Of course, do your own due diligence. This is quite a complex fund. Like we saw with the surge in rates, PDI is very sensitive to changes in interest rates and other market conditions than a non-leveraged fund, so, a sharp dropoff could introduce a new challenge. There is credit risk as well. Further this is a closed-end fund and, given the supply and demand for buying the shares, may trade at a premium or discount to the fund's net asset value. So you want to buy when you have the best sale, which is why we do think it best to wait.

Still, if you are looking for a diversified, well-managed fund for high-income, PDI merits your consideration. There is risk, and you have to be ok with the leverage, interest rate sensitivity, and credit risk. But as long as the payout keeps rolling in you can see shares fall dramatically over the next few years and come out on top as long as the dividends keep getting paid. We rate the fund a buy, but suggest waiting for the next dip if you are new to the fund.

Your opinion matters

Is the fund too risky? Do you see the price continuing to erode? Are there other high income funds you like? Are you a reluctant shareholder? Have you been buying for months, or will this be your first purchase? Are you a long-term owner? Do you trade around a core position? Let the community know below.

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