PDI - PDI: This 15%-Yielding CEF Is A Strong Buy

2023-12-08 00:02:22 ET

Summary

• The Federal Reserve is expected to lower interest rates in 2024, which could benefit fixed income assets included in the PIMCO Dynamic Income Fund.
• The fund primarily invests in income-producing securities such as non-agency mortgages.
• The PDI has a solid track record over a long period of time.
• PDI has potential for net asset value growth as the Federal Reserve ends its tightening policy.

The Federal Reserve is widely expected to lower interest rates next year, which could be a powerful catalyst for fixed income assets like the ones including in PIMCO Dynamic Income Fund ( PDI )'s investment portfolio. The Dynamic Income Fund is engaged in buying assets in multiple fixed income sectors globally and currently supplies a massive 16% dividend yield. I believe the Dynamic Income Fund is facing a potentially powerful catalyst for net asset value growth next year as the Federal Reserve is set to bring rates down. I believe the PDI is a promising bet on the end of the Federal Reserve’s tightening process and I have established a speculative long position!

What is PDI's strategy and what assets does the Dynamic Income Fund invest in?

The Dynamic Income Fund has an actively-managed investment portfolio that contains income-producing securities such as non-agency mortgage debt, high-yield credit opportunities, non-USD debt, commercial mortgage-backed securities and other similar categories. The fund seeks to generate income, which is its primary investment goal, while capital appreciation is a secondary concern.

The Dynamic Income Fund had about $4.5B in net assets in its portfolio and total managed assets of $7.8B. The managed asset total includes reverse repurchase agreements, preferred shares and derivative instruments. The PDI is structured as a closed-end fund and its largest investment category is non-agency mortgages with an investment share of 26%. The second- and third-largest investment categories were high-yield credit with an investment share of 21% and non-USD developed market debt with a share of 15%.

I have represented the fund's top fixed income categories in the chart below (the part of the pie chart that doesn’t show percentage figures implies that all categories have a fund investment share of less than 2%).

Attractive long term investment returns

The PDI has been around for a while and returned, since its start in May 2012, a solid 10.26% annually. Since the portfolio is invested chiefly in rate-sensitive fixed income assets, the Dynamic Income Fund's net asset value is vulnerable to a changing interest rate paths. The fund, however, did quite well over a long period of time and achieving a 10% annual average return, achieved in widely different markets, is no easy feat.

Inflation trends, NAV trajectory and upside revaluation potential

The number one reason to own the Dynamic Income Fund is that the Federal Reserve is all but likely done with its tightening policy. Inflation fell to just 3.2% in October... which was the lowest level since August. The 1-year trend in inflation strongly suggests that the Federal Reserve will follow the inflation curve in 2024. Since fixed income assets gain in value (which the PDI owns in its portfolio) when interest rates decrease, the Dynamic Income Fund could see a reversal of its net asset value trend next year as well.

The PDI's net asset value has come under pressure from higher interest rates in the last year since the fund's portfolio consists chiefly of rate-sensitive fixed income assets such as mortgages and other debt instruments. In the last year, the Dynamic Income Fund's net asset value declined 9.5%, but I expect this trend to change next year, when the Federal Reserve is expected to cut the federal funds rate.

NAV premium

The closed-end fund reports a daily net asset value for investors, and the most recently reported net asset value is $16.90 (as of 12/05/2023). The fund's market price is $18.24 which implies a 7.5% premium to net asset value. The premium has increased lately, largely, I believe, due to solidifying market expectations that the Fed is truly done with raising interest rates.

PDI is a monthly payer with a 15% yield...

The distribution is the main reason to own the Dynamic Income Fund. PDI pays a monthly distribution of $0.22 which calculates to a forward dividend yield of 15%.

What investors shouldn’t buy the PDI, risks

The Dynamic Income Fund is chiefly a vehicle that will appeal to dividend investors, especially because the PDI pays its distribution monthly. The fund is also concentrated in income-producing fixed income securities, not equity securities, and the fund does have considerable NAV risks in case the Federal Reserve will keep its interest rates higher for a longer period of time.

Final thoughts

The fixed income focus is what makes the Dynamic Income Fund attractive for dividend investors, especially because the Federal Reserve appears to be done with raising interest rates... which should boost the values of mortgages and other fixed income assets. With inflation cooling, the Federal Reserve appears to be just on the brink of ending its tightening policy.

Since fixed income values increase during periods of falling interest rates, the Federal Reserve may create net asset value tailwinds for the Dynamic Income Fund in 2024 and even beyond. I like that the Dynamic Income Fund has been around for a while and proven itself over a number of years, including those that included high interest rates, resulting in 10% annual average NAV returns!

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