PDI - PDI: What Investors Should Know About Its Sensitivity To Interest Rates

Summary

• PIMCO Dynamic Income Fund remains one of the most popular funds across the entire CEF space owing to its high yield and strong historic returns.
• One of the key performance factors for the closed-end fund since the start of last year has been its sensitivity to interest rates.
• In this article, we look at the PDI fund's supposed large bucket of short-dated assets and whether it allows the fund to mitigate its interest rate profile.
• Our takeaway is that this short-dated asset bucket doesn't appear to exist, but even if it did, it wouldn't tell investors much of anything.
• Investors should instead look to the fund's duration, yield curve, and credit risk profile to understand how it may respond to various rate scenarios.

This article was first released to Systematic Income subscribers and free trials on Jan. 12 .

PIMCO taxable closed-end funds ("CEFs") remain popular income options both because of their high yields as well as because of their strong historic returns, 2022 notwithstanding

In this article we take a deep dive into the PIMCO Dynamic Income Fund (PDI) - the largest and best-known of the PIMCO CEFs. Specifically, we take a look at the fund's interest rate profile and the key metrics for investors who want to understand how interest rates drive the fund's performance in the current environment. A discussion of the relevant drivers should hopefully provide useful carryover into other PIMCO funds as well as the broader CEF space.

If last year has shown us anything, it's that changes in interest rates can be the overwhelming driver of performance. This is especially the case for leveraged credit CEFs that not only hold rate-sensitive assets, but also use rate-sensitive leverage instruments and derivatives such as interest rate swaps to manage interest rate exposure. In short, to understand the performance of such funds, investors need to come to grips with the different ways the funds are impacted by changes in interest rates across their various instruments.

The Mysterious Case Of Short-Dated Assets

A factoid that gets a lot of play in the commentariat is that PDI has 35% of its assets maturing in less than a year. And this is very good, because it's key to reducing the impact of the rising Fed policy rate. In addition, it can also allow the fund to take advantage of higher yields by recycling short-term assets into longer-term assets.

First, let's take a look at what these assets are. The fund's website indeed shows a figure of 35% for assets maturing in 0-1 years.

However, it may be surprising to learn that this number is not corroborated by the fund's actual holdings. And no analyst who points to this 35% number can actually point to specific assets that add up to 35%.

An actual look at the fund's holdings shows that there are actually $620m of assets maturing in less than a year (we counted those maturing both in 2022 and 2023 - the holdings report was as of Nov-22) versus total assets of $7.6bn which is 8% (14% on NAV).

Why does the website say 35% but the actual itemized report shows 8%? It's not clear. It's possible that the website shows lagged information. Alternatively, what often happens is that PIMCO roll up all of the fund's positions into its reporting - stuff like repo, swaps, FX forwards etc. most of which is very short-dated (nearly all repo and all FX trades are sub-1Y).

However, if we just count repo against total assets, the number comes out to be 45% plus the 8% of real positions or about 53% which is much larger than the listed 35% so there is something else going on. Possibly, because repo have a negative sign in the reporting, adding -45% to +8% gets us close to 35% if you flip the sign.

In short, the 35% number is simply not in the holdings report. And its proponents have not actually bothered to highlight which assets go into this bucket. It could very well be wrong - this wouldn't be the first time PIMCO had an issue in their reporting. In one of our recent PIMCO monthlies we showed how some of the CEF interest rate swap positions had the opposite direction in the shareholder reports relative to their holdings spreadsheets.

Fortunately, we don't have to know whether the 35% short-term assets number is correct or not because even if it were correct it wouldn't give us much insight into the fund's behavior as we discuss in the sections below.

Do Short-Dated Assets Limit The Impact of Fed Rate Rises On The Fund?

In this section we go with the flow and assume that the 35% number is true. Here, we investigate the first of two common comments which is that such a large number of short-dated assets significantly limit the impact of Fed rate rises.

Before getting into the details, an inkling that the fund's sensitivity to interest rates wasn't particularly low even with such an apparently large amount of short-dated assets is the simple fact that its NAV fell by 28% over 2022 (the fund's high distribution coverage suggests it wasn't overdistributing very much which, otherwise, could have exacerbated the drop in the NAV). This is at the worse end of credit CEFs over 2022 so it's not at all clear that investors should take any comfort that such a large amount of short-dated assets is helping the fund mitigate the impact of rising interest rates.

More substantively, the 35% number of presumably short-dated assets does sound very good but it doesn't actually mean anything and the reason it doesn't mean anything is because there is the matter of the rest of the fund.

For example, there is no reason why PIMCO couldn't run a barbell allocation - putting a lot of capital into very long duration assets at the same time it put a lot of capital into short-dated assets. The 35% number sounds impressive, assuming everything else is equal but that's purely an assumption.

To get a sense of the fund's actual sensitivity to interest rates, looking at its short-dated position is beside the point. Rather, we need to look at its overall position. And that overall position is nicely summarized by duration. Now, those paying attention to PIMCO funds will have noticed that the durations have increased from about 3 to about 4 over the past year - an increase of 25%.

This means that analysts who are guiding investors about interest rate sensitivity of PIMCO taxable CEFs should be talking about an increased sensitivity to interest rates rather than talking about what's in the short-dated bucket, particularly as that large short-dated bucket looks to be imaginary. A duration of 4 puts the fund in the neighborhood of a typical high-yield corporate bond CEF although the NAV performance of PDI was significantly worse - a 28% NAV drop versus 22% for the average HY CEF.

As a sidenote, some readers may reflexively say that we should look at total NAV returns (i.e., including distributions) rather than the change in the NAV over 2022, however, for the purpose of gauging the sensitivity to interest rates we really do need to look to the NAV (assuming distributions were roughly in line with income).

The key takeaway here is that, whatever the merit of the 35% short-dated asset bucket, it tells us nothing about how the fund will perform in various rate scenarios.

Do Short-Dated Assets Help Drive The Fund's Yield Higher?

Now let's turn to the second component of the common view - that the large amount of short-dated assets can be used to increase the fund's yield profile.

It's very tempting to say that the great benefit of having a large number of assets maturing soon is that these assets, which were acquired when yields were lower, can now be put to work at much higher yields and this dynamic can significantly boost the yield profile of the fund.

As tempting as this is to say it would be wrong. This is because the assets held by the fund are already trading at today's high yields. That's why the fund's NAV has dropped as much as it had in 2022 - it's a reflection of the fact that assets that traded at low yields in 2021 are now at much higher yields in the fund's portfolio.

Assets maturing at high yields that are put to work at similarly high yields don't change the fund's overall yield profile. In fact, because the yield curve is inverted, moving short-maturity assets into longer-maturity assets will likely lower the fund's overall yield rather than raise it.

Now, it is true that a fund's income profile can rise if the assets acquired at lower yields and coupons are reinvested at higher yields and coupons (keep in mind we are going with the dubious assumption that the fund does indeed have a large short-dated asset bucket). This is because short-dated assets that were acquired at coupons of 2-3% can now be rotated into assets with yields at least twice that.

However, income is not the same as yield. In other words, an increase in income does not, in fact, lead to a larger amount of wealth generation if there is no corresponding increase in yield. A 5%-coupon bond which matures and is rotated into a new 8%-coupon bond trading at the same yield does not increase the fund's overall yield. Of course it's possible for the fund to acquire assets at higher yields but that would require it to increase its risk profile as well - something it can do at any moment without having to wait for any assets to mature.

Crying Fire In A Burnt-Down Theater

Let's come back to the original claim that having a lot of short-dated assets is good because it reduces the impact of higher Fed rates. This is the kind of comment that sounds sensible but we are not told why this is something we need to worry about. After all, if interest rates moved mechanically with the Fed, someone needs to explain why Treasury yields are around 1% lower from their October peak while the Fed has continued to hike without interruption and will continue to do so for the next few months at the very least.

It's a perfectly valid statement to say we should worry about higher interest rates when the Fed policy rate is zero and when longer-term Treasury yields are sub-2% but less so when everyone expects the Fed to move past 5% in short order and that path is fully priced into assets. In other words, interest rates do not move with the Fed - they move if the market's expectation of what the Fed does changes. And that change in expectations is, in turn, what moves broader asset prices.

A more sensible thing to say might be - well, inflation could prove stickier than expected and the Fed could keep pushing past today's consensus level of the terminal Funds rate. And because the yield curve is inverted you can actually earn a higher yield in shorter-dated assets while avoiding the tail risk of higher rates. That's a reasonable claim but it needs to be defended. It also needs to recognize the potential risk which is that rates actually move lower because inflation moves lower quicker than people expect or because we enter a recession. That's the kind of dynamic that has actually been playing out in the last few weeks as inflation indicators and levels of economic activity continue to fall.

The Real Sources Of Rate Sensitivity

While the concept of duration is much more helpful than the amount of short-dated assets in a given fund, even this concept is incomplete.

This is because duration by itself is not sufficient to tell us what the fund's NAV is going to do when interest rates move. Duration only addresses the change in asset prices due to changes in rates. It is not designed to tell us what credit spreads are going to do in case rates move higher.

Let's illustrate this - PDI ran a lot of 2022 with a duration of around 3-3.5x. Treasury yields rose by 2-4% depending on which tenor you look at. This rise in yields would translate to a drop of around 6-13% in the fund's NAV versus 28% which was its actual drop. Clearly, looking at risk-free rates is not going to do a good job of getting a good gauge of the fund's actual rate sensitivity.

This is because there are (at least) 4 missing links - credit spreads, yield curve, (changing) leverage and idiosyncratic factors. PDI doesn't primarily hold Treasuries so we need to look at what risky yields have done and risky yields have risen more than Treasury yields i.e. credit spreads have risen since the start of 2022. HY corporate bond yields rose by around 4.5% while HY bond credit spreads rose by around 2%. This also doesn't get us anywhere near a 28% drop but it does get us closer.

The second missing link in interest rate sensitivity is the yield curve - PIMCO CEFs tend to hold yield curve steepeners and the yield curve flattened hugely this year which likely resulted in losses for its CEFs, including PDI.

Third, PDI has tended to boast one of the highest leverage levels in the entire CEF market. This means that, even if it runs at a lower sensitivity to interest rates on the portfolio basis, on a NAV basis its sensitivity to rates can be very high simply due to its high leverage. This also explains why the fund has underperformed the average HY bond CEF in 2022 excluding dividends (it performed almost exactly as the average HY bond CEF with distributions included) even though it holds a lot of floating-rate assets, which proved to be more resilient than corporate bonds in 2022. Its higher leverage has more than fully offset its larger amount of floating-rate holdings.

Lastly, the PDI fund has had bad luck with a number of positions. The obvious ones are Russian and Ukrainian bonds. For instance, there were two Ukraine bonds the fund has held for all of 2022. At the start of 2022 the total value was close to $21m. The value as of November-22 for the same bonds was $4.3m. A small part of this drop was due to the fall in the EURUSD rate and this was likely hedged out by the fund but the bulk of that move is for the obvious reasons of what's happening in Ukraine right now. Country Garden Holdings - a Chinese property developer is another position that had an absolute bath over 2022, starting the year marked not far from par, now marked around 30% in the portfolio. These are just three of a number of positions that have moved lower and are unlikely to fully come back even if interest rates move lower.

This highlights that idiosyncratic losses, which are more likely in a difficult market environment, could push the NAV below what we expect if we rely strictly on markers of interest rate sensitivity. Net net, PIMCO have done a good job managing their CEFs through market cycles, so this is not something we should lose much sleep over, but the risk is there.

Takeaways

The key takeaways of this article is that to understand how a given fund may respond to changes in interest rates investors should ignore things that either appear false (i.e., the 35% short-dated bucket which no proponent is apparently able to itemize) or unimportant even if they were true (i.e., even if PDI did have 35% of its assets in very short-dated assets, it wouldn't give investors a good idea of how it would respond to changes in rates).

Rather than focusing on this red herring, investors should instead look at a number of other more relevant metrics such as duration, yield curve profile, leverage and credit risk profile. Although there are more factors to understand, in aggregate they will leave investors with a much better understanding of how a given fund could behave in various rate outcomes. No one said CEF investing was easy.

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