PDO - PDO: Come For The Distribution Stay For The Capital Losses

2023-10-19 14:51:19 ET

Summary

• PDO fund entered the market at a bad time and is now in a tattered state.
• We examine the current setup from the perspective of pricing, leverage and the macro environment.
• The fund is diverging from other PIMCO funds like PTY and PFL and this has important implications for your investment.

On our last coverage of PIMCO Dynamic Income Opportunities Fund ( PDO ) we offered little hope for sustainable returns. We liked the fund for a bounce, but the longer term setup looked really bad. Hence our title " Trade The Trounce, But Fade The Bounce ". Those that took our advice and navigated this landmine with the nimbleness of a ninja, made a quick buck. The longer term story followed our script and the fund is now in tatters.

We look at the current setup and update our thesis.

The Fund

PDO came into the market during the "peak stupidity" era. The inception date was in January 2021. That might seem a harsh term for the market, but the proof is right there in the chart below showing investment grade corporate bond yields.

The chart runs over about a decade and you can see the insanely low yields investors were ready to bid for long dated bonds on the right hand side of that chart. So the price chart for PDO that followed should have not exactly been a surprise.

PDO had of course coupled the worst time to enter the market alongside that sword which cuts both ways. Leverage.

Current Setup

Waiting for the official recession might seem like waiting for Godot. But that patience is ultimately rewarded here, unlike in the story. But junk bond investors need to know here is that there are no good outcomes that come out of this. There are bad and severely bad outcomes. When bank loan standards tighten and tighten this rapidly, GDP ultimately freezes.

Yes, timelines can vary and the COVID-19 stimulus and accumulated savings from then are distorting the picture. But the end result is in the extremely high probability zone. We will have wider junk bond spreads.

Sure, that creative license red arrow may not actually represent how far they blow out and yes, that chart is older and some tightening has happened. But we are not close to being done and junk bonds will be a hard place to work things out.

Now, here are the two bigger issues. PDO carries junk that goes well, deep into junk.

If you had coined something as the opposite of SWAN (Sleep Well At Night), this profile above would be it. So the pain here is likely to be above average.

The second issue is that PDO is still splurging on its credit card. What we mean by that is the leverage is really high.

As we have stated before, CEF Connect presents the leverage as a debt to assets metric. So the 47.71% comes from dividing $1,195.97 million by $2,508.881 million. There is nothing wrong with the math but we believe and want to reiterate that this always understates the dangers to common investor's mind. A more appropriate measure is showing debt to equity or debt to common assets. That figure works out to 91%. We think this is the true representation of the leverage as the fund will move with a delta of 1.91X to any changes in market conditions for underlying assets. What is truly remarkable here is that other PIMCO funds have suddenly realized that they are going to be taken to the slaughterhouse if they insist in dialing up the risk right into a recession. Take PIMCO Corporate and Income Opportunity Fund ( PTY ) for example. They were running leverage which was at 48% (by CEF Connect calculations) and they are now down to 25.24%.

PIMCO Income Strategy Fund ( PFL ) is also reducing leverage in a similar manner.

So the divergence is interesting. If credit markets bounce, PDO managers will look like geniuses. If they don't then well, they will be selling a lot more on the way down to stay within the 50% mark. While PTY and PFL might have sold low, PDO will sell assets at an even lower mark in our opinion.

Verdict

The one thing that PDO shareholders have going for them is that the pricing is good. The 6% discount to NAV, while not the most extreme level, is certainly better than bidding it up to a 10% premium.

The Z-scores show that this is a bit undervalued relative to its history.

The pure premium/discount comparison also shows that it might be a better value relative to PTY.

It is hard though to get excited about a fund wading deep into junk territory with close to maximum allowed leverage. A 6% discount is not exactly a floor either. We can easily see 20% occur in a credit event and then you add the losses from credit spread blowouts, magnified by leverage, and you are likely to be left wondering how exactly what was the appeal of that double digit distribution yield. Since inception you are down 45.18% on price and 23.09% including distributions (assuming you paid no tax on them).

Those distributions also look like they are in jeopardy.

We think this cycle has not fully played out and PDO's relatively higher leverage makes it risky compared to other funds like PFL and our favorite , Barings Corporate Investors ( MCI ). We would stay out until we see the credit spread blowout in combination with leverage reduction.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.

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