CA - PIMCO Dynamic Income Fund: I'd Wait A Few Months

2023-03-13 23:38:36 ET

Summary

• The last time I wrote about the PIMCO Dynamic Income Fund, I gave it pretty bullish coverage.
• As a bond fund, PDI can really gain from interest rate hikes, provided you buy after the hiking is done.
• Last week Jerome Powell indicated that he was prepared to take interest rates even higher than previously thought.
• We may see interest rate hikes lasting until the Summer, unless the recent bank runs cause the Fed to pivot.
• For this reason, I'd hold off on investing in PDI for at least another few months.

It’s been almost two months since I last covered the PIMCO Dynamic Income Fund ( PDI ). In my last article on the topic, I rated the fund a buy, owing to rising interest rates. I did counsel investors that it might be best to wait a few months before buying, because these high yield funds tend to perform best after a period of rate hiking is over. At any rate, the fund delivered 0.75% total return since I wrote about it, outperforming the market.

Initially, I didn’t plan on doing any follow-up coverage on PDI. I thought that the fund had some potential in the long run but might struggle in the near term due to the high likelihood of further rate hikes. The fund’s holdings tend to decline in value when the risk free rate of return rises, as such developments cause the opportunity cost of bonds to increase. I was a little surprised by the strong performance PDI delivered despite rate hiking having occurred in the period between my article publishing and today. I was expecting the fund to do well, but I thought the best buying opportunities would be in the second quarter.

Which brings us to today. The second quarter is right around the corner and the Fed looks like it still has more rate hikes up its sleeve. Potentially, the hiking could last through the Summer and culminate in a 5.75% fed funds rate ! Not everybody agrees with this – Goldman Sachs recently said that it expected no further hikes at the March Meeting owing to the recent bank collapses. However, such comments by analysts tend to be speculative–Powell’s most recent comments indicated more hikes to come.

If the prices of the bonds in PDI’s portfolio come down because of the rate hikes, then the best entry points for the fund will be in the future. For this reason, I’d encourage anybody considering PDI to delay purchasing it for a few more months, as there is a chance that interest rates will rise higher than where they are now. The fund is not facing disaster, though, so I think that current holders are safe if they continue holding it.

PDI - What It Owns

A good first step in analyzing a fund like PDI is looking at what it owns. This is a high yield fund, after all, with a staggering 13.57% yield . It pays to look at where that yield is coming from, because it’s extremely high and therefore a product of high perceived risk.

Unfortunately, PDI has 1826 holdings, making it difficult to analyze each bond in the fund one by one. We can, however, look at the allocation in different types of bonds.

According to the holding list that Seeking Alpha Quant has on file , most of PDI’s biggest holdings are corporate bonds. This is what you’d expect to see, because you’re certainly not getting anywhere near a 13.5% yield with U.S. treasuries. There are some foreign treasuries with ultra high yields (Argentina’s 10 year bond is all the way up at 49% ) but currency fluctuations could change the USD denominated returns of those bonds.

The table below shows characteristics of the top three holdings in PDI (per the company’s latest holding sheet).

As you can see, some of PDI’s bonds are quite risky. The Wesco Aircraft bond’s yield implies much higher credit risk than is average for the bond market. Moody’s last rated the company Ba2 , which is sub-investment grade on its rating scale. On the other hand, the CIBC and Barclays bonds have credit ratings within the investable category, so not every single holding within PDI is extremely risky. A lot of the holdings are, though, which is part of why PDI is able to offer such a high yield.

It’s debatable whether such risk is a good thing. In a recent memo , Howard Marks noted that, in this tighter monetary environment, investors were being better compensated for risk (with compensation measured in terms of yield not past performance) than in the past. That the world’s most respected bond investor is saying this is definitely a good sign, but it’s important to remember that such points about an asset class don’t always apply to all the individual assets within it. PDI’s fund managers could easily blow it with bad picks.

Given the massive diversification in PDI, how can we evaluate the fund’s holdings within the constraints of an article?

One approach would be to look at the holdings by term to maturity. According to PIMCO’s website, PDI has 29% of its money in assets with under a year to maturity, which indicates less than average exposure to interest rate risk. As a bond gets closer and closer to maturity, it trades closer and closer to its principal amount, regardless of what direction monetary policy heads in.

This would appear to be a positive thing for PDI’s portfolio holdings, but it’s important to note that some analysts have questioned whether the holdings are really as short dated as PIMCO is claiming. For example, one author calculated that only 8% of PDI’s assets were maturing within a year, compared to the 35% PIMCO claimed at the time. When I looked at the fund’s holdings sheet myself, I did notice that the majority of the maturity dates were far more than a year into the future. However, many of the heaviest weighted assets had shorter terms to maturity; for example the Wesco bond mentioned earlier has the heaviest weighting of all the bonds in the fund and it matures in 2026–three years from now. That’s not an extremely long term bond but it’s not under a year. After looking at PDI’s holding sheet I’m inclined to agree with the writer who said that PDI’s actual holdings don’t quite line up with the percentage of 0-1 year maturities PIMCO was claiming.

Another approach we can take is to look at the fund’s holdings by asset class. PDI doesn’t just hold corporate and government bonds, it also holds mortgage backed securities and swaps; this information can give us some information about how risky the fund is.

As you can see, the biggest asset classes by far are mortgage backed securities and high yield credit. The risks in these categories are increasing, but are not historically high. Mortgages in general saw default rates rise in the fourth quarter, to 3.96%. That was up from Q3, but down from the same quarter a year before. Q3 had an extremely low default rate, according to Mortgage Bankers Association . So, defaults increased, but from a very low base. I would characterize residential mortgages as being not particularly risky but trending riskier, due to rising rates on variable rate mortgages. Of course, this extra risk is being compensated for by higher yields on new mortgages.

The corporate credit picture is similar. A Deutsche Bank study covering U.S. bond markets showed CCC rated debt defaults at a 40-year low and BB/Bs near-zero. This bodes well for PDI’s holdings on average because it goes against the commonly repeated notion that the environment we are in right now is a particularly risky one. However, in this case the data simply generalizes about 2022 as a whole year; it’s possible that there was an uptick in defaults on CCC rated debt in the fourth quarter compared to earlier in the year, the DB research doesn’t say.

A Word on Costs

One definite negative about PDI is the fee structure. The fund has a 1.10% management fee, and a 2.64% total expense ratio. This is far above average for ETFs and even mutual funds. The reason why the total expense ratio is so much higher than the management fee is because some of PDI’s strategies are costly to execute. For example, when you enter into interest rate swaps, you both pay and receive interest. In some cases, you may end up paying more interest than you receive over the life of the contract. These fees tend to add up over time, resulting in rather high expenses for PDI fund holders.

The Bottom Line

The bottom line about PDI is that it is a rather pricey fund that gives investors exposure to high yield debt. High yield debt is a complex world where risk and return potential have to be carefully analysed, and where key information sometimes isn’t as readily available as it is for stocks. It pays to invest in such assets in the form of a fund managed by experienced professionals, and PIMCO’s team are certainly experienced. The assets that PDI owns are worth considering right now; it’s just unfortunate that the fund’s fees are so high.

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