PDI - PIMCO Dynamic Income Fund: Its Moment Has Come

Summary

• PIMCO's dynamic income fund outperformed stocks in 2022, with a mere -15.55% price decline.
• It has a 13.88% yield today.
• Bonds tend to perform well after periods of rising interest rates, provided that most of the interest rate hiking is done.
• It will only take one or two more rate hikes for the Fed to hit its terminal rate goal.
• For this reason, I think PDI will become a great buy in the second quarter, maybe as soon as March.

Last year was a comparatively good one for bonds, which out-performed stocks. Although bond funds declined for the year, they pulled ahead of the S&P 500 by about 5% .

Late last year, I wrote an article about the Vanguard Total Bond Market ETF ( BND ), in which I said that the fund would be a good buy in 2023. Since I wrote the article, the fund has delivered a positive return, which I didn't expect-I still maintain that the best buy point will be in the second quarter of 2023.

This year, I've had my eye on fixed incomes much more than I usually would. I recently added a 5% yielding term deposit to my portfolio, and I may add some bond funds in the second quarter.

One bond fund that I've been interested in lately is the PIMCO Dynamic Income Fund ( PDI ). It's a highly diversified bond fund that, thanks to its recent selloff, has acquired a 13.88% yield . PDI has always been a high yielder-the historical norm is about 10%--but today it has a higher yield than ever before.

When I wrote about BND last year, I concluded that it was a better buy than PDI, because PDI was too risky. Today, I feel a little differently. PDI is still much riskier than BND, but now it has a truly mouth-watering yield. As such, investors are being much better compensated for the risk they assume by buying the fund. In this article I outline a mildly bullish case for PDI, based on its increasingly high yield, while counselling that the best buying may be in a few months' time rather than today.

Pimco Dynamic Income Fund - Characteristics

Pimco's Dynamic Income Fund is a highly diversified fixed income fund that holds:

• U.S. government bonds, the exposure to which appears to be net-short (explanation below).

• High yield corporate debt.

• Investment grade corporate debt.

• Mortgage backed securities.

• Foreign bonds.

• Municipal bonds.

A quick note on the "net short" exposure to U.S. government debt. I inferred this from the fact that the fund says its exposure to such debt is -2.58%. When I looked at the footnotes to that claim, it said that exposure to assets may be via interest rate swaps. I take this to mean that PDI has entered into interest rate swaps in which it pays the return on government bonds in exchange for the return on higher yielding debt. Below you'll see a number of fixed-for-floating swaps that PDI is invested in. PDI pays the fixed rate on these swaps so it does appear to be "short" U.S. treasuries in this sense.

Consistent with its high yield, some of PDI's holdings are quite risky. Take for example the Envision Healthcare bonds. Those yield 14.7%, mainly because the bonds were such a large burden to the company last year. In 2020, Seeing Alpha's news team reported that Envision had to restructure its debt in order to stay afloat. Today, much of its debt is still outstanding-hence its presence in PDI's portfolio. Being wholly owned by KKR & Co ( KKR ), Envision may be able to get a transfer of funds from its parent to keep it a going concern, but should KKR choose to sell the company, then its bonds will exist in a state of limbo. Moody's ( MCO ) most recent rating on Envision's debt was C , indicating sub-investment grade status.

Apart from the holdings, some other facts about PDI worth knowing are:

• It has a 1.1% management fee. This would be very high for an equity index fund but is not that high for an actively managed bond fund.

• It has a 2.64% total expense ratio. This is extremely high for any fund that's not a hedge fund, which is a factor that investors will want to take seriously.

PDI's management says that the expense ratio on PDI is so high because the fund incurs a lot of costs to execute its investment strategies. This makes sense; if you look at the swaps above, for example, there are certain fees to enter into these contracts. However, from the buyer's perspective, a cost is a cost, so that's something you'll want to look at before buying PDI.

Is PDI Worth the High Expense Ratio?

Having looked at PDI's holdings and fees, it's time to ask, "is this fund worth investing in?"

As mentioned in the section on holdings, some of PDI's bonds are mighty risky.

However, they also compensate investors in the form of high yields, so the matter is more complicated than it appears.

Leaving aside the matter of risk, PIMCO's expenses are high enough that they could take a bite out of your investment. Below is how $100 worth of NAV grows over time if the assets see 0% price appreciation and have 2.64% fees taken out.

As you can see, the NAV shrinks quite a bit over time. It does not shrink as much as you might think, the reason being fees have a kind of reverse compounding effect when the base amount stagnates or shrinks. If there's no growth, then an X% fee will be lower and lower each year, with no capital appreciation. Had NAV remained at $100 each year, then the amount lost to fees would have been $13.20, instead of the $12.55 that was actually lost. Still, you lose a lot of money to fees each year with a 2.64% expense ratio, whether the fund's holdings go up, down or sideways.

The good news is that PDI is now paying a 13.88% dividend yield. That more than makes up for all the NAV shrinking that occurs in the table above. However, the fees do appear to eat up the NAV enough over five years to meaningfully eat into total returns, so you'll want to be seeing some of PDI's holdings make capital gains.

Will they actually do so?

With many of PDI's bonds being junk bonds, you'd have to expect that at least some of them will default. However, others could rise in value.

Bonds in general tend to rise in value when interest rates fall. The reason has to do with how bond prices are calculated. If a bond costs $1,000 and has a 10% yield, it pays $100 each year. If the treasury yield is 5%, the first $100 payment is worth about $95. But if the treasury yield falls to 2%, the value of the first $100 payment is about $98. The payments go lower and lower the more the treasury compounds over time, as explained by the formula:

Cash flow divided by [(1 + discount rate)^number of compounding periods].

We calculate the value of bonds this way to account for opportunity cost. The lower the yield on other bonds, the higher the value of the bond in question.

This would imply that, if the Fed is near the end of its hiking cycle, then PIMCO's holdings could start realizing capital gains soon. The "opportunity cost" for a bond investment is the treasury yield plus some risk premium. The Fed's terminal rate goal is 5.1% . The current Fed policy rate range is 4.25% to 4.5% . This implies that after two more 50 basis point hikes, the Fed will hit its terminal target range.

Will the Fed decide to cut rates after that? So far, it has not signalled that it will do so, but in a recent memo, Howard Marks wrote that he expected long term rates to fall somewhere between 2% and 4% , and to NOT fall to 0% any time in the near future. Marks said in that memo that he was not a forecaster and that his own prediction should not be taken as a certainty, but this is a man who has compounded at 19% over many decades: his opinion carries some weight. If his forecast comes to fruition, then rates should fall after hitting the terminal rate of 5.1%. That would produce a capital gain for investors buying PDI after all the rate hiking is done, as 4% is significantly lower than 5%, and PDI's high yield investments will start to look appealing after rates fall.

Conclusion - PIMCO's Dynamic Income Fund is Buyable in the Second Quarter

Having looked at all of the relevant factors-holdings, fees and macro conditions-it appears that PIMCO's dynamic income fund will be a good buy in the second quarter. The Fed has repeatedly signalled that it wants to hit about a 5% policy rate. If it keeps hiking at 50 basis points per meeting, that level will be hit in two more meetings. Two more rate hikes means some short term downside is possible for PDI. However, after 5% is achieved, rates should plateau. The Fed has not signalled it will go significantly higher than 5%. In the longer term, there are indications that rates could eventually go to 2% to 4%. If that happens, then those who bought PDI when rates were 5% will be sitting pretty.

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