PDI - PIMCO's 14.2% Yield PDI To Gain From Rate Cuts (Upgrade)

2024-01-16 18:22:10 ET

Summary

• PIMCO's Dynamic Income Fund is a comparatively good value amid today's downward-trending inflation rate, inflated stock prices, and rapidly growing U.S. economy.
• PDI has high yield and diversification, but comes with higher-than-average default risk and is highly leveraged, making it riskier than average bond funds.
• PDI has a positive lifetime total return despite a negative price return since inception, as its $37.42 in lifetime dividends easily outweighs the $6.31 lifetime capital loss.
• Fed chair Jerome Powell recently said that 75 basis points worth of rate cuts were coming in 2024. If that forecast comes true then PDI will likely experience a capital gain.
• In this article I make the case that PDI is a good income buy today.

When I last covered PIMCO’s Dynamic Income Fund ( PDI ), in May 2023 , I rated the fund a hold on the grounds that it would be a be tter buy in the future after more rate hikes had taken place. The fund initially dipped in value after I wrote the article, then started rising again when treasuries rallied late this year, consistent with what I expected.

Today, the economic situation is much more favorable to PDI than it was when I last wrote about it. Additionally, as a fund that holds mostly long term bonds (it has a 5.78 year average term to maturity), it is uniquely sensitive to interest rate swings, much more so than short term bond funds such as money market funds.

Firstly, the inflation rate is trending downward, which suggests that interest rates will come down in the future.

Second, stock prices have been rising for a year, which makes yield hard to find in equities.

Third, the economy is healthy, with high growth and low unemployment, which makes defaults less likely than they would otherwise be.

These three factors combined make a strong case for investing in a high yield bond fund like PDI. Today’s high yield, low inflation environment points to the possibility of positive real returns from bonds, while high stock prices make debt attractive compared to equity.

However, a fund like PDI is never risk free. High yield bonds typically carry higher default risk than government bonds, and all bonds are exposed to interest rate risk . So, investors have to be careful when investing in PDI. Not only is the fund exposed to the usual risks (interest rate, default) that all bonds are, it’s also highly leveraged ( 40.4% effective leverage ), which means that it is riskier than the average bond fund.

Nevertheless, there are enough macroeconomic factors going in its favor right now to make PDI worth the investment. Additionally, the fund’s yield is so high that it can deliver a high total return even if the price declines over a prolonged period of time. For this reason, I consider Pimco’s Dynamic Income Fund a buy today.

PDI Fund Characteristics

Before looking at its holdings, we need to explore PDI’s basic characteristics. These are crucial for investors looking to make an informed decision in the fund. According to its fact sheet, PDI has the following characteristics :

• A 14.2% yield.

• $17 in net asset value (meaning at today’s price of $18.69 the fund trades at a 9.9% premium to NAV).

• 3 month trading volume of 1.5 million.

• A 15.5% yield on NAV.

• A 14.2% yield on shares (this is the yield that shareholders actually earn).

• $7.9 billion in total assets.

• $4.3 billion in net assets.

• A 5.8 year average term to maturity.

• 281.5 million units outstanding.

• A 1.1% management fee.

• A 5.8% MER.

• A monthly payout schedule.

Overall, this fund has the characteristics you’d expect of a popular actively managed income fund, which is to say that it has a very high yield and lots of diversification, but a high management fee. A word on PDI’s expenses is in order here: although PDI’s 1.1% management fee is only moderately high, the total expense ratio is far higher, at 5.8%. The reason for the high total expense ratio is the fact that the fund uses costly strategies. For example, it invests in credit default swaps and interest rate swaps, derivative contracts that you must pay regular sums of money to enter into. The fees stemming from such instruments do take a bite out of total returns, but the fund’s distribution is quoted on an after-fee basis, so the investor holding PDI in a tax sheltered account does in fact collect a 14.2% yield at the end of 12 months.

A word on PDI's net asset value ("NAV"): the fund currently trades at a slight premium to NAV, which is not a positive in itself. However, with a 14.2% yield, the fund is primarily an income play rather than a capital gain play: as I'll show in the next section, this fund could easily deliver high total returns even if the price declines to meet the current NAV. Also, if the Fed cuts this year as Jerome Powell hinted at the last meeting, many holdings in the fund will experience capital gains, as bonds typically rise in price when rates decline.

Total Returns - Past and Future

If you look at PDI’s chart, you might be a little alarmed to see that the fund has delivered a negative price return since inception. The fund went public at $25 and trades for $18.69 today. So, the price return has been -25%. However, the fund has paid so many dividends since inception that it actually has a positive lifetime total return. Below, you can see a sampling of PDI’s 12 year dividends paid, courtesy of Seeking Alpha Quant:

For the full list of dividends, see the PDI dividend history page on Seeking Alpha.

As you can see, the “adjusted amount” column sums to $37.42. So, we have $37.42 in income and a $6.31 capital loss, for a $31.11 total return. With a starting amount of $25, that gives us a 124% total return over 12 years.

PDI's high returns from dividends are likely to persist into the future. Despite the high yield, the fund has a BBB (not high but investment grade) rating going by the combined ratings of all rating agencies covering the fund. In fact, AAA rated bonds are the third largest asset category included in the fund. Finally, going by sector, the fund is disproportionately concentrated in airline bonds and mortgage backed securities. Airline profits are steadily rising while the U.S. economy is growing at 5.2% with only 4.7% unemployment, which should keep mortgage defaults within reason.

Fund Holdings

It would be impossible to do a complete review of all of PDI’s holdings, since the fund has thousands of different bonds in it. Nevertheless, it is possible to describe the fund’s holdings by category, and give a few examples of each one. Seeking Alpha has conveniently divided PDI’s holdings into seven categories , which gives us a way to describe what the fund owns. You can see those categories, along with descriptions and examples of each one, in the table below:

These holdings mostly appear sensible. As mentioned in the previous section, the U.S. economy has a 5.2% growth rate and 3.7% unemployment. It also has 3.4% inflation , which is above target but below the 2022 inflation rate. These positive macro variables argue for low defaults on PDI's mortgage backed securities. Airlines are growing profits rapidly and COVID lockdowns are far behind us, so the airline bonds should pay off. The fund's U.S. government bonds all have high ratings and are backed by taxing power, so they should deliver good returns if held to maturity. The municipal bond category has some risky assets in it: for example Argentine bonds denominated in Pesos. Argentina's 200% inflation rate makes these risky. The other asset categories like derivatives and 'other' are largely hedges, which help reduce the risk in the aforementioned government, airline and MBS bonds.

Valuation

As a bond fund, PDI can’t be valued using multiples and other techniques used to value stocks. However, we can value it using a “discounted dividend valuation,” which is like a discounted cash flow valuation only without an assumption of growth, and with dividends in place of free cash flow. I didn't use this model in valuing PDI in the past, but today it makes sense to include it, as it expands on my previous analyses which focused on the fund's portfolio characteristics, adding a clear fair value estimate. DDM is a good valuation technique for a bond fund, as such funds typically pay fixed coupons, so they are valued based on the income actually earned by holders, not hypothetical income as represented by free cash flow.

We can start with the distributions. PDI pays a distribution of $0.2205 each month, which works out to $2.645 per year. At Friday’s closing price of $18.69, that gives us a yield of 14.2%, as I mentioned previously.

More important than PDI’s yield is the discounted value of its dividends. Normally we would take the $2.645 in distributions per share and discount it at an appropriate benchmark like the 10 year treasury, which currently yields about 4%. However, many of PDI’s holdings (e.g. distressed debt) are quite risky, so we need to include a large risk premium. With a 6% risk premium, PDI’s $2.645 in per unit distributions produce a fair value estimate of $26.45. This would seem to imply that PDI has 41.5% upside, although the fund’s high risk and leverage argue for the possibility of capital losses. Using a very high risk premium of 10%, for a 14% discount rate, gives a fair value estimate of $18.89, which is about what PDI trades at today. Taking the average of both estimates gives a $22.67 fair value estimate and 22% upside. These are my official estimates of PDI's fair value and upside; given today's unit price of $18.49, I therefore consider PDI a buy.

Risks and Challenges

As we’ve seen, Pimco’s Dynamic Income fund is a very high yield CEF that could easily be worth the investment even if the price goes nowhere, or declines slightly. On the whole, it looks like a great asset to consider investing in–it should do reasonably well if rates stay where they are now, and it will positively rally if rates actually fall. Nevertheless, this is a riskier than average fund, one that exposes investors to the risk of capital losses. Some specific risks investors face include:

• Interest rate risk. If interest rates go up rather than down this year, then PDI will likely experience a capital loss. All bonds are subject to interest rate risk, but PDI, as a fund holding mostly long term bonds, is more subject to this risk than a typical money market fund--long term bonds decline in price more than short term bonds when rates rise. As I wrote at the start of the article, inflation has been trending downward in recent months. Shortly after the Q3 inflation report came out, Jay Powell said that he saw the Fed’s policy rate coming down 75 basis points in 2024. That would be bullish if it transpired. However, the inflation rate actually ticked upward to 3.4% in December, bucking the previous trend. If that turns into a new trend then we’ll likely see rate hikes rather than cuts, which would be bearish for PDI, as bonds go down in price when rates go up.

• Currency risk. Some of PDI’s holdings are subject to currency/FOREX risk. For example, the fund holds some Argentina government bonds, most of which are denominated in U.S. dollars, but a few of which are denominated in Argentine pesos. For example, the 115% yielding City of Buenos Aires bond. That 115% yield might sound enticing, but just recently, Argentina’s inflation rate surged to 200% . If PDI held it for 12 months, the Buenos Aires bond contributed a -85% return to PDI’s unitholders.

• Default risk. Last but not least, like all bond funds, PDI is subject to default risk. For your average money market fund, “default risk” is more theoretical than real, as governments rarely default on their bonds, but in PDI’s case, the default risk is material. Some of the entities that PDI invests in are quite stressed financially. Examples include Silicon Valley Bank bonds (yes they still exist ), Argentine municipal bonds, and Softbank bonds . These entities all have above average default risk, and PDI holds their debt at above-average weightings. Empirically, the default rate on high yield debt like that owned by PDI was 2.6% in July . So, the risk of default here is very real.

The risks above are worth keeping in mind. On the other hand, PDI has a number of hedges in place (e.g. credit default swaps) to ensure that investors don’t suffer too severe a negative outcome. I could see some defaults taking place, but probably on less than 5% of the portfolio. Plus, if Jerome Powell is to be trusted, interest rates will come down this year. On balance I think those buying PDI today will earn a positive rate of return over the long run.

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