RCS - PIMCO's RCS Likely To Cut Distribution 30% Downside Possible

2023-03-17 08:51:22 ET

Summary

• RCS, a fixed income closed end fund, has an impressive long term performance.
• LQD, a fixed income ETF, has a solid track record too, but not as impressive.
• We start off with a focus on RCS and then compare it with LQD and show why LQD is the better one to hold at this time.

PIMCO Strategic Income Fund, Inc ( RCS ) invests in an eclectic mix of fixed income securities to achieve its objective. Its long term raison d'être is to generate more income than high quality U.S. debt securities of intermediate term. Evident in its sector snapshot as of February 28, is the fund's inclusivity to fixed income securities of all shapes, forms and origins, be it corporate debt, mortgage and asset backed securities, government debt, and non sovereign debt.

While predominantly comprised of U.S. securities, the fund managers have the leeway to go beyond the borders and across the oceans to find their fixed income winners.

At varying times, one could also find emerging markets in the above listing. On the maturity spectrum, most of its holdings mature within 1-3 years, which is a smart thing in the current environment. The portfolio level maturity after considering the callability based on embedded options for RCS is just over 6 years.

Due to the preponderance of shorter maturity holdings, the funds interest rate sensitivity or effective duration is modest and under 4 years. This indicates the extent to which the NAV would appreciate or depreciate with a correspondence decrease or increase in underlying interest rates. Maturity and duration positively correlate to each other, with the latter coming in under the former.

We end our introduction with a quick word on leverage. RCS uses leverage to enhance their returns, which generally works wonderfully during times of low interest rates.

Maybe not so much since 2022, which we will talk about under our Outlook section further down.

Our aim today is to look at RCS and also compare with an ETF that invests in USD denominated, investment grade corporate bonds. We wrote about iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD ) back in 2020 and were not too impressed given the risk reward set up at the time. LQD has roughly double the portfolio maturity and duration,

but it comes out ahead in our comparative analysis today.

Outlook

RCS has been a great fund from a long term perspective. Since early 2002, the fund has handily outperformed iShares iBoxx Investment Grade Corporate Bond ETF. Total returns on NAV (and we stress this part) have been more than double.

Moving on to nearer term changes, it has become apparent that the fund is struggling to deliver. Over the last year it marginally beat LQD.

Over the last 5 years it has underperformed by about 6%.

There have been two drags here. During the 2018-2020 timeframe, the rally in all bonds made it hard for RCS to generate alpha. During the last 2.5 years the higher fees were a huge drag relative to LQD.

Keep in mind that LQD charges less than 10% of what the expense ratio shows for RCS.

We say "shows" as the RCS data is old (as of June 30, 2022). With higher rates across the board, the expense ratio is probably well over 2% today. We think RCS is going to continue to struggle to deliver here and the glory days a well behind.

Verdict-Why RCS Is A Strong Sell

Ok, so far we have given you the fund background and explained why its recent NAV returns have been mediocre. That information works out to a "hold/neutral" rating at best. After all, one has to weigh the longer term numbers and give the fund the benefit of the doubt. But that is unfortunately only half the story. Our Strong Sell ratings come from two other facts. The first is the premium to NAV. RCS trades at a ridiculous 24.19% premium.

For the recent performance we would be hard pressed to pay a 2.4% premium, let alone 10X that. As you can see the fund has traded at a discount as well. That journey which we think is inevitable, will make you total returns incredibly painful. Another way to visualize this is to see the evolution of price and NAV over the last year. That

That gap will be filled and it won't be pleasant.

Now you may wonder what makes us so confident about that? Well, no one can be certain about the financial markets, but the UNII report from PIMCO does show the biggest problem here.

While most PIMCO funds are struggling and PIMCO Dynamic Income Fund ( PDI ) appears to be a disaster, RCS has got its work cut out as well. We don't think this is sustainable and a distribution cut looks to be in the works within the next 12 months. That cut should realign the discount and create a whirlwind of downtrend. If we go into a recession over the next 12 months, you will likely see credit spreads blow out as well. The combination of the two events could easily drop RCS prices by over 30%. At present investors have a chance to buy 24% more NAV of LQD by selling RCS. We think they should use it.

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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