PTY - PTY: A Somber Future

2023-03-09 10:52:28 ET

Summary

• PTY's 10.5% monthly paid distribution rate looks at risk with a fiscal year-to-date distribution coverage ratio of 68%.
• The CEF's highly diversified portfolio of fixed-income securities is set to come under continued pressure on the back of rising Fed funds rates.
• With PTY only cutting its dividend twice over the last two decades, a cut would be a rare event but not entirely catastrophic, and the premium is set to remain.

PIMCO Corporate & Income Opportunity Fund ( PTY ) last declared a monthly distribution of $0.1188 per share , in line with its prior distribution and for a 10.5% yield. The closed-end fund has been a stable bulwark for fixed-income investors for years, but there are threats lurking. PTY now faces one of the most brutally Darwinistic macroeconomic environments since 2008. Sticky inflation, still-rising Fed funds rates, and a hawkish FOMC have all aggregated to form the disruptive backdrop for the bulk of the CEF's portfolio. At risk is the monthly payout, which looks increasingly precarious against a fiscal year-to-date distribution coverage ratio of 68% . This is the lowest coverage of all taxable PIMCO CEFs.

With the CEF essentially now earning roughly 68 cents for every dollar in distribution paid out on a cumulative year-to-date basis, bears have come out to declare themselves as Cassandras in that warnings of the health of the fund were always going to be true. PTY cut its payout as recently as September 2021, when its monthly distribution fell 8.6% from $0.13 to the current level. This was a payout that had remained constant for nine years since 2012 when it was itself raised from $0.115 per share. Indeed, in a history spanning two decades, PTY has only cut its dividend twice. The CEF, which was created just after the dot com crash, maintained its payout during the 2008 financial crisis and during the early onset of the pandemic. Hence, a future cut, if it happens, would be an incredibly rare event and a somber reflection of the new macroeconomic conditions.

A Levered Fixed Income Portfolio

PTY's portfolio is vast and heavily weighted towards high-yield credit, non-agency mortgage-backed securities, and emerging market debt. Non-investment grade or junk bonds form the largest percent of PTY's portfolio as a per market value exposure. The underlying positions are niche and range from Ghanaian sovereign debt to a small 0.479% position in experiential REIT VICI Properties ( VICI ) and corporate bonds issued by American Airlines ( AAL ).

Hence, whilst the CEF is better suited for defensively-minded investors, it has explicitly taken on a more aggressive foot forward with junk bonds and non-agency MBS. These offer higher cash flows but are more susceptible to macroeconomic volatility. In the case of the latter, they're not backed by mortgages issued by government-sponsored agencies like Fannie Mae or Freddie Mac. Further, with the primary mortgage rates being pulled up by FOMC hikes, fears around defaults are mounting and the US housing market has been highly disrupted with some expectations that house prices could experience an up to 20% fall through 2023.

The CEF's maturity profile is also mixed in terms of its utility against the current environment. Only 15.48% of securities held are up for maturity within a year, with the bulk majority of securities having a greater than 3-year maturity profile. What does this mean? That the CEF will be unable to fully benefit from rising rates to recycle its portfolio to higher-yielding investments. Indeed, SOFR currently stands at 4.55% compared to 0.05% a year ago.

The Rich Premium To NAV Masks Underlying Angst

SOFR of course partially drives the pricing of some newly issued securities, and its surge drives down the overall value of PTY's portfolio. To be clear here, PTY could force up its coverage if it could more actively swap matured positions for higher yielders. This also forms a core reason for bulls to not be entirely worried about the lack of coverage as the portfolio will remain somewhat dynamic on the back of the maturities that do fall ahead of its June 30, 2023, fiscal year. The portfolio turnover stands at 58% with total effective leverage at 34.27%.

Against a somber macroeconomic context, the CEF trades on a buoyant 22% premium to its NAV. This premium was once north of 50% with the PIMCO reputation driving investors to pay up for its management and inherent stability. Hence, bulls could see the recovery of this sentiment back to its highs as a potential factor for alpha in the years ahead whilst bears might flag this as a driver for further downside pressure. The Fed funds rate will remain elevated compared to its near-term historical average, and it might be hard for bulls to justify the exuberant premium the CEF previously traded on.

Is PTY a sucker yield? Not really. The CEF had to lean on the return of capital as recently as the summer of 2021 with a ROC of 0.0283 per share, around 21.8% of its monthly distribution, paid out from August 2020 to July 2021.

Hence, we might not see a cut but rather a ROC payment to keep the distribution rate at its current level. Indeed, the most recent cut to the distribution came on the back of 12 months of ROC payments. This forms one of the most destructive ways for a CEF to return value to shareholders so a cut of the distribution whilst sobering would be preferred to ROC. PTY is a hold against a somber future, with the PIMCO management forming good stewards of long-term capital but faced with immensely difficult investing conditions.

For further details see: