PTY - Will PTY Ever Return To Its Glorious Days?

2023-05-26 12:24:48 ET

Summary

• From its inception to 2021, PTY outperformed overall markets vastly in total returns.
• It's been lagging lately due to uncertainties in the economy.
• I believe it will return to its glorious days as uncertainties get cleared.
• This might take a lot of time and investors may want to stay disciplined and patient, though.

PIMCO Corporate and Income Opportunity Fund ( PTY ) used to be on top the world. The fund used to have a performance that left most stocks in its dust. From its inception until August 2021, the fund enjoyed total returns of 1060% versus S&P 500's ( SPY ) total return of 600% during this time, almost doubling market's overall performance. The fund had such a great performance that if you had invested $10k into PTY at the time of its inception, you'd be collecting $10k in annual dividends which is a yield of 100% on your original investment.

Then "something" broke in August 2021 and the fund has been vastly underperforming since then. As a matter of fact, PTY's total returns since August 2021 are down -27% even with reinvesting its rich dividends.

It all started in August 2021 when the fund cut its monthly dividends from 13 cents per share to 12 cents per share and it's been straight downhill since then. Investors are fully expecting more dividend cuts even though the fund not only has maintained 12 cents per share for more than 16 months but also paid a special dividend of 15 cents at the end of last year which made up for the 1 cent dividend cut that was made 15 months ago.

In addition, the fund also suffered from one of the fastest and most aggressive rate hike campaigns in Fed's history. In one year, Fed hiked rates from near 0% to 5.25% and it might not even be fully done. When bond yields rise, bond prices drop in proportion. It's good for those funds that are still in accumulation stage and buying up new bonds but bad for those who are already fully invested not to mention leveraged.

As a result, PTY's NAV has been on a steady decline, dropping from $15 per share to just short of $11 per share. While the fund still commands a premium of 15% against its NAV value, this premium is near 5-year low if you don't count the COVID crash of March 2020.

Moving forward, we have indicators showing a probability of 68% for recession in the next year. This is the highest signal we've had in this indicator in the last decade, even higher than spring of 2020 when the global economy was in a lockdown. PTY owns a lot of corporate bonds with "junk" rating and these tend to suffer the most during a recession. Even a mild recession can put a lot of these companies out of business and a severe recession can wreak a havoc in PTY's portfolio of bonds. If that happens, a dividend cut might be one of this fund's least worries as it could see its book value collapse.

Below is how the fund's NAV performed during the great recession of 2009. The fund's NAV dropped by as much as 75% at the worst of the recession and then quickly had a V-shape recovery once the economy started showing signs of life.

Interestingly enough, the fund maintained its dividend of 11.5 cents per month during the entirety of the recession and never cut its dividends. At one point the fund's dividend yield was close to 25%. The fact that fund didn't cut dividends during this period inspired a lot of confidence in investors.

The management was able to navigate one of the toughest times in financial history without much permanent damage and investors continued to pay a premium for this fund. If you don't count a brief period where the fund traded at a discount to its NAV, it traded for a premium of 5-10% during most of this period.

We don't know exactly how PTY would perform in a future recession but it seems to have passed the test in the last recession which certainly wasn't mild by any measure. In fact it was the most severe recession since the Great Depression in 1930s. We saw 2 of the biggest 3 car companies in the US go bankrupt while Ford barely avoided bankruptcy along with many banks and industrial companies which also came close.

One of the biggest risk factors for this fund is leverage. Currently the fund's leverage rate sits at 31% which includes preferred shares, reverse purchase agreements and credit default swaps. The fund's management is working actively to reduce leverage where they see risk and increase leverage where they see opportunities. In this regard investors will simply have to have faith in management's ability to manage leverage effectively to maximize their gain potential and minimize their risk factors.

To be fair, even though the fund is mostly known for investing in high-yield corporate bonds (also known as "junk bonds"), these bonds actually make up only 36% of the fund's total assets. As of today, the fund invests in more than 830 different debt instruments including short and long term government bonds (13%), mortgages (14%), emerging market debt (8%), municipal debt (2%) and debt from developed nations outside of the US such as Japan and Europe (15%). While some of these debt instruments will underperform during a recession, others might outperform as people run to safety.

A great majority of the debt held by the fund will expire within 5 years with average maturity being 7.25 years. About 25% of the fund's debt instruments will be mature in less than a year, another 16% in 1 to 3 years and another 27% from 3 to 5 years. Only about 32% of the fund's debt holdings have maturities longer than 5 years (most of them being mortgages). This allows the fund to have better visibility overall.

Historically, the best time to buy these types of funds is during midst of a recession. It might sound counterintuitive to buy a leveraged high yield debt fund during a recession when there is blood in the streets but funds like this typically perform the best 6-12 months after a recession. For example in 2009 the fund returned 78% from April to December while the recession was still going on.

Similarly the fund returned about 52% from March 2020 to February 2021 while the global economy was in deep recession due to COVID lockdowns.

This might make it seem like investors should wait until a recession occurs and then buy this fund but we don't know when or if a recession will happen. We could have a recession 6 months from today or we could go several years without having a recession. If we don't get a recession and this fund recovers, you might miss out on great returns both in dividends and share price recovery.

Then what should an investor do? Since the fund is already down significantly in the last 16 months, I would start buying in small chunks and build a very small position. I would add to this position slowly each month while also reinvesting dividends but I wouldn't go all in and keep some cash on the sidelines in case an even bigger buying opportunity occurs. If not, I would keep adding slowly but surely.

As to the main question in the title of this article of whether PTY will ever return to its glorious days, I think it will but this may take some time. There is currently a lot of uncertainty in the global economy driven by inflation, rising interest rates, slowing growth, rising debt levels, political instability and many other factors. These things won't clear themselves overnight but they eventually will. Investors' job is to remain disciplined, remain patient and add to their investments when they get buying opportunities so that they can grow their assets and income over time. As uncertainties in the global economy get solved, this fund can also return to its glorious days but it will take time, possibly even several years.

At the end of the day, it's up to each investor to decide what their goals are, what their timeframe is, what their strategies are and what tools they will be using. I am personally buying the dip in PTY slowly and in small chunks right now because it's fitting my long-term goals and I encourage you to also do the same if it also fits your goals and investment philosophy.

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