2023-12-04 11:26:03 ET
Summary
- PMF has seen a strong gain in the short term. This momentum has certainly been favorable for holders, but I'm concerned about its sustainability.
- Leverage costs are still a headwind going into 2024 that will pressure net income earnings.
- However, the risk-reward proposition for PMF going into 2024 may not be favorable, and avoiding the fund may be a wise decision.
Main Thesis & Background
The purpose of this article is to evaluate the PIMCO Municipal Income Fund (PMF) as an investment option at its current market price. This is a closed-end fund with a primary objective "to seek current income exempt from federal income tax."
I cover the municipal market on a regular basis and that includes the three national muni CEFs from PIMCO. PMF is one that I often consider, but have been reluctant to recommend due to its highly leveraged profile. This message was consistent early this year when I wrote about it and placed a "hold" rating on the fund. In hindsight, this was probably a correct outlook (although sell would have been similarly appropriate):
This performance certainly leaves much to be desired. But PMF has gotten a strong boost recently and that made me stop and consider if this fund is deserving of a rating change heading into the new year. After review, I actually see a few fundamental reasons why I would avoid this option in favor of other muni funds - if one is committed to owning this exposure in 2024. I don't think PMF's outperformance will continue, and I will explain why in detail below.
Recent Rally In Muni Sector Worth Mentioning
To begin I do want to touch on the broader muni backdrop - and how it has impacted PMF - in the short term. As I already noted, I don't think the risk-reward proposition is very favorable for PMF going into 2024. I think avoiding this fund is probably going to make sense as it has for most of this year. Yet, anyone who has followed this fund closely knows that it has performed extremely well recently. This momentum has taken me a bit by surprise and I will be the first to acknowledge it could continue. While I personally don't think it will, a consideration of the likelihood of each outcome is always warranted.
So, just how well has PMF done recently? Does a 157% return sound good enough (after accounting for the distribution), in just a one-month period?
This has been quite the bull run for a fund that has generally struggled this year. For those who stayed put despite earlier losses, this was surely a welcomed reprieve. And for those who timed this well through buying in more recently, kudos!
And this bullishness extended beyond just PMF. As a leveraged CEF, the gains are going to be higher than a passive basket of muni securities when the sector is in favor. But we should still consider that munis as a whole saw a rash of investor interest (and buying) as the market began to price in a more dovish Fed in 2024:
As you can see, investors have turned positive in this sector in a big way. After a struggling 2022 and 2023 (for the most part), bonds as a whole have gotten wind in their sails and muni in particular are soaring higher. This has been beneficial to PMF, and most muni funds in the open market. As a holder of securities in this sector, I am certainly happy to see this, but it makes me a bit more cautious going into 2024 than I would have been a month ago. While momentum plays can ride higher for a while, they tend to give me pause because what goes up cannot always go up forever. This makes selectivity on new positions very important in my view at this time.
Valuation A Mixed Bag
My next topic for discussion related to PMF is the fund's valuation. This is an attribute I always dive into with any CEF - especially those from PIMCO because they can often trade at (what I consider) wild premiums.
PMF has not had this problem for a while but it is worth noting that back in April the fund did sport a premium in the 5% range. This is near my personal cap for what I would consider invest-able and was central to why I did not recommend the fund at that time. Looking back, I was right on that call, but we should consider now that this metric has changed. No longer at a premium, PMF now sits with a discount to NAV (albeit a small one):
So - what isn't to like here? The fund is cheaper than it was before and it is at a discount now. Why wouldn't this make the fund a "buy"?
This is where the discussion gets a bit subjective. Personally, I would not fault someone for saying PMF is a buy at a 1% discount. I will lay out the reasons why I disagree at the present moment, but that doesn't make me right and/or someone else wrong automatically. Valuation arguments can never really be "won" - it is dependent on one's own personal comfort level and outlook. The price at which one should pay for any CEF is a constant matter of debate and thus should be taken with a grain of salt always.
But I have two problems with this current valuation. One, a 1% discount is not really "cheap" when we consider there are a plethora of muni CEFs in the market that trade at much wider discounts. Some of these from other fund managers are in the double-digit range. So if we are shopping based on valuation or discounts to NAV as a critical element, one could be well served by finding a CEF that has similar exposure but a much cheaper valuation. Two, PMF, despite seeing its premium evaporate since April, continues to trade at a more expensive price than its two sister funds:
Fund | Discount to NAV |
PMF | (1.1%) |
PIMCO Municipal Income Fund II (PML) | (6.1%) |
PIMCO Municipal Income Fund III (PMX) | (6.1%) |
Source: PIMCO
This should support why I see a rotation out of PMF as making sense at the moment. While the fund may look like a reasonable buy in isolation, two other funds exist from the same bond manager with similar holdings at a much cheaper price. It seems to me that there isn't much of an argument to be made in favor of PMF over either PML or PMX if valuation is a concern. For me, it is, which is why I would suggest selling PMF and rotating into one of these sister funds if PIMCO is your bond manager of choice.
Income Metrics Are Weak, Will Struggle To Improve
Expanding on the above discussion, PMF also falls short in another important category. This is income production. At present, the fund has a large negative UNII balance, and its coverage ratios are not very comforting. Worse yet, similar to the valuation story, PMF has the worst ratios of the three national muni CEFs from PIMCO, as shown below:
I simply don't see the logic in buying the PIMCO CEF with the worst coverage (at present) and the narrowest discount. While these figures are fickle and can (and often do) change from month-to-month, we have to make decisions today based on the data we have. And this data suggests PMF is not the best option.
The other challenge I have impacts PMF, but it is also relevant for any leveraged CEF - muni or otherwise. This is the fact that the yield curve remains inverted. While bonds have seen a large upswing on the prospect of short-term interest rates declining next year, the fact is that short-term rates have not actually declined much yet. While the yield curve's inversion has narrowed a bit, it is still inverted, and that puts pressure on leveraged CEFs that borrow in order to re-invest at the longer end of the curve:
I have discussed this at length over the past two years so it should suffice here to say that this remains a major headwind for PMF and other funds and readers need to evaluate this carefully. Until the yield curve normalizes, leveraged products are going to see income pressure. To be fair, they can overcome this in other ways, but it is going to be difficult.
A case in point is PMF. The fund's expenses have soared as a result of the spike in short-term borrowing and that is a fact that is not going to change until we see Fed movement next year (if we end up seeing it at all):
The fact is that quality munis are not offering yields in excess of 5% - even at the longer end of the curve:
This means bond managers like PIMCO either have to go down in quality or get creative somehow in order to deliver investors value in excess of the management fee and interest expenses. Given how poorly PMF has done over the past year, PIMCO will have to forgive me if I say I am not overly confident in their ability to navigate the upcoming calendar year.
New York Can Ride Out Weakness For Now
My last topic takes a look at the broader muni backdrop for the state of New York. This is important because this jurisdiction represents the largest individual state exposure in PMF's portfolio:
This is not surprising because New York is a large issuer of muni bonds, as are the other high-population states, such as Texas, Illinois, and New Jersey.
While all of these states have unique fiscal challenges (and none are really considered the "gold standard" when it comes to fiscal prudence) I am not overly concerned with this make-up. Over the longer term, I will want to see some structural changes in New York and elsewhere to really get comfortable owning their debt for years. But in the immediate term all of these states, including New York, are positioned well enough to make good on their obligations. This is because rainy day funds have grown measurably over the years, as measured by a percentage of general fund spending:
While Texas has seen a dip, it is still the highest in relative terms. The other states clock in at lower percentages but have seen growth. This gives me some comfort over the top-heavy weightings all of these states represent in PMF's portfolio.
Another supporting factor is that states like New York, or more aptly, cities like New York City, are starting to take action to increase revenues right now. One item that has made headlines very recently is the soon-to-be-enacted "congestion pricing" coming to the Central business District of Manhattan. This is a program aimed at raising revenue and relieving traffic congestion throughout Manhattan all the way to the southern tip of the Financial District. The current proposal for who would pay into this is as follows:
What this shows me is that cities like Manhattan are getting serious about finding more revenue streams. While we can debate the merits of this proposal and how appropriate it is from a public policy perspective, there is little doubt that this will improve the city's short-term financial position. That is the kind of development that muni bond investors want to see, all other things being equal.
Bottom line
PMF has seen a sharp move higher over the past month and that is certainly a welcome sign for investors. With states and cities maintaining some large rainy day funds, PMF trading at a discount to NAV, and bonds as a whole getting renewed investor optimism - there is a chance more gains could be on the way.
However, I would caution against getting too optimistic here. While I think munis as a whole have a path forward for gains in 2024, I am short on optimism when it comes to PMF. The fund's discount looks attractive in isolation, but it pales in comparison to its sister funds. Further, the cost of leverage is still too high, and this makes the weak income metrics a real headwind for the next few months. Finally, I believe the market is overestimating how dovish the Fed will be next year, and that suggests to me that fixed-income investors should take big wins - like what PMF has experienced recently - as an opportunity to take chips off the table.
All of these factors tell me that a downgrade for PMF is in order, and I would urge my followers to consider muni CEFs with a better risk-reward proposition going forward.
For further details see:
PMF: I Don't Trust The Recent Rally