2023-04-21 19:01:23 ET
Summary
- With a potential recession on the way, locking in higher yields in the credit markets makes sense to me right now. Munis are one way to play this idea.
- PMF is a decent fund, but it appears expensive relative to its sister funds from PIMCO and other muni CEFs on the open market.
- Recent income metrics were fairly weak, suggesting the latest distribution cut may not be the last.
Main Thesis & Background
The purpose of this article is to evaluate the PIMCO Municipal Income Fund (NYSE: 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 last covered PMF about eight months ago when I placed a "hold" or neutral rating on the fund. I didn't see a lot of upside and - in hindsight - I was right. Since then it has seen a negative total return in excess of 9%:
Fund Performance (Seeking Alpha)
This weakness is obviously a concern and I thought now was a good time to assess whether or not a turnaround is in the cards. After review, I think continuing to approach this fund cautiously is the right move and I will explain why in detail below.
Recession Coming? Munis Could Be A Good Bet
To start this review, I will consider a few reasons why investors would want to be considering munis right now. Anyone in this space likely remembers (with distaste) how poorly it performed in 2022. While we have seen a nice bounce in 2023 thus far, there has been an elevated amount of volatility. So the verdict is still out on how munis as a whole will perform this year. With that in mind, leveraged muni plays (like PMF) should be taken with care.
On that note, what are some reasons for investors to buy in to the sector at the moment? One in particular is recession risk. This has been something we have heard about for over a year now to no avail. But the reality is a recession is getting closer as the Fed continued to tighten in Q1 and economic conditions worsened. Compounding this backdrop was the financial crisis that, while brief, rattled the sector. This has put pressure on small businesses and others and led to concerns that credit will be more difficult to come by in the future. This is often a precursor to a recession, so readers should monitor this closely:
Recession Signal (Credit Markets) (Charles Schwab)
This likely stems from the question - why would this be a good thing for munis?
The answer is due to munis' historical performance during recessions. While the 2020 recession is not a great guide given how poorly the sector performed, that was not unique to munis but was reflective of the challenge of bond and credit markets more broadly. If we look back at other recessionary time periods, we see munis have generally been a lucrative play:
Historical Performance During Past Recessions (IG Muni Sector) (FactSet)
The takeaway for me is that if readers are expecting tough times ahead, then shifting some part of their allocation from equities to munis could make a lot of sense. While equity returns are going to dwarf munis over long stretches of time, this thesis is challenged when we are in recession (especially deep recessions). By contrast, those environments tend to be when equities offer negative returns and munis deliver gains.
Whether we will see a recession later this year or not remains to be seen. But if we do, then funds like PMF could help one obtain a smoother ride.
Credit Ratings Often Stable As Well
Expanding on the above point, munis also compare favorably to other bond markets during recessionary periods because they are seen as more stable. This can often be a self-fulfilling prophecy since long-term performance justifies this outlook. As a result, credit agencies are slow to downgrade (if at all) and investors are slow to sell. This means the sector can help stabilize a portfolio that is going through some ups and downs in other areas.
For perspective, let us look at the stability of the credit rating environment for munis compared to corporate debt. While downgrades are rare for munis over decades, the corporate bond sector sees a substantial amount of volatility by comparison:
Bond Credit Ratings (past recessions) (Moody's)
What I infer from this is munis tend to be less volatile than corporates over time, including during recessions. This is fundamental to why the primary way I access credit markets is through muni bonds. I have very limited exposure to fixed-income in other areas and I don't see that changing in 2023.
Why Not PMF Then? Valuation Not Cheap
So if one does expect a recession and munis often perform well in recessions - why not buy PMF here? That is a valid question and quite frankly I wouldn't necessarily fault anyone from holding (or even buying) PMF at these levels as an equity hedge. There is some merit to doing so.
The problem rests not with PMF in isolation but how expensive it is on a relative basis. What I mean is, PMF doesn't really seem all that frothy on the open market. The current premium is just over 5% - not outrageous. Further, much of the downside from my August 2022 article (the 9% drop) has come from premium narrowing. This speaks to the general resiliency of the underlying holdings. At that time in August, PMF had a premium in excess of 12%. That is simply too much for me, and the drop since then vindicates that. But it also shows that the bulk of the 9% fall in the interim was due to the premium falling from 12% then to 5% today. So the market price is obviously much more attractive this time around. That is the good news.
The bad news (for PMF, not for investors) is that we don't invest in funds in isolation. This is especially true of PIMCO investors because the fund manager offers two very similar muni funds. These are the PIMCO Municipal Income Fund II ( PML ) and the PIMCO Municipal Income Fund III ( PMX ). This means that there really is no reason to overpay for munis from PIMCO. Investors have multiple funds to choose from and, at time of writing, PMF happens to be the most expensive by a fairly healthy margin:
Fund | Current Premium to NAV |
PMF | 5.06% |
PML | 1.35% |
PMX | (1.34%) |
Source: PIMCO
The conclusion I draw here is a simple one. Even if one likes munis there are a lot of options to choose from. PMF is not cheap, and its sister funds have a marked advantage when it comes to buy-in price. This doesn't even include the plethora of CEFs out there trading at discounts. Suffice to say, I don't see a lot of value at this level, and that is key to why I urge patience here.
Income Story A Source For Concern
My last point concerns PMF's income stream which on the surface looks pretty good. Who wouldn't like a 5% yield that is tax-free? Not a bad deal, right?
The answer is conditional because it depends how sustainable that income is. As investors in PMF are surely aware, the distribution used to be higher (the yield was similar because the share price was also higher!). However, PMF got caught up in the wave of distribution cuts for muni CEFs to start the year. This was not a good sign as the cut for this fund was especially deep:
Distribution Cut (PIMCO)
This is surely a good part of the reason why PMF has been on a downtrend this year. With such a negative headline to start the year, who is really surprised?
YTD Performance (PMF) (Seeking Alpha)
Of course, this drop in share price does open up an opportunity for fresh cash. With a 5% yield and a price well below where it started the year, that looks like value potential.
Unfortunately, I can't make that argument at this juncture. Aside from the other attributes already mentioned in this review, PMF's income stream continues to be under pressure. This means that buying on the latest distribution cut sell-off may be ill-advised because another cut could be in the cards. For support, look to PIMCO's UNII report published last week:
As you can see, the story isn't that pretty. While I always caution against emphasizing one month's worth of data, there isn't a lot to be optimistic about here. With PMF seeing such a dramatic income cut very recently, coupled with the fact it is still under-earning what it needs to maintain the current payout, I use this as further support to be cautious on the fund.
If we see another income cut and subsequent drop in price, that will give me another chance to evaluate this story. Similarly, if PMF's income metrics improve measurably in the upcoming months that will give me a much brighter outlook. But, until then, my wary stance remains unchanged.
Bottom line
PMF has had a tough start to 2023 on the backdrop of higher interest rates, an income cut, and the inverted yield curve. Looking ahead, it is hard to be much more optimistic here. On the bright side, I think munis will see a boost when the Fed begins to pause and a recession takes hold. The quality of the underlying bonds will come in handy at that point.
However, investors need to be discerning with how they approach this play. PMF has a premium to NAV, has sister funds that are markedly cheaper, and continues to see income pressure as short-term rates have risen faster than long-term rates (this yield curve inversion has pressured funds that use leveraged - such as PMF). For these reasons, I don't see a case for upgrading my rating on the fund and will keep a "hold" stance in place for now.
For further details see:
PMF: The Value Just Isn't There, Despite A Favorable Muni Backdrop