2023-12-28 15:30:25 ET
Summary
- PIMCO Strategic Income Fund aims to provide high current income by investing in debt securities issued by American and foreign entities.
- The RCS closed-end fund has seen positive total returns over the past five years despite a decline in share price.
- The fund has a high level of leverage and a declining distribution over the past several years, which may be concerning for investors.
- The Federal Reserve might disappoint the market by failing to deliver as many rate cuts as it expects, which could cause a correction in the fund's share price.
- The fund is currently trading at an enormous premium on net asset value.
The PIMCO Strategic Income Fund (RCS) is a closed-end fund ("CEF") that specializes in providing its shareholders with a very high level of current income. As is the case with most PIMCO funds, the fund aims to achieve its objectives by investing in various forms of debt securities issued by American entities. This has generally been a good place to be recently, as the market has sent the price of most fixed-rate securities soaring in anticipation of six rate cuts by the Federal Reserve next year. That scenario seems highly unlikely unless the economy falls into a severe recession within the next month or two, so potential investors should be somewhat cautious about buying fixed-rate securities too aggressively right now.
With that said, the PIMCO Strategic Income Fund has a 10.30% yield right now, so investors who are planning to hold the fund over the long term might be willing to stomach a bit of volatility as the distributions should eventually cancel out any short-term share price declines and should result in positive results if the fund is held for long enough. This has been the case over the past five years, as the fund has delivered a positive total return despite suffering a 36.61% share price decline:
In the case of this fund, it was the COVID-19 panic that was responsible for most of the poor price performance over the past five years and not the reversal of the Federal Reserve's monetary policy. It still makes the point, though, that the total returns could still be positive over the long term even if the fund's shares do decline next year if and when the Federal Reserve fails to cut interest rates to the degree that the market expects.
As regular readers may recall, we last discussed the PIMCO Strategic Income Fund back in September. Obviously, the market environment has shifted considerably since that time. In September, we were in the midst of a pessimistic market as investors began to accept the reality of the Federal Reserve's "higher for longer" monetary policy. Obviously, things are different now as the market has been surging as investors attempt to front-run the Federal Reserve's pivot.
As such, we might expect that shares of the PIMCO Strategic Income Fund have delivered a fairly good performance since the last time that we discussed the fund. This is certainly the case, as shares of the fund have appreciated by 8.99% since the date that my previous article was published. This is significantly better than either the Bloomberg U.S. Aggregate Bond Index ( AGG ) or the Bloomberg High Yield Very Liquid Index ( JNK ):
If we include the distributions that have been paid out by the fund and the two indices, the total return that investors have received looks even better. This is because the PIMCO Strategic Income Fund follows the same business model as most closed-end funds. Basically, the fund pays out all of its investment profits to the shareholders in the form of distributions. This is one reason why its yield is so high compared to the indices. When we include the effect of these distributions, we see that investors who purchased the fund on the date that my previous article was published are up 12.11%. Once again, this is better than either of the indices:
As already mentioned, there is no guarantee that the fund will be able to hold onto all of these gains. After all, it seems likely that bonds will give up some of their recent gains in the very realistic scenario that the central bank will disappoint the market. However, that does not necessarily mean that the fund is a bad purchase today, especially for long-term investors. Let us investigate and try to determine the fund's potential as an investment.
About The Fund
According to the fund's webpage , the PIMCO Strategic Income Fund has the primary objective of providing its investors with a very high level of current income. Specifically, the website states:
[The fund] seeks to generate a level of income that is higher than that generated by high-quality, intermediate-term U.S. debt securities as a primary objective and capital appreciation to the extent consistent with this objective.
The focus on income makes a lot of sense for a PIMCO fund. PIMCO is generally known as a bond fund house and as such most of its funds are invested in bonds and other debt securities. This one is not an exception to the rule, as the website states that:
The fund normally invests at least 80% of its net assets (plus any borrowings for investment purposes) in a combination of income-producing securities of non-corporate issuers, such as securities issued or guaranteed by the U.S. or foreign governments, mortgage-related and other asset-backed securities issued on a public or private basis, corporate debt obligations, and other income-producing securities of varying maturities issued by U.S. or foreign (non-U.S.) corporations or other business entities, including emerging market issuers and municipal securities.
This description strongly suggests that this fund can invest in just about any kind of bond that its management thinks is best. This can even include foreign securities, which could be useful for American investors who are looking to reduce their exposure to the United States without needing to sacrifice their income or return potential. However, right now, the fund is not actually employing this ability to invest in foreign-issued securities. As of right now, 86.87% of the fund's assets are invested in securities issued by domestic companies or governments:
The chart shows both the market value percentage and the duration-weighted exposure. While the figures can be drastically different depending on the terms of the specific bonds held by the fund, we can still see that the overwhelming majority of the fund's assets are invested in American securities. Thus, this fund is not an especially good choice right now for people who are looking to improve the international diversification of their portfolio. One of the expected effects of a Federal Reserve pivot is a decline in the value of the dollar, which will almost certainly be the case if the pivot causes inflation to take off again. As such, there could be a good argument for increasing your foreign currency exposure by purchasing assets that produce income in other currencies. This fund does not appear to be a great way to accomplish this task right now, either.
In recent months, there has been a great deal of concern surrounding mortgage-backed securities, or MBS. This has been partly due to a few high-profile defaults. For example, back in June, Westfield and Brookfield Properties opted to default on a $558 million mortgage on a shopping mall in San Francisco. WeWork ( WEWKQ ) declared bankruptcy last month, citing $18 billion in debt. This is almost certainly going to have an effect on the commercial mortgage space due to the fact that this company was a major tenant in many urban office buildings and the renegotiation of its leases could put a strain on the ability of the companies that hold mortgages against those office buildings to make the mortgage payments. There are some analysts who have cited the growing problem in the mortgage market as one of the reasons why the Federal Reserve has reduced its hawkish rhetoric.
When we consider this, it might be concerning to learn that the PIMCO Strategic Income Fund has more than half of its assets invested in mortgage-backed securities:
As we can see, the fund has 62.79% of its assets invested in mortgages, and another 3.27% invested in commercial mortgage-backed securities. The figure is substantially higher when we look at the duration-weighted exposure to these securities. Any problems in the mortgage sector could have an adverse effect on this fund for this reason.
Fortunately, at this time, the problems appear to be confined to the commercial mortgage space. Unlike the subprime mortgage crisis back in 2007 and 2008, there does not seem to be a massive number of defaults in the residential mortgage space. While it is true that the continuing high inflation has devastated many households, as roughly 62% of American households are now living paycheck-to-paycheck, there is still some space for them to cut back on discretionary spending before defaulting on their mortgages.
Rather, the real problem in the real estate space right now seems to be commercial mortgages, as the trend towards remote work has caused vacancy rates in office buildings to surge to the point where owners do not have the rental income to afford the mortgages on the buildings. The fund's exposure to commercial mortgages is quite low, as we already saw. Thus, we should not have to worry about this too much despite the fact that the fund is currently heavily weighted toward mortgage-backed securities overall.
As mentioned in the introduction, the bond market has been roaring lately as investors attempt to front-run a pivot by the Federal Reserve. As I stated in a recent article :
The market expects that the federal funds rate will be around 4% at the end of 2024. That would require six rate cuts, totaling 150 basis points over the next twelve months. As I have pointed out in various previous articles, the only realistic way that this happens is if the economy falls into a severe recession within the next two months. There has only been one time in history when the central bank has cut interest rates by more than 125 basis points in a single year in the absence of a recession. The Federal Open Market Committee only meets eight times per year, so it would need to cut interest rates at six of them so it can only fail to do so at two.
The Fed funds futures market is pricing in an 83% chance that the first-rate cut comes at the March meeting. That seems unlikely considering that the figures show that the economy improved in November compared to October. The market's anticipation of a near-term pivot made sense in October, but the recent numbers cast a great deal of doubt on whether or not the central bank can really cut rates by 150 basis points without reigniting inflation. Early indicators show that consumer spending remained strong this holiday season which casts further doubt on whether or not the "Goldilocks scenario" can actually be achieved.
For its part, the Federal Open Market Committee does not believe that it will be able to cut interest rates to the degree that the market is anticipating next year. The current projections from the Federal Reserve are for a 4.6% effective federal funds rate at the end of next year. That implies three interest rate cuts over the full-year period. Thus, there is a great deal of risk that the market has overshot and could be vulnerable to a correction. This is why anyone purchasing the PIMCO Strategic Income Fund right now should be prepared for some short-term pain, as the Federal Reserve's failure to meet the demands of the market would cause the shares of this fund to decline.
While there may be some short-term risks in purchasing this fund, its long-term performance has been excellent. As we can see here, the fund's investors have benefited from a 55.71% total return over the past ten years:
This fund has certainly shown its ability to perform quite well over time. However, it is important to keep in mind that interest rates were incredibly low over nearly the entire period. The fund has not yet shown its ability to perform in an environment in which real interest rates are positive and monetary conditions are not incredibly loose. However, it seems likely that interest rates will be at very low levels over most of the coming ten years. After all, the economy and the market have generally shown that it is addicted to cheap credit and the Federal government's own finances will become very strained if interest rates remain at today's levels since there is no politically palatable way to impose austerity on the United States. Thus, the fact that this fund has proven that it can perform in a low-rate environment might still make it reasonable to acquire if you can hold it for a long time.
Leverage
As is the case with most closed-end funds, the PIMCO Strategic Income Fund employs leverage as a method of boosting the effective yield and total return of its portfolio. I explained how this works in my previous article on this fund:
In short, the fund is borrowing money and then using those borrowed funds to purchase bonds and other income-producing assets. As long as the interest rate that the fund pays on the borrowed money is less than the yield that it receives on the purchased assets, the strategy works pretty well to boost the effective yield of the portfolio. As this fund is capable of borrowing at institutional rates, which are considerably lower than retail rates, this will usually be the case.
However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As a result of this, we want to be sure that the fund is not employing too much leverage because that would expose us to an excessive amount of risk. I generally do not like to see a fund's leverage exceed a third as a percentage of its assets for this reason.
As of the time of writing, the PIMCO Strategic Income Fund has leveraged assets comprising 33.11% of its portfolio. This is a bit less than the one-third level that we would normally like to see a closed-end fund possess. The fund's leverage is also less than the 34.19% that it had the last time that we discussed it. That continues a trend that we have been seeing among most closed-end funds that we have been discussing lately. As most readers are well aware, most closed-end funds have seen their leverage go down over the past few months.
As is usually the case, the reason for this is that the fund's net asset value has increased over the past three months. As we can see here, the fund's net asset value per share is up 4.52% since the date that my previous article on this fund was published:
It should be fairly obvious why this would decrease the fund's leverage over the period. After all, an increase in the net asset value basically means that the fund's portfolio got larger. If its outstanding leverage remained the same, the leverage would thus represent a smaller percentage of the portfolio. This is exactly what we see with this fund over the period.
As was the case the last time that we discussed the fund, the PIMCO Strategic Income Fund appears to have a very reasonable level of leverage right now. The fund is striking a nice balance between the risk and the return, so we should not have to worry too much about its leverage. With that said though, we probably will see this fund decline more than the broader bond market indices if the Federal Reserve disappoints and bond prices fall as a result.
Distribution Analysis
As mentioned earlier in this article, the PIMCO Strategic Income Fund has the primary objective of providing its investors with a very high level of current income. In order to achieve this objective, the fund invests in a portfolio that primarily consists of bonds and similar assets that deliver the majority of their total returns in the form of direct payments to the shareholders. In the current market environment, bonds deliver higher yields than most investors have become accustomed to over the past twenty years. Those yields are declining though, particularly for long-term and intermediate-term bonds such as the ones that are held by this fund. The fact that this fund uses leverage helps to offset this issue with declining yields though as it allows the fund to collect payments from more bonds than it could otherwise control solely with its own equity capital. The fund also trades bonds in an attempt to profit from changes in their prices that come from variations in interest rates. The fund pools the money that it receives from both sources and then pays it out to its shareholders, net of its own expenses. We might expect that this would allow the fund's shares to have a respectable yield.
This is indeed the case, as the PIMCO Strategic Income Fund pays a monthly distribution of $0.510 per share ($0.612 per share annually), which gives it a 10.30% yield at the current price. This is certainly a respectable yield that compares quite well to many other bond funds. Unfortunately, the fund has not been particularly consistent with respect to its yield. As we can see here, the PIMCO Strategic Income Fund has been cutting its distribution over the past several years:
This is something that might reduce the fund's appeal in the eyes of those who are seeking a safe and consistent income from the assets in its portfolio. However, it has managed to keep its distribution stable since 2020, which is a feat that very few other fixed-income funds have been able to accomplish. In particular, most funds took fairly severe losses during 2022 that forced them to cut their distributions in order to avoid destroying their net asset value. The fact that this one did not have to do that bears investigation as we certainly do not want it to be struggling to maintain its distribution if doing so is destructive to the net asset value.
In addition, the fact that the fund's distribution has been declining is not something that we want to see in an inflationary environment. After all, we need our incomes to increase simply to maintain purchasing power as the prices of everything that we purchase go up. The fund's declining distribution has had exactly the opposite effect. That is not really the best thing for retirees or others who are dependent on their portfolios to provide the income that they need to sustain themselves.
As I have pointed out in the past, the fund's distribution history is not necessarily the most important thing for an investor today. After all, anyone who purchases the fund today will receive the current distribution at the current yield. This investor will not be affected by the actions that the fund has taken in the past. The most important thing for today's investors is how well the fund can sustain its current distribution. Let us investigate this.
We have a relatively recent document that we can consult for the purpose of our analysis. As of the time of writing, the fund's most recent financial report corresponds to the full-year period that ended on June 30, 2023. As such, it will not include any information about the fund's performance over the past half-year period. That is somewhat disappointing as there have been a few things that occurred during that period. In particular, we saw a bond bear market that lasted from mid-July until mid-October. We also experienced a powerful bond bull market that began in mid-October and continues to the present day. These two very disparate market environments could have handed this fund both gains and losses, but we have no way of knowing how well the fund navigated these environments. It is still a couple of months until the fund releases an annual report with this information, so we have to go with what we have at the moment.
During the full-year period, the PIMCO Strategic Income Fund received $25.382 million in interest and $208,000 in dividends from the assets in its portfolio. When we combine this with a small amount of income from other sources, the fund had a total investment income of $25.606 million during the period. It paid its expenses out of this amount, which left it with $17.754 million available for shareholders. This was, unfortunately, nowhere near enough to cover the $27.677 million that the fund distributed over the same period. At first glance, this is almost certainly going to be quite concerning as we would normally prefer a fixed-income fund to fully cover its distributions out of net investment income. This one obviously failed at this task.
However, there are other methods through which the fund can obtain the money that it needs to cover its distribution. For example, it might be able to turn a profit by selling bonds in a strong market environment that is characterized by rising bond prices and falling interest rates. This is exactly the market environment that we have today. Unfortunately, the fund generally failed to accomplish this during the period in question. During the full-year period, the PIMCO Strategic Income Fund reported net realized losses of $13.114 million but these were partially offset by $6.292 million in net unrealized gains. Overall, the fund's net assets declined by $13.521 million after accounting for all inflows and outflows during the period. Thus, the fund clearly failed to cover the distributions that it paid out over the full-year period.
Fortunately, the fund seems to have at least partially corrected this problem since the closing date of its recent report. As we can see here, the fund's net asset value is up 1.62% since July 1, 2023:
This strongly suggests that the fund has managed to cover all of the distributions that it has paid out since the closing date of its annual report. It managed to do this and still has a bit of money left over. That is a good sign, however, we do not know how much of this has been due to realized gains as opposed to unrealized gains. As everyone reading this is no doubt well aware, unrealized gains can be very quickly erased by a market correction. As such, there could still be a risk that such a correction will reverse what we see here and make the fund unable to cover its distributions for another year.
For the most part, the distribution is probably sustainable, but it is close enough that we should keep a close eye on the fund's net asset value going forward.
Valuation
As of December 27, 2023 (the most recent date for which data is currently available), the PIMCO Strategic Income Fund has a net asset value of $4.39 per share but the shares currently trade for $5.99 each. This gives the fund's shares an enormous 36.45% premium on net asset value. That is one of the largest premiums possessed by any closed-end fund, and while it is normal for PIMCO funds to trade at a premium, this is still an incredibly expensive price to pay for the fund. It is also a much larger premium than the 32.94% premium that the fund has had on average over the past month. As such, it might make sense to wait until the fund trades for a more reasonable price before purchasing its shares.
Conclusion
In conclusion, the PIMCO Strategic Income Fund is a reasonably solid bond fund that provides its investors with a very high current yield. The fund claims to have both American and foreign exposure, but right now it cannot really be counted on to provide exposure to foreign debt markets.
The fund also might be at risk of giving up some of the gains that it has seen over the past few weeks if the Federal Reserve is not as accommodative as the market is pricing in. There is a very real risk of that, as the market is pricing in a "Goldilocks scenario" that seems unlikely to actually occur. The PIMCO Strategic Income Fund also trades at an enormous premium on net asset value adding even more risk. It might be best to keep watching this fund and waiting for a better entry price.
For further details see:
RCS: A Decent Bond Fund, But Best To Wait For A Better Entry Price Given Risks