Income

PIMCO Dynamic Income Fund: Not out of the woods yet (NYSE: PDI)

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Thesis

The PIMCO Aggressive Income Fund (New York Stock Exchange: PDI) has seen choppy times since 2020 following the outbreak of the pandemic. As you can see from the following graph, the fund has provided good returns to its investors in the past. Its annualized returns (including dividends) have averaged 9.3% CAGR since inception and 4.36% CAGR over the past five years. In contrast, its total return over the past three years has been negative 1.83% and investors have suffered a considerable loss of 8.9% since the start of the year.

Such a large correction brought the valuation and dividend yield back to an attractive level. Currently, the fund is yielding 12.8% and its premium is near a multi-year low. However, my thesis in this article is to warn readers not to be seduced by cheap valuation and high surface yield. As you will see next, there are substantial interest rate risks ahead, and the valuation isn’t that cheap when adjusted to risk-free rates.

PDI

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Z-score and dividends are attractive

Price declines in the recent past have brought the valuation of PDI to an attractive level. The fund was once a flagship fund (perhaps still is) in its own space and has always enjoyed a considerable price premium. As you can see from the following chart, its average premium has been consistently above 10% in the past through 2020. Its premium has averaged around 10.2% over the past five years and 11 % over the last three years. Due to recent price contractions, its premium is down to just 3.46% at the time of this writing. Such a premium brought the Z-score back to the current value of -0.77 on an annual basis, indeed a quite attractive level.

In terms of dividends, the fund now yields 12.8%. It is not only significantly higher than most benchmark rates such as the 10-year Treasury rate (around 3.2%), the S&P 500 (around 1.6%) or the BAA yield (around 5.4 %). It is also at an attractive level compared to its own all-time high. Over the past three years, the fund has returned an average of 10.6%. And, over the past five years, it has returned an average of 10.4%. Its current yield of 12.8% is more than 20% above these historical averages.

So if you are attracted to PDI, there are certainly good reasons. However, my opinion is that you should not be seduced by the cheap premium and high return. Premium is cheap only in relative terms. The fund always sells above its net asset value. In terms of profit, as you will see immediately below, there are substantial headwinds that will weigh on its earnings in the near future.

PDI

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Headwind 1: The Yield Curve Could Invert

The fund’s first priority is to seek high current income (and capital appreciation is a secondary priority). Within such a focus, the fund invests primarily in debt securities, as shown in the following fund description (emphasis added by me):

The fund normally invests worldwide in a portfolio of debt and other income-generating securities of any type and credit quality, with varying maturities and related derivative instruments. The fund’s investment universe includes mortgage-backed securities, investment grade and high yield corporate bonds, developed and emerging market corporate and sovereign bonds, other income-producing securities and related derivative instruments.

The fund will be under two pressures in the current inflationary environment. First, all of its exposures are interest rate sensitive. Take the example of its mortgage exposure. The mortgage sector is its main exposure, representing approximately 30.2% of its total assets. In an inflationary environment, the mortgage industry will come under enormous pressure as the yield spread narrows or even reverses. And the yield curve, defined as the yield spread between 10-year and 2-year Treasury yields, did indeed briefly invest in April 2022.

Second, rising interest rates will also put pressure on the fund’s earnings by increasing its borrowing costs. A big reason for its success in the past is attributed to its use of high leverage and lower borrowing rates. At the time of this writing, the fund has total investment exposure of $8,386 million, total common assets of $4,488 million, and therefore total debt of $3,897. Such a level of indebtedness results in a relatively high effective leverage ratio of 46.48% and makes it sensitive to further increases in borrowing rates.

PDI

PDI Fund Description

Headwind 2: Relatively narrow performance gap

In terms of dividend yields, current PDI yields aren’t that high when adjusted for risk-free rates. An effective way (and in my opinion the only reasonable way) to gauge dividend yield is to assess valuation relative to risk-free interest rates. The details of these concepts and approaches were provided in our previous article:

Dividend yields and the yield spread are what we check first before making any investment decisions. Fortunately, we have had very good success with this approach due to:

  • Dividends provide a back door to quickly estimate owners’ income. Dividends are the most reliable financial information and the least subject to interpretation.
  • The dividend yield spread (“YS”) is based on timeless intuition. No matter how times change, the risk-free rate serves as the gravity of all asset valuations and therefore the spread ALWAYS provides a measure of the risk premium investors pay over risk-free rates.

Against this backdrop, you will see below that when adjusted for interest rates, current PDI dividends are less attractive than on the surface.

The first chart below shows the yield spread between the PDI and the 10-year cash since 2014. The dividend yield is calculated based on TTM dividends. As can be seen, the spread is limited and treatable most of the time. The spread was between about 7.0% and 12.0% most of the time. Which suggests that when the spread is close to or above 12.0%, the PDI is significantly undervalued relative to the 10-year treasuries (i.e. I would sell treasuries and would buy PDI). And when the yield spread is close to or below 7.0%, it means the opposite.

Today, the spread is around 9.6%, near the middle of this historical range. So while the 12.8% dividend yield is attractive in absolute terms, there is no apparent safety margin in terms once the risk-free rates are adjusted.

PDI

Author

Finally, for readers familiar with our analyses, you know that short-term returns are highly correlated with the yield spread for funds or stocks that have demonstrated earnings power and stable dividends. This is also true for PDI. The chart below shows the 2-year total return (including price appreciation and dividend) of PDI when purchased at different yield spreads. You can see there is a clear positive trend, and the Pearson correlation coefficient is 0.85. And again, the current yield spread of 9.6% does not provide a clear buy signal.

PDI

Author

Summary and other risks

There are good reasons for PDI to grab your attention now. Its return of 12.8% is more than 20% higher than its historical averages of the last 3 or 5 years. Its premium to NAV is near a multi-year low. However, the thesis here is to warn you not to be seduced by cheap valuation and high surface yield.

Its earnings will come under two pressures in the current inflationary environment. First, all of its exposures are interest rate sensitive. And second, it uses relatively high leverage (with an effective leverage ratio of 46.48%) and rising interest rates lead to higher borrowing costs.

Its dividend yield is around 9.6% above risk-free interest rates, close to the middle of this historical range, thus offering no apparent margin of safety.

Finally, note that PDI’s higher expense ratio will continue to create a structural headwind going forward. The management fee alone is 1.1%, and the total expense ratio (excluding interest expense) is 2.04%. Compared to its long-term annual return of 9.3%, fees already accounted for nearly 12% and 22% of its pre-tax returns. When borrowing costs are included, the total expense ratio is 2.78%. And as mentioned above, the cost of borrowing may increase further in the future if inflation persists and interest rates continue to climb.

PDI

PDI Fund Description