The PIMCO Dynamic Credit and Mortgage Income Fund (PCI) is an attractive closed-end fund (“CEF”) considering its big 8.6% yield, discounted price versus its net asset value (“NAV”), and because its share price has been performing very well (see price chart below). However, past performance is no guarantee of future results (or anything, really, for that matter), and a look under the hood shows that PCI is exposed to some very big risks. This article provides an overview of the fund, reviews the big risks investors may want to consider, and concludes with our opinion about investing in PCI.
PCI Is Attractive for Multiple Reasons:
Delivering Strong Income & Price Appreciation: PCI is attractive because it has been successfully delivering on its income and price appreciation objectives. Specifically, the objective of the fund (according to PIMCO) is “to seek current income as a primary objective and capital appreciation as a secondary objective.” And for your reference, the chart below shows how well the fund has been achieving those objectives in recent years. Specifically, the price has been up and down (but up significantly since 2016), and the total return (price appreciation plus income distributions) has been up a lot for a fixed income fund (it’s up over 67% since 2016).
Flexible Investment Mandate: PCI has a wide mandate in terms of what types of fixed income securities it can own, and the fund has been able to generate its recent attractive returns and big income payments by owning mainly non-agency mortgage securities, as well as a variety of others, as shown in the following table (holdings as of 10/31/18).
Non-agency mortgage securities generally pay higher interest rates than agency mortgage backed securities, but non-agencies are also riskier because they’re not guaranteed by government supported agencies like Fannie Mae, Freddie Mac or Ginnie May. Non-agency loans can include jumbo mortgages, commercial mortgages and subprime mortgages—such as the ones that led to the financial crisis. This will be important when we discuss the big risks later in this report.
Special Dividends: Also worth mentioning, PCI has a history of paying out an additional “special dividend” in December. Although one was not paid in 2017, it was paid in 2016, 2015, and 2014. And based on the fund’s recently released Undistributed Net Investment Income report, it seems highly possible a special dividend will be declared and paid this year, considering PCI’s distribution coverage ratio year-to-date is over 121%, and it’s around 180% over the last 3- and 6-month periods. Historically, the special dividend is declared in late December, and it goes ex-dividend in late December, so there is still time to “get in” on the special dividend if one is to be declared this year (which seems increasingly likely).
Discounted Price (versus NAV): another attractive quality for PCI is that it currently trades at a discount to its net asset value, or NAV. Closed-end funds often trade at significant premiums and discounts relative to the value of their holdings because they are “closed” meaning there is no mechanism to keep the price close to the NAV as there is in ETFs or mutual funds, and rather CEF prices are driven by supply and demand. The discount basically means if you invest in PCI you are buying the income payments of the underlying bonds, at a discount. We’ll have more to say about the discounted price later in this report.
The Big Risks:
Despite PCI’s attractive qualities, it also faces a variety of big risks. And we have highlighted a variety of them below.
PCI Holds Risky Assets: Simply put, this fund invests in higher risk assets. As we saw in the table earlier in this report, the majority of the assets are risky non-agency mortgage securities (as described earlier). Also, you can see in the table that only a small percentage of the holdings are “investment grade.” The fund’s management team makes it clear that PCI holds risky assets in their most recent quarterly update by writing (emphasis ours):
“Despite lingering tensions between the U.S. and China and challenges in emerging market assets, as strong fundamental backdrop persisted and contributed to outperformance of U.S. risk assets relative to those abroad. U.S. equities rallied, corporate credit spreads tightened, and the dollar strengthened. Meanwhile, The Fed and BoE both hiked, the ECB confirmed plans to cease asset purchases by year-end, and the BoJ adjusted its yield curve control policy.”
The fund management team is attributing their strong performance (through Q3-18 to the outperformance of “risk assets,” which is basically what this fund owns. When the market is healthy, this fund’s assets perform well, but when we enter a “risk-off” environment—the fund underperforms (often by a lot). And for more perspective, we actually saw this fund start to sell off and underperform in October and November of this year. The big question now is, are we in the first or the last inning of the sell-off? (or somewhere in between). The point is that when the market gets soft, PCI can perform very poorly.
Credit Spreads Can Blow Out: This next chart shows what happens to the price of PCI when credit spreads “blow-out” as they started doing in early October. Specifically, PCI sold-off because that’s what “risk assets” do when credit spreads widen. For perspective, we also included the price change for a treasury ETF to show that treasuries are a “flight to safety” asset, and they do the opposite of PCI in risk-off environment. Worth mentioning, our price chart near the beginning of this report shows how dramatically PCI sold-off in 2015 (and into 2016) when credit spreads widened much further than they have so far this quarter (i.e. PCI could still sell-off much more).
The Discount to NAV Can Get Much Wider: This next chart shows that although PCI currently trades at a discount to its net asset value, that discount can still get much wider as it did in 2015 (i.e. this would cause significant downward pressure on the price of PCI).
Prepayment Speeds Can Increase: If something dramatic were to happen in the housing market, this could have a dramatic impact on the value of this fund considering it owns mostly mortgage securities. For example, if new housing market regulations were introduced or if interest rates were to decline, these could both accelerate prepayment speeds of the underlying mortgages and adversely impact the value of the fund. This fund’s price volatility is driven more by mortgage credit spreads than by interest rate risk, but it does have a duration of 4.9 years and Fed Chairman Powell recently suggested interest rates were approaching normal (which is a change from what he said in his previous statement).
Significant Leverage: Another big risk factor to be aware of with this fund is that it uses a significant amount of borrowed money (i.e. leverage). This is not uncommon for closed-end funds, but it does add risk. Specifically, when times are good, the leverage is helpful. But when things sell-off, the leverage makes things worse. Granted this fund gets institutional rates on its borrowing (i.e. it costs less for PCI to borrow than the average investor), and PCI has a disciplined process is place to monitor and manage the leverage, but it’s still a risk. Most recently, the leverage ratio was 43.6%; that’s a lot for a risky bond portfolio, and it’s a big part of the reason the returns have been even more volatile over the last two months.
High Expense Ratio: The expense ratio on this fund is high, and expenses detract from your total returns. According to PIMCO, the gross expense ratio is 4.2% and the net expense ratio is 2.1%. The gross includes the cost of borrowing (the leverage we discussed above). Nonetheless, a 2.1% net expense ratio (which includes operating costs and management fees) is a lot, even for a closed-end fund. And it is a risk that detracts from your returns.
Conclusion:
As you may be aware, we currently own shares of PCI, but we like to balance out its risks with a lower risk bond CEF (BTZ) which has lower risk assets (BTZ is also currently trading at a bigger more attractive discount to NAV, uses slightly less leverage, and has a significantly lower expense ratio, but also a moderately lower yield). We recognize the risks of PCI as described above, but we don’t expect the shares to sell-off significantly more than they already have. However, if we are wrong, that’s why we own both PCI and BTZ within our even more widely diversified, attractive holdings, portfolios.