PIMCO CEF Update: PDX is in no rush to be a credit fund

In this article, we provide an update on the PIMCO CEF suite. Specifically, we’re discussing changes in distribution coverage in July. We also discuss the allocation profile of Dynamic Income Strategy Fund (PDX) and its apparent strategy to remain less of a credit fund and more of an energy fund that many investors expected at the time of its strategy change at the end of 2023.

Coverage update

Based on six-month figures, distribution coverage in the taxable and tax-exempt suites continued to grow. As we highlighted previously, much of the apparent strength of taxable funds is in PDO, whose 6-month coverage is 116% – the only taxable PIMCO CEF with distribution coverage above 100%. The average in the rest of the taxable amount is 73%. Although most funds have seen an increase in coverage, the absolute numbers are not particularly impressive.

More interesting, perhaps, is the continued rise in municipal fund coverage levels, with the average now hovering at 113%. All PIMCO Muni CEFs have 100% north coverage. What’s particularly odd about this rise is that the short-term rates that serve as the anchor for the cost of leverage haven’t changed that much yet, given that the Fed has yet to cut policy rates. This at the same time as the funds’ fixed rate assets are, well, fixed. With short-term rates unchanged, and therefore leverage costs and asset coupons unchanged, the rising coverage of Muni funds is somewhat of a puzzle.

That said, there are a few other factors that could drive net investment income and, by extension, coverage to increase. Muni yields have fallen, which, by reducing leverage, creates additional capacity for funds to add assets and income. Second, the funds can be rolled into higher coupon municipal bonds. Third, funds could rotate to slightly less expensive leveraged facilities, such as bonds with a tender option over floating forward rates. Some of the funds saw an increase in outstanding preference, however, the increase is not large enough to account for all of the increase in coverage.

The increase in Muni coverage coincided with the redemption of nearly all of the funds’ auction preferences, or ARPSs, which makes sense because ARPSs were very expensive. At the same time, coverage levels above 100% are not supported by fund shareholder reports, which show a high level of ROC. Finally, we don’t take the 100%+ coverage figures at face value and our view remains that the funds are, in fact, overallocated.

PDX is in no rush

As many investors remember, PDX was an energy-focused fund. At the end of 2023, it changed its name from “Energy and Tactical Credit Opportunities” to “Dynamic Income Strategy Fund”. It also changed its strategy from investing at least 80% of its net assets in the energy sector to investing at least 25% in the energy sector. The new name was a kind of mix between the Income Strategy Fund (PFL) and the Dynamic Income Fund (PDI), both of which are entirely credit funds. This probably gave the impression that PDX would be moving to a more credit focused fund. However, this did not actually happen.

The Fund maintains a consistent allocation to both common stocks and exposure to MLP stocks, as shown below.

The overall equity allocation is close to half of the portfolio and not far from the fixed income allocation.

Finally, its energy allocation is around 65% of the portfolio, well above the 25% threshold.

All in all, it’s fair to say that PDX is in no rush to change its allocation, and so, 9 months after announcing its initial strategy, investors shouldn’t hold their breath. Given that the fund’s current allocation is entirely in line with its strategy guidelines, the significant equity and MLP allocation is likely there for the long term. If the fund is able to shift its $212 million position in Venture Global, perhaps it could then increase its credit allocation; however, this is speculation.

After an initial tightening of the discount following the announcement of the change in strategy, the discount has stagnated around the double-digit level. This is in contrast to an average double-digit premium across the rest of PIMCO’s taxable portfolio. As long as the fund’s allocation remains focused on MLPs and equities, this is unlikely to change in our view. We can see this in the fact that the discount PGP – a mixed equity/fixed income fund trades at the lowest valuation in the PIMCO taxable suite and the fact that the MLP sector CEF shows the second highest discount in the CEF space.

Returns and Rating

The PIMCO taxable funds with the strongest returns to date are the CMBS overweight pair PAXS and PDO, as well as the equity overweight PGP. Despite the ongoing crisis in the office space, the broader CMBS sector has performed well this year and continues to trade at a relatively high yield. On average, PIMCO’s CEFs have outperformed their multi-sector peers this year. Despite its steady decline, PDX was able to outperform in the PIMCO tax pack thanks to the strength of the MLP sector.

The average premium of taxable funds is quite high compared to the last few years, although below its historical level.

The average PIMCO CEF taxable premium is approximately 18% above the rest of the taxable CEF market.

Unlike their taxable counterparts, the national PIMCO Muni CEF ratings are not far from the broader municipal CEF sector. Earlier distribution cuts and disappointing performance due to high leverage have soured investors’ views on the suite.

RCS is somewhat unusually the highest premium fund in the taxable suite. The fund has delivered a total NAV CAGR return of 3.5% over the last 5 years, which looks interesting to many people despite the underperformance of average multi-sector CEFs. At that valuation, and given the composition of the fund’s portfolio, it is almost impossible for it to outperform the investor’s capital (ie taking into account the premium) going forward, unless the premium continues to move further from the levels stratospheric.

From 2022, the NPVs of taxable funds have fallen substantially. Because distributions have not adjusted, this has made the funds more attractive to some investors as distribution rates have increased.

We’ve previously highlighted our preference for PDX and PGP, and they’ve performed well this year. They provide an attractive component to higher quality/longer duration holdings such as muni and preferred funds in a limited income portfolio.

Ultimately, the performance of CEFs will be determined not only by idiosyncratic factors but also by the broader market environment. And in this regard we remain cautious. Our CEF valuation ‘swirlogram’ shows that we are very much in the expensive CEF valuation quadrant – not far from where we were at the end of 2021. The only difference is that the discounts are slightly wider and nominal interest rates are higher than in 2021. 2021. This suggests that we are likely to see better entry points into the CEF for new capital in the medium term.