Buy The Big Dip +13%: PDI (NYSE:PDI)

In collaboration with Treading Softly

Have you ever thought about taking survival gear with you in the car or when you go camping?

When you look at survival gear, it can often seem like a lot of extra weight or a little tangible benefit in advance. However, the saying holds true: “I’d rather have it and not need it than not have it when you need it.”

When you have a flat tire, you want to have that spare even though 99% of the time, you don’t need it. In that moment of need, it’s better to have it and have it for all those times you didn’t need it than to need it and just not have that spare tire. Also, if you are camping and there is a wild animal situation, you would rather have security and the ability to protect yourself than not, and possibly be left to what the animal decides to do to you.

There are fewer emergency panic situations that you need to have a backup for in the economy. Interest rates could play a massive role in stimulating or slowing economic activity, and the Federal Reserve must strike a delicate balance between trying to maintain an economy that benefits the average person while controlling inflation so it doesn’t run away and cause irreversible damage. The question becomes when the Federal Reserve decides to take action: Did they move too fast or did they move too slow? It’s incredibly difficult to move at the right time, especially when the impact of your choices isn’t usually fully seen until a year or two later. This is how interest rates work when the Federal Reserve decides to lower or raise them; it takes time for it to seep through the economy and show its effects.

As income investors, we have the advantage of being able to buy in all market situations. This means that we are buying very valuable income today, tomorrow, the day after, and so on, regardless of what the Federal Reserve decides to do or what administration is in office.

The questions are: “What income is the best to buy?” or “Where should we focus our attention?”

Today, let’s examine exactly that question and give an example of a place that I think is worth buying income from.

Let’s dive in!

Is it cut too early or too late?

The Fed is finally getting ready to cut interest rates, and mortgage rates are falling in response. As with other types of debt, lower rates mean higher prices.

The 30-year mortgage rate hit its highest level since 2000, meaning for mortgage investors, prices were the lowest since 2000. Mortgage rates have started to fall, but history suggests they could fall further as The Fed is starting to taper. When the Fed started cutting rates in 2001, mortgage rates fell (prices rose) for about three years.

It was a great time to own mortgages. It was mortgage performance during this period that led to the mortgage over-enthusiasm of 2007. Mortgages were viewed as “safe” investments because it is a bill that most people are inclined to go to extreme lengths to pay. and when they did default, properties could often be sold for more than was owed. MBS (Mortgage-Backed Securities) became highly sought after as mortgages were packaged and repackaged into CMOs (Collateralized Mortgage Obligations) and CMO squared – CMOs that owned CMOs. All of this enthusiasm for mortgages stemmed from the experience that mortgages proved to have low default rates and rising prices through the Dot-com recession. As an asset class, those who invested in mortgages through the Dot-com bust were rewarded. And, as the market is apt to do, it takes a perfectly good thing and goes too far with it.

Today, things are much different. The Great Financial Crisis is strong in investors’ memories. Even though the CMO and the square CMO are in a museum next to a Tyrannosaurus Rex skeleton, the fear remains. So many investors have been burned by mortgages, especially those who dumped them for pennies on the dollar. They had bought high and sold low. Who buys?

PIMCO is a fund manager with over $1.8 trillion in assets under management. It is highly regarded for fund management, particularly in the fixed income sector. At High Dividend Opportunities, PIMCO is one of our favorite CEF (closed-end fund) managers, and we own several of them. During the GFC, PIMCO was one of the main buyers of non-agency MBS, buying mortgages that others were selling at distressed prices. Many of those mortgages ended up in PIMCO Dynamic Income Fund (NYSE:PDI), resulting in 13.6%.

while POI is diversified, with non-agency mortgages accounting for almost a quarter of its assets and over 57% of its DWE (Duration-Weighted Exposure). Source

As a result, we can expect the PDI to be particularly sensitive to what happens to mortgage rates. In recent years, this has been a clear negative as mortgages have underperformed corporate and other types of debt. The main reason for this underperformance lies with the Federal Reserve.

The Federal Reserve has been a significant buyer of “agency” MBS. These are mortgages that are guaranteed by agencies such as Fannie Mae or Freddie Mac. MBS held by PDI are different; they are not guaranteed and are credit risk. In other words, if a borrower defaults, PDI gets less money. Whereas with an agency MBS, if a borrower defaults, the investor is complete.

However, the price of non-agency MBS will be significantly affected by the price of agency MBS. After all, investors should always be willing to pay more for an alternative that has no credit risk. At the end of 2022, the Fed stopped buying MBS and began allowing its balance sheet to “run down.” In other words, it allowed MBS to mature without replacing them.

The loss of the largest buyer of MBS since 2010 had a negative impact on agency MBS prices, which in turn affected non-agency MBS prices.

Bottom line: Buying low and selling high starts with buying low. PIMCO bought non-agency MBS when it was very low following the GFC. Today, we have the opportunity to buy PDI while it is low and enjoying high earnings and price recovery as lower interest rates provide a tailwind for valuations of all debt. MBS sold off largely due to technical conditions rather than fundamental concerns about the borrower’s ability to repay. This means more growth potential for us.

Conclusion

PDI is a great example of an income investment that is trading well below its past prices, but poised to rise quickly as interest rates fall.

The Federal Reserve is unlikely to cut interest rates once to the perfect value. QE often occurs in cycles, with multiple rate cuts, with a wait-and-see approach between each one, waiting to see how the economy and market react before proceeding with further rate cuts.

As rates go down, everything is adjusted on the risk scale. Treasuries will see lower yields as well as mortgage bonds and so on as everything adjusts to the new paradigm in the interest rate environment. This adjustment means that the trading values ​​of those different vehicles increase, so their yields may decrease. Essentially, what we will see is a slower version of what we saw when interest rates went up. When interest rates rose rapidly, the trading value of these various investments fell in line with the new interest rate paradigm. As interest rates fall, the values ​​of these investments will rise again.

This means that the various holdings within the PDI will be direct beneficiaries of every reduction in interest rates, and you can be a direct beneficiary alongside them by owning them through the PDI itself.

When it comes to retirement, it’s often great to collect income from sources that will benefit from changing interest rates, all without having to do the work of choosing those investments yourself. The team at PIMCO has a legendary track record of delivering returns and value to its shareholders, simply because they know the credit markets like no other. You don’t have to be an expert in the credit market, having originated loans or trading loans on a secondary market, to benefit from them. You simply have to know who to use to your advantage. This is one of the major benefits of my Unique Income Method; we understand our limits and know where we need to increase them by reaching out to experts. That way, whether interest rates rise, fall or trend sideways, you can collect massive amounts of income from the market to stoke your spending fires and leave you with a reservoir of cash in your coffers.

This is the beauty of my income method. That’s the beauty of income investing.