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Taxable fixed-income, closed-end funds have fared poorly in 2015. Highly visible distribution cuts by category leaders have been followed by sharp selloffs and price declines with very high premiums falling to discounts. There may be opportunities in taxable, fixed-income funds although one might want to wait for a decision on interest rates before taking any action. It took a long time but the market has finally decided that the PIMCO High Income Fund (NYSE: PHK ) is not worth a premium. After running a premium in the stratosphere for seven years, PHK closed below par today, just five months after running a premium of 66%. PHK was clearly a house of cards. It was earning less than 65% of its distribution. But investors stuck with the fund and even defended it vigorously long after the writing was on the wall. A distribution cut was inevitable and when it came it wiped the premium off the board. On Sept 1 the fund announced a 15% cut in its distribution. Now, two weeks later (Sept 14), what had been the second highest premium in fixed-income CEFs is gone. This chart shows PHK’s premium/discount history. What you may not realize is that the right side does not show a vertical cut-off of the mountain at the end of the chart; that’s a vertical drop to near-zero. Interestingly, if someone buys the fund at today’s discount, the yield will be 17.4% until PIMCO drops the distribution further. It was that sort of return that driving the premium, and I’d not be surprised to see that premium moving up between now the next cut. Some might argue that with that distribution there is an opportunity, but I’m certainly not among them. Continuing to deliver that distribution after September (ex-date was Sept 9) at today’s -0.43% discount, will mean PHK has to pay out 17.3% on its NAV [Distrib NAV = Distrib Price /(1-(Premium/Discount)]. So, if PHK was a house of cards, parts of that house remain standing. And inevitably they must fall. Look for another distribution cut soon. For those of us not invested in PHK, there is a lesson here. One might choose to avoid all closed end funds, especially in this time of market uncertainty. And the steady declines in fixed-income CEFs ( discussed here ) says that many may have taken that tack. To my mind there is real opportunity in this market even though returns have been dismal and discounts continue to grow. Identifying those opportunities with confidence is going to be tricky however. I’ve written several times about the PIMCO Dynamic Income Fund (NYSE: PDI ), most recently this week . It is, in my view, well poised to provide strong returns in the near- to mid-term future. One of its qualities, which so many funds in this category lack at present, is that it is earning its distribution handily. Its current undistributed net investment income or UNII as a percentage of its distribution is the highest in the category, a category where 55% of funds are failing to cover their distributions from investment income. What other funds might be attractive on this metric? Right now, the strongest subcategory looks to be mortgage bond funds. I’ll be discussing this group in detail shortly, but I’ll mention a few highlights here as preview. The Western Asset Mortgage Defined Opportunity Fund (NYSE: DMO ), the BlackRock Income Trust (NYSE: BKT ) and the First Trust Mortgage Income (NYSE: FMY ) are standouts for their positive levels of UNII. FMY’s modest market cap and volume make it somewhat problematic in terms of liquidity, which is always a consideration in CEFs. DMO and BKT fare better on liquidity metrics. DMO is paying a 10.2% distribution yield; BKT’s is 5.9%. DMO has the best 1yr return on NAV in the category and it has recently dropped to a small discount. Anyone interested might want to start with a hard look at DMO. PDI is another consideration in the mortgage space. Although not a mortgage bond fund its present portfolio (30 June 2015) comprises 66% mortgage securities, so today it is two-thirds of one. The potential advantage is that if mortgages go south, PDI’s management has the flexibility to move out as readily as they moved in. What about those with existing positions? My advice to anyone invested in fixed-income CEFs is to take a look at the NII status of their holdings to see how well the fund is earning its distribution. Negative UNII alone does not necessarily mean one should sell a fund, but a persistent negative on this metric is a most worrisome sign. It could well mean that one should start looking for a suitable exit point. Waiting until distributions are cut to bring them in line with NII can be devastating not only to income, but to the value the portfolio as well. I’ll add as an aside that the value of UNII as an indicator of a fund’s status and distribution stability does not transfer to many of the equity funds. Details are outside the scope of this discussion, but I’ll note many solid equity funds, especially those that use options (option-income or buy-write funds), routinely show negative UNII and its evil twin, Return of Capital. They can even be a part of a fund’s investment objectives as they can create tax-advantages to the shareholder. It’s not clear what the Fed will do this week, but should they finally decide to raise rates, expect a move out of many of the fixed-income funds and sharp increases in the absolute values of discount. That may well be the best buying opportunity since the infamous taper-tantrum. Time spent now searching out quality funds may be rewarded. Disclosure: I am/we are long PDI. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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