Why I Sold Pimco High Income Fund
Summary PHK has managed to attract a premium near its historical average before its dividend cut. Although another cut is unlikely in the near term, the current premium is overly generous. Historical price trends have created clear buy and sell signals which indicate PHK is too pricey at its current premium. However, if PHK can continue its recent and opaque increase to NAV, a new higher price target may be in order. Pimco High Income Fund (NYSE: PHK ) consistently paid out the same dividend for over a decade, until a 15% cut that management insisted was reflective of the secular stagnation argument for lower global growth that has come to quietly dominate many economists’ thinking. In management’s words: “Generally, the changes in distributions for PHK, PCI and PDI take into account many factors, including but not limited to, each such Fund’s current and expected earnings, the overall market environment and Pimco’s current economic and market outlook.” The market’s response was unsurprising – the fund reached a 52-week low of 6.87 and saw its premium to NAV – once the highest in the CEF universe – fall to zero. This was a tremendous buying opportunity and I heavily added to my position before encouraging investors to not worry about a dividend cut anytime soon . A dividend cut remains unlikely. Since October, the new payout has remained steady. In November, NII covered distributions by 92%, and NII has remained just a hair under 10 cents since April, when NII fell precipitously to about 7.2 cents per share, as it also was in March and January. 92% is still not full coverage, leaving some investors concerned about PHK’s future payouts. However, PHK is preparing for an interest rate hike and the ability to buy new issues at new, higher rates. Prepping for the Rate Hike The duration of PHK’s holdings has fallen to 4.7 years as of the end of September, down from over five years earlier in 2015. The fund has been cutting the duration of its holdings for a long time in anticipation of raising rates, which actually hurt performance in 2014, as management acknowledged in its semi-annual report from September 2014 – and which management attempted to rectify by buying swaps: “Despite the Fund’s short exposure to the long end part of the curve, which has hurt the performance, overall increased duration exposure with interest rate swaps contributed positively to performance as Treasury rates declined.” Now the fund seems to be doubling down on its expectation of an interest rate hike. If Yellen does raise rates in December or early 2016 and high yield issues offer higher yields as a result, PHK will be able to churn into higher yielding debts and fully cover dividends more easily. (For more on how higher rates can be good for PHK, please see my two earlier pieces on the subject: Part 1 and Part 2 ). A Safe Payout – So Why Sell? The market seems to have accepted that PHK’s new distribution is about as safe as the old one, and may last just as long before being cut again. Yet I sold the fund because the market has overpriced the value of PHK’s new payout. As of November 25th, the fund’s premium over NAV was 24.65%, almost at the average premium the fund enjoyed over its lifetime before the dividend cut: In other words, the market is roughly pricing the fund’s ability to fund future payouts at the same premium as it has priced that fund’s future payouts before the dividend cut. At best, the market is punishing PHK with a premium that is 5% below its historical average. Is that sufficient for a 15% dividend cut? The Technical Concern There also is a technical argument to be made against buying PHK now – but keeping it on a watch list in the future. Since 2010, when the fund’s premium to NAV remained sustainably high, PHK has followed a steady pattern of slow appreciation to a peak, followed by a decline, and then a steady appreciation again: (click to enlarge) This pattern held for most of 2014 until the high yield market began to see serious risk aversion and a tightening of credit spreads at the end of the year, partly due to the strong dollar, partly due to rising oil prices, partly due to fears of collapsing liquidity, and partly due to fears of higher defaults resulting in an increase in interest rates: (click to enlarge) While I believe short-term speculation on asset prices is almost always a losing game, in the case of PHK the return to form seems to be congealing, and since the dividend cut the slow appreciation followed by a steep drop-off seems to be coming back to the name: (click to enlarge) However, we are currently not seeing a steep sell off as we did in the middle of September and earlier in November. This trendline, its historical performance, and its new payouts have all given me clear price targets to buy, sell and hold this stock which are currently telling me to wait until returning to the name. A Silver Lining? There is hope for PHK, however, which may help it close the gap on its current premium. In the last few days the fund’s NAV has shot up to its highest point since its dividend cut and the first sign of an increase in NAV since the beginning of 2015: (click to enlarge) It’s unclear how the NAV for PHK shot up so quickly in such a short period of time. Because bonds, especially high-yield bonds, are particularly illiquid, this could be the result of a new mark-to-market for a holding that was temporarily mis-priced due to thin trading. Alternatively, it could be a result of a cumulative appreciation of the high yield market as the fears of earlier in the year briefly fade. A third option is that the fund made a new purchase that was particularly undervalued by the market. In any case, the fund’s NAV shot up after the spread between high yield and U.S. Treasuries widened, giving more opportunities for fund managers to find high-yielding assets to fund distributions: (click to enlarge) This could mean PHK will find more ways to increase its NAV and close that gap between its current premium and the premium that it deserves after a dividend cut. I will continue to watch PHK closely to see if its ability to increase NAV is sustainable, or if the market decides to under-price the fund again. Until then, I’m waiting on the sidelines.