The purpose of this article is to evaluate the PIMCO Dynamic Credit Income Fund (PCI) as an investment option at its current market price. PCI has seen some weakness in October, along with most of the broader market, but I believe this opens up a reasonable buying opportunity. The fund’s coverage ratios are weak, and refinancing activity will remain high, so that is certainly a key risk. However, with a yield over 11% at current prices, PCI can afford to adjust its distribution and still offer a very competitive income stream. Further, mortgage delinquencies, while high on a historic look-back, have been declining in the short term. This shows the housing market is improving, justifying positions in MBS. Finally, PCI has a current valuation very close to par, which is generally a very attractive time to initiate new positions.
First, a little about PCI. It is a closed-end fund with a primary objective “to seek current income, with a secondary objective of capital appreciation”. Currently, the fund trades at $18.90/share and pays a monthly distribution of $.1740/share, which translates to an annual yield of 11.05%. I reiterated my neutral view on PCI during my previous review in July, as I continued to view risk-on assets cautiously. In hindsight, this outlook was reasonable, although perhaps too pessimistic, as PCI has registered a gain around 3% since then:
Source: Seeking Alpha
As we approach the end of the year, I thought another look at PCI now was timely, to see if I should consider changing my outlook. After review, I see a bull case emerging, given the fund’s cheaper valuation, combined with on-going volatility in the equity market. As such, I have increased my rating to bullish, and I will explain why in detail below.
Price Is Cheap Based On Short-Term Valuations
To begin, I will take a look at PCI’ valuation. While the fund does sport a slight premium, it is actually quite small based on its trading history. Unlike many other CEFs, PIMCO’s products tend to trade at premiums consistently, and sometimes quite large premiums. PCI, while rarely in the double-digit premium range, does tend to trade at a premium price above where it currently sits. I view this positively, and more so now than during my last review.
To understand why, consider that, despite PCI rising in market price since late July, the fund is actually cheaper to buy now than it was then. This indicates PCI is seeing its underlying value increase, which is always a positive sign. To put the current figure in perspective, see the chart below:
|Current Premium to NAV||1.0%|
|Premium to NAV in July||2.3%|
|YTD Premium Average||4.5%|
|Current Premium to NAV – PDI||3.2%|
The takeaway here is PCI seems quite reasonably priced at current levels. The fund is slightly cheaper than it was in the middle of the summer, and has a noticeably lower premium than its year-to-date average. Further, its premium is also lower than the current premium for its sister fund, the PIMCO Dynamic Income Fund (PDI). This tells me PCI offers a reasonable buy-in point, and I believe investors should not expect the current valuation to be available for long, as the fund’s history suggests a higher premium is likely to re-emerge.
Mortgage Market Is Actually Improving
I will now shift to the underlying securities within PCI, to expand on why I like the fund at these levels. While PCI’s valuation is enticing, the fund does still trade at a premium, and the Q1 sell-off shows the fund can trade at steep discounts when conditions deteriorate. Therefore, it is critical to examine the fund’s holdings, to gain confidence that we won’t see a repeat of sharp losses.
First, I will take a look at the mortgage market, which is usually the area I focus on when I review PCI. This is because agency and non-agency MBS make up the bulk of fund holdings, and it has been this way for some time. While PCI’s exposure to the MBS sector has declined by about 5% since my last review, it still stands at over 45% of total fund assets, as seen below:
As my readers know, mortgage debt is an area I have preferred for a while, although I have been favoring agency MBS given the challenging macro-climate. While I still feel investment grade debt is the right play for the risk averse, I see some merit to increasing exposure to the non-agency MBS sector for the time being. While this sector lacks the direct Fed support that the agency MBS sector is receiving, improving conditions in both the labor and housing markets give me comfort that we won’t see a return to Q1 lows.
For support, let us consider employment figures. While an 8% unemployment rate is not something to necessarily celebrate, we have to recognize this is a sharp improvement from where we stood a few months ago, as seen below:
Source: Bureau of Labor Statistics
Ultimately, this graph shows we have a long way to go, but it also shows improvement. Fortunately, this improvement is making its way into the mortgage market. In fact, mortgage delinquency numbers improved in September, with the number of seriously delinquent mortgages (90+ days) falling for the first time since the start of the pandemic. According to data analytics firm Black Knight, the number of properties in all stages of delinquency declined in September, which is an encouraging sign:
Source: Black Knight
My point here is it appears the worst may have passed. In fairness, the broader economy still faces some significant challenges, and millions of mortgages are still in forbearance. However, we are seeing signs of progress, and I have to expect we will continue to see better numbers in the months ahead as more jobs come back.
My takeaway is this reality supports building a stake in PCI right now. I was cautious before, as PCI had a slight premium, but the fundamentals of housing market were deteriorating. Today, PCI has a cheaper price, and underlying metrics are improving. While non-agency MBS do pose a higher risk than agency, rising home values continue to increase the amount of equity homeowners have in their homes. This is a trend that has been on-going over the past decade, and continues today, despite the pandemic, as seen below:
Source: St. Louis Fed
As home values and equity rise, homeowners have that as an added incentive to avoid foreclosure, supporting the underlying securities in a fund like PCI. My conclusion here is the macro-conditions warrant buying in to MBS for now.
Income Metrics Remain Weak – Refinancing To Blame
Through this review, my take on PCI has been quite positive. However, I must point out this is not a risk-free investment. While I see merit to buying a sector like non-agency MBS over other, non-investment grade sectors, we have to recognize there are factors that could send PCI lower. One area of particular concern is the fund’s income production, which has been quite weak over the past few months. While delinquency figures have improved in the MBS market, they are still at a historically high level for the past decade. This has taken its toll on PCI’s income metrics, which were quite poor in the most recent UNII report for September, as seen below:
It is fair to say this should give investors some caution. The coverage ratios are a red flag, and the negative UNII balance has remained stuck at $.25/share. This is about one and a half months of income in arrears for the fund. Add this story up, and investors have a right to be concerned about the sustainability of the current income stream.
With this in mind, it is worth examining why this is the case, and much of it has to do with refinancing across the fixed-income world. As corporations and municipalities have taken advantage of lower interest rates in historic ways, so too have homeowners. A large percentage of new mortgage applications are related to refinancing, as homeowners are locking in historically low rates. This impacts PCI’s income stream, as fund management will have to replace those refinanced/retired securities, with new ones at prevailing, lower rates.
While refinancing activity was its highest back in Q1, the trend has not gone away by any stretch. Yes, the amount of refinancing has come down, but it has remained stubbornly high as 2020 has gone on, well above the activity we saw in the last few years, as illustrated below:
The point here is to emphasize that the income challenge facing PCI is not going away. Refinancing will remain a major macro-trend as long as interest rates remain at historic lows. With the Fed unlikely to make any adjustment to the benchmark rate until 2021 (if then), PCI, and other funds like it, will find it challenging to maintain their current distribution levels.
I have been reluctant to slap a buy rating on PCI for most of 2020, but I finally feel the time is ripe. The income coverage remains a chief concern for me, but that has more to do with the interest rate environment, rather than a deterioration of the fund’s underlying assets. With a double-digit yield, PCI is in the position where it could cut its distribution and still attract plenty of investor interest. That is a good position to be in. Further, the fundamentals of the MBS market are improving, as unemployment drops and more homeowners move to current on their mortgages. Finally, the fund has a very small premium to NAV, and is priced well below its own average, its primary rival (PDI), and most PIMCO CEFs. Therefore, I believe a bullish rating on PCI is justified, and encourage investors to consider this option at this time.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PCI over the next 72 hours. 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.