PTY and PDI: Abyssal Configurations (NYSE: PDI)

We’ve already covered the PIMCO junk bond funds. On our recent coverage, we had improved PIMCO Corporate & Income Opportunity Fund (New York stock market :PTY) to a “Hold” rating after having them at “Strong Sell” earlier in 2022.

We usually gave you a negative to extremely negative view on PTY and PIMCO Income Strategy Fund II (NFP). If you accepted, you stayed out and now you have money to buy many amazing offers with great returns. If you disagree, you own them and we can bring you the proverbial stork with good news.

Things will be better from here.

No, you won’t recoup your losses, but you should start seeing total returns in the positive column. We are also upgrading PTY from a strong sell to a hold while keeping PFN on hold.

Source: The paradox Cash looking like a trash can

It was a good time to call back the hostility as PTY CEF delivered a scintillating total return from there. This outperformed the broader stock market, represented below by the S&P 500 ETF (TO SPY) as well as SPDR Bloomberg Barclays High Yield Bond ETF (JNK).

We are here today to tell you why we are transferring PTY and its cousin, PIMCO Dynamic Income Fund (New York stock market :PDI) to a strong sale, once again. To do this, we will break down our thesis into 5 parts.

1) Recession seems inevitable

Faced with a constant deluge of data, investors often lose sight of the big picture. Although some recent data (consumer spending, GDP) are stronger than expected, forward-looking indicators have not budged. Major economic indicators are deeply entrenched in negative territory.

The LEI is the best track we have on manufacturing and non-manufacturing performance. The old data set already appears to be in recessionary territory.

Even companies are sending the same signal.

Regular disappointments during earnings season, on this scale, have only occurred in recent decades when the economy goes into a recession, or a financial crisis, or both.

Source: Bloomberg

Yes, we freely acknowledge that the exact timing may be difficult to determine. But that’s irrelevant in the larger scheme of things. You wouldn’t be too unhappy with yourself if you left the theater for five minutes. Before the fire broke out.

2) High yield bonds are not priced for recession

What makes our setup worse is that bonds in general are very poorly priced. Here, we are not talking about Treasury Bonds, which are in fact ringing a big alarm bell. We are referring to investment grade bonds and high yield bonds that value happiness and bliss as far as the eye can see.

For the curious, these models are based on the “deviations” of these bonds from historical averages and where they need to be to adequately discount risks.

3) PTY and PDI prices are much worse

Ok, so the recession is coming and bonds of all kinds are not priced for it, but what about PTY and PDI? Surely they are cheap? Well, if you bought them at the worst possible time, in the middle of 2021, then yes, they would seem relatively “cheap” to you.

Unfortunately, the two objective parameters by which we evaluate these funds suggest that they are anything but cheap. The first metric is of course where high yield bonds in general are valued and the answer is in point 2.

The second is how these funds are valued relative to their own net asset values. PDI is trading at a 13% premium to NAV. That’s an astonishing number considering that it results in a Z-score of 1.93.

A Z-score this high screams that your forward returns are likely to be very low, even ignoring other factors. But what struck us here was that even at the start of the ZIRP (Zero Interest Rate Policy), the fund was often trading at a steep discount. It wasn’t until after 2016 that investors let go of the idea that the Federal Reserve would ever offer them anything for their deposits and would offer that fund up to a constant premium. Therefore, the current premium is really weird in an era where you can get a 5% return from a 1-year treasury.

PTY is a bit cheaper compared to its short and long term history, but expensive, nonetheless.

The Z-score is a bit lower, but when this is over, we expect strong negative Z-scores to appear.

4) Avoid leverage over leverage

There are huge risks associated with buying high yield bond funds, and they get worse when you pay ridiculous premiums. With closed-end funds, you increase the additional risk by using leverage on leverage. PDI CEF is using 40.7% when last checked.

PTY has reduced it a bit recently.

However, both present an additional risk that we believe is inappropriate at this time.

Verdict

19 months ago, we used the same title for two of PIMCO’s flagship funds.

PFL, as can be seen, has had a total return, including distributions, of minus 21.38% since then. PTY fared better with a negative total return of 18.91%.

The maximum drawdown, including distributions, was 42% negative for PFL and 36% negative for PTY as of this article. While we don’t expect an exact repeat, we will simply say that a 10% repricing of high yield bonds, amplified by leverage and a move to a 10% discounted NAV will cause the price to fall 32.30% on the PDI.

On PTY, it works out at a 36.78% drop.

It’s just the math. Keep in mind that junk bonds fell 43% in 2008.

We’re just showing you how repricing can get you a 32-37% drop from a 10% drop in junk bond prices. So be careful there.

Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.