PIMCO CEF: Assessing the impact of rising short-term rates


Darren415

This article was first published to Systematic Income subscribers and free trials on July 21.

In this article, we provide an update on the PIMCO CEF Suite. Specifically, we discuss the leverage and hedging changes for the month of June. We have also consider whether the rise in short-term rates this year should increase or decrease the funds’ taxable income levels.

Leverage Update

As we discussed in our last PIMCO update, the continued credit sell off in June pushed the suite of taxable funds to deleverage further.

Change in last month's borrowings

Systematic income

The Access Income Fund (PAXS) is an exception because, as a recently launched fund, its leverage was still at low levels, so it had room to catch up. The fund continued to add borrowings, as shown in the chart below, with a total of almost $500 million mostly in repos.

PCM and PDI have now become top levers with a level of almost 50%.

PIMCO Taxable CEF Leverage

Systematic income

The taxable suite has deleveraged each of the last 3 months. The graph below shows the total amount of deleveraging (ie the decrease in total borrowing) over this period. The rebound in credit performance in July will likely put an end, at least temporarily, to that and may even allow PIMCO to add assets that have been dumped over the past few months.

Change in borrowings over 3 months

Systematic income

On the flip side of the envelope, a 20% drop in borrowings for a 50% leveraged fund will drop its bottom line by about 7.5% if it keeps leverage at the same level, all other things being equal. Of course, we don’t know exactly what assets the funds sold. Each fund maintains a certain level of money market and low yielding assets, so if these were abandoned, income levels would be less affected.

For example, PDO reduced its pension liabilities by $171 million from March to June and also reduced its cash (i.e. pension assets + treasury bills) by $87 million. Thus, only about half of its deleveraging was in higher yielding “real” income assets. It’s certainly better than more income assets being purged from his portfolio. However, this strategy of carrying a large cash balance is not ideal since the cash in a leveraged fund does not, in fact, earn any interest since it requires the fund to fund it through the repo. In other words, if that cash wasn’t there, the cash would simply pay off some of the repo, thereby reducing the leverage cost of the fund.

If we look at the borrowing levels of the larger funds, we see that PIMCO added assets in March, but was then forced to back down as the continued decline in prices forced the funds to deleverage. It’s unclear exactly what happened and PIMCO isn’t going to discuss it, but it appears they added assets too early and were caught off guard when asset prices continued to fall.

PIMCO borrowing levels

Systematic income

The image in the PIMCO Muni CEF is, without doubt, even more interesting. Remember that PIMCO tends to manage its Muni funds (as taxable funds, for that matter) at a high level of leverage. The drop in municipal bonds this year has mechanically pushed up fund debt levels. However, what is interesting is that PIMCO actually added borrowing into its Muni funds (ie further increasing leverage) in January and April.

PIMCO Muni CEF Changes in total borrowings

Systematic income

This combination of bond price declines and additional borrowing has caused PIMCO Muni’s average debt level to increase by up to 50% – well above the 35-40% level of the average tax-exempt CEF. .

PIMCO Muni CEF Medium Leverage

Systematic income

In fact, in June, 4 out of 9 funds had leverage levels above 50%.

PIMCO Muni CEF Leverage

Systematic income

This one is a bit of a puzzle. PIMCO muni funds have a 50% leveraged cap mandate, like the one shown below in the PML prospectus, so it’s unclear what’s going on here.

PIMCO Leverage

PIMCO

And it’s true that the leverage at the end of the month was no more than 50% (although it’s closer to 51-52% on an intra-month basis most likely), so maybe that the view is 50.3% is quite close to 50%.

PIMCO Total Effective Leverage

PIMCO

Cover update

The key hedge to remember for PIMCO CEF investors relates to the recent discrepancy between their Muni and taxable funds. Despite the fact that the Muni funds have added some borrowing, the fact that their assets are fixed rate while their liabilities are floating rate has resulted in a drop in their hedging levels (especially given that they have no not reduce their distributions).

Taxable funds, on the other hand and as we will see below, can and do hold floating rate assets and use derivatives which can easily change the exposure between fixed and floating rates. This has resulted in much better holding of taxable coverage levels.

PIMCO Muni and Average Taxable Coverage

CEF Systematic Income Tool

The hedging model in Muni funds is quite simple – the funds with the lowest hedging are those with the highest net asset value distribution rates. As we discussed earlier, there is nothing magical about PIMCO funds like PML, PYN and PCQ which have unusually high net asset value payout rates – these funds simply have lower coverage.

Muni Fund 6M Mobile Distribution Cover

CEF Systematic Income Tool

Muni UNII levels have also started falling across all funds.

UNII Municipal Fund

CEF Systematic Income Tool

PIMCO does not disclose tax-exempt leverage costs, but we can get a good idea from Nuveen that does. The chart below shows the leverage costs for a large Muni Nuveen Quality Municipal Income Fund (NAD) which have nearly doubled since last year. This will continue to rise more or less in a straight line to the peak of the fed funds rate and will continue to put pressure on tax-exempt fund income levels.

NAD CEF Leverage Costs

Systematic income

The taxable coverage seems a little more stable although there are large variations. AOP is, as usual, there with high comedic coverage that will likely continue to grow despite a modest increase in its cast.

Coverage of taxable funds

CEF Systematic Income Tool

The taxable UNII levels are all above zero with PDO, once again, playing the role of a hero pointing towards another big special coming later this year. PAXS UNII has also grown rapidly despite its recent launch and we are also expecting a special offer later this year from this fund.

UNII taxable fund

CEF Systematic Income Tool

A look at the income profile

Generally speaking, the income profile of a credit CEF is a function of the sector allocation, the mix of fixed coupon and variable rate assets, its debt structure and the evolution of these factors over time.

The biggest factor in CEF income levels right now is the sharp rise in short-term rates this year. Few funds outside of unleveraged equity CEFs have remained immune to this engine.

To understand how a given fund’s income is impacted by changes in short-term rates, we need to break down the fund’s sensitivity to changes in short-term rates into its assets, liabilities, and any off-balance sheet derivatives.

In this section, we use the PDO as a case study to understand how the taxable income level of PIMCO suites might react to rising short-term rates. PDO is a decent fund to use as it is large and more representative of PIMCO’s broader taxable suite than a fund like PDI which overweight MBS.

Unfortunately, PIMCO does not specify exactly which assets in its portfolio are variable rate or fixed rate (at least not entirely as they would show a capped variable rate as a non-floating rate asset, for example), however, we can make estimates. For example, we can assume that 100% of loans are floating rate while 100% of bonds, preferred stocks and mortgage REITs are fixed rate. We assume that half of non-agency MBS holdings are floating rate, which is probably conservative, as is the 75% ABS assumption. From this floating rate asset figure of $1669 million, we subtract the entire repo (i.e. when PIMCO borrows money against collateral, paying a floating rate). We also add net pay-fixed/receive-Libor swaps.

If we perform this bottom-of-the-envelope calculation, we find that PDO’s floating rate net exposure is approximately $260 million or 16% of its net assets. There is clearly some uncertainty about this figure, so it is far from accurate. However, what we can conclude is that it is probably not negative, meaning that PDO income is either neutral to rising short-term rates or is benefiting modestly from it.

PDO assets

Systematic income

Take away food

Within the taxable suite, we continue to hold AOPs. As we recently highlighted, the fund has benefited from its not-unexpected distribution hike with its discount compressing to the rest of the taxable suite, although a significant gap remains. We continue to view the fund as attractive, but are keeping an eye on PAXS as a potential alternative should it depreciate further against PDO.

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