PDI: 50 CEF and BDC High Yield Bonds: These 3 Are Worth Considering (NYSE:PDI)

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This has been a terrible year for bonds. Since interest rates have risen sharply, bond prices have fallen sharply (and lending in general has been tumultuous). There are reasons to believe that interest rates will stabilize in early 2023 (as foretold for CME fed funds futures), but we all know how quickly expectations can and do change. In the meantime, having attractive CEFs and BDCs (while waiting for their prices to rebound) may be much more tolerable considering some offer very large distribution payments. Let’s start with PIMCO Dynamic Income Fund (New York Stock Exchange: POI), currently yields more than 13% per year (monthly payment).

PIMCO

PIMCO

1. PIMCO Dynamic Income Fund, Yield: 13.3%

PDI is the behemoth over $4 billion gorilla in the room. Revered by many, its price has dropped and its performance has increased considerably this year.

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PDI was already a large fund, but grew to be one of the largest at the end of 2021-2022 when the assets of two other PIMCO CEFs were merged. And as you can see from the chart below, it’s quite large compared to other bond EFCs.

POI

data as of Friday 28-Oct-22 (CEF Connect)

And what’s special about PDI (besides its massive size, huge performance, and significantly reduced price) is that it has an impressive performance track record. You haven’t reduced your distributions, and this year you continued to get the dividend from income and not from capital gains or a return of capital (ROC is often undesirable because it can reduce your cost base, leading to a surprise tax on earnings). capital gains if/when you sell your shares). Here’s a look at PDI’s distribution history, and as you can see, it even has a history of paying additional special dividends.

POI

CEF connection

However, PDI has been playing a strong defense this year as it has cut its duration (interest rate risk) from over 5 to around 3.4 as it has been strongly outperforming the regulatory leverage limit of the 50% (Leverage can increase returns and income during good times, but magnify losses in bad times, like this year.) This year’s defensive repositioning has been far less than ideal, but PDI now has about 28% of its holdings maturing in 0-1 years, and is increasingly well-positioned to benefit from higher rates once the Fed Fed stop rising so aggressively (hopefully soon, but scheduled for early 2023 according to CME fed watch).

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One drawback of PDI is that it trades at a premium to NAV. If you don’t know, CEFs generally have a fixed number of shares and are therefore traded based on supply and demand, often leading to significant price premiums or discounts compared to the net asset value ( or NAV) of the underlying holdings. Here’s a look at PDI’s historical premium discount.

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CEF connection

These premiums and discounts are different than most mutual funds and exchange-traded funds (they have mechanisms to ensure that the price stays very close to the NAV), and these divergences create risks and opportunities for CEF investors. We generally prefer to buy things at a discount (rather than at a premium), but in the case of PIMCO CEFs, premiums are often high and common because the company is trusted by investors and has a long history of strong returns.

Overall, we view PDI as an attractive high-income investment opportunity, expect NAV declines to stop once interest rates stabilize, and the fund’s outsized distribution yield makes it much easier to tolerate any short-term volatility in the future. We have had PDI in the past, but we sold it earlier this year. However, if you’re a contrarian investor, now is a good time to consider adding stocks (it’s very high on our watch list).

two. main street capital (MAIN), Yield: 7.2%

Switching gears from CEF to BDC, Main Street is a perennial favorite for its in-house management team and long track record of success. However, stocks have fallen (and yields have risen) this year.

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However, from a long-term standpoint, Main Street’s dividend has grown dramatically over time, and it also has a history of paying supplemental dividends.

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Main Street Capital Q2 Investor Presentation

Main Street is also particularly well positioned to benefit from the change in the macro environment, as higher interest rates mean higher net interest margins and more earnings for MAIN. Main Street also offers a conservative level of leverage (compared to peers and within regulatory limits) and also has an attractive mix of first lien lending through equity investment opportunities (as we will show in a later section of this report). ) . And as an important note, Main Street consistently trades at a higher book price than almost all peers (due to its attractive differentiated business), so don’t let that necessarily put you off. Main Street is an attractive, long-term, high-paying investment, and is currently trading at a very attractive price relative to its value.

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CDB in general:

Generally speaking, if you don’t already know, CDBs are similar to bond EFCs in that they are investing in loans, but unlike bond EFCs (where loans are usually already carefully packaged into a large issue publicly traded bond market), CDBs typically underwrite the loans (and financing terms) themselves, thus creating significant risk and reward opportunities.

BDCs are also eligible for RIC tax treatment for US federal income tax purposes (meaning they can essentially avoid corporate income tax if they pay their income as dividends), and their dividends they can be ordinary or qualified (a good thing for tax purposes). Here’s a look at a variety of important data points on more than 25 big-dividend BDCs, including Main Street Capital (the table is sorted by market capitalization).

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data as of Friday 28-Oct-22 (Stock Rover)

In addition to Main Street, you’ll likely see at least a few names you’re familiar with on the list. The list also includes important data on price-to-book ratio, market capitalization, year-to-date returns, dividend yield, and more.

It is also important to note (and similar to bond CEFs), BDCs are subject to regulatory leverage limits. Specifically, the debt-to-equity limit was raised to 2x in 2018, but as you can see below, most BDCs stay well below that limit (especially Main Street).

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Fitch Ratings

Another important BDC consideration is how much of its investments are fixed or floating rate, and how much of its own debt is fixed or floating rate. This makes a big difference as interest rates continue to rise. And you can get some perspective on the differences between the BDCs in the chart below from earlier this year.

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Fitch Ratings

It’s also critical to understand how changing interest rates (and market conditions) can affect a BDC’s book value. For example, the chart below shows the type of debt and financing that different BDCs have, as well as giving you an idea of ​​how this affects losses in challenging market conditions (this data is late in the second trimester, but still provides important perspective).

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Fitch Ratings

It is important to note that CDBs and bond CEFs are very different investment vehicles, and within each group there are very different subcategories. However, they are cousins ​​in the sense that both invest primarily in loans, both are drastically affected by changes in interest rates, and both have sold very strongly this year.

3. BlackRock Multi-Sector and Credit Allocation (BIT) (BTZ), Yields: 10.4%, 10.3%

Going back to CEFs, some investors see BlackRock as “second class” compared to PIMCO (especially considering BlackRock’s growth firm tilt toward “ESG” investing and away from its actual fiduciary responsibility to protect investors’ assets). However, and notwithstanding, we find these two BlackRock funds very attractive. BlackRock has massive resources across the company to support strategies, and the funds trade at an attractive discount to NAV (something we like) and have negative z-scores (another thing we like).

And despite terrible returns this year for fixed income and bond funds, we think these funds are positioned to benefit when interest rate hikes subside, given that they have been able to add new investments to the strategy they offer. higher yields. BlackRock is a bit more conservative in its use of leverage (versus PIMCO), which some investors prefer. We have owned both of these funds in the past, but sold them (early this year and late last year) when the Fed accelerated its path of raising interest rates. BTZ offers a slightly higher credit quality and higher NAV discount, but it also has a more bumpy distribution payout history, something some investors don’t care about, but others just can’t stand. Both funds are attractive here.

The bottom line

If you enjoyed the insights in this report, we have a couple more interesting insights here: Top 10 High Yield Bond CEFs and BDCs. Just know that the market could still get worse before it gets better, and that these opportunities should be included as part of a prudently diversified, long-term, goal-focused portfolio.

Disciplined long-term investing is a winning strategy (it has been time and time again throughout history) and owning things that offer big consistent income payouts can make it much easier to wait out the eventual upswing.

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