This article was first published for Systematic Income subscribers and free trials on October 19.
In this article, we provide an update to the PIMCO CEF suite. Specifically, we discuss changes in leverage and spread coverage for the month of September. Us Also discuss how the income profile of interest rate swaps held by taxable funds has changed during this period of rising short-term rates. Overall, we continue to favor the Dynamic Income Opportunities Fund (PDO) trading at a discount of 8.2% and a current yield of 11.6%.
Loans from taxable funds fell for the sixth month in a row with all funds seeing a drop except (PAXS), which has been building up its leverage after its inception this year.
In the last 6 months, the general reduction of loans of taxable funds is of the order of 15-40%. On a total asset basis, this results in a smaller drawdown, closer to 10-15%, which is directly related to the fund’s income profile. These days, a deleveraging has less of an impact in terms of lost revenue because the cost of leverage is so high, but the lost revenue is still there.
The reason for this continued deleveraging has to do with the simple fact that a drop in the fund’s equity level or NAV (which has occurred every month this year except July) mechanically increases your leverage. PIMCO funds try to keep their funds below a 50% leverage level (funds that have ARPS like PFL, PFN and others have a lower limit), which requires a drawdown of loans to restore leverage to lower levels. The chart below shows the average monthly change in PIMCO’s taxable CEF NAV.
PAXS appears to have completed its leverage buildup and is now on par with PDO as the second most leveraged fund in the suite.
After a strong deleveraging in July, the municipal funds have not done much.
However, as Muni’s NAVs continued to fall after July, the leverage of Muni funds has increased and, once again, is not far from its 50% leverage limit. This increases the likelihood of another deleveraging if municipal bond yields continue to rise.
Taxable coverage fell for all but two funds: RCS and PAXS. The reason for the continued increase in coverage is clear to PAXS: the fund has been increasing its leverage over time. All but one of the taxable funds have greater than 100% coverage.
Coverage levels of municipal funds have continued to fall and all funds have coverage levels well below 100%.
Rising leverage costs, as well as recent significant deleveraging in the Muni suite, have continued to eat into net income.
A tangent in the PIMCO data
In this article, we take a quick look at whether swap income is affecting the overall income levels of PIMCO’s taxable funds. This is because these funds are heavy users of swaps, as we discuss below, and changes in short-term rates have an impact on the level of income generated by swaps. However, we must first make a complaint about PIMCO’s reports – readers who are not interested in our complaints can skip straight to the next session.
In general, PIMCO’s CEF reports are very good. There are detailed statistics on their website and monthly updates regarding leverage, coverage, UNII and other key factors. However, one area where it appears to fail is in aligning its holding reports (provided on its website as Excel spreadsheets) with its semi-annual shareholder reports.
For example, consider the following two screenshots: the top one is from your shareholder report and the second is from your stock spreadsheet. Both are as of June 2022 and both document their interest rate swap portfolio.
We highlight the same interest rate swap in both, the larger swap, or the 2026 $483 million swap. Note that on the shareholder report it shows as “Pay Floating Rate”, but on the spreadsheet it shows as “Receive Floating Rate”. The order of trades is the same in the two reports, however the “Side” i.e. Pay or Receive is all over the place.
We use the numbers from the stockholders’ report for three reasons. First of all, they are audited whereas stock spreadsheets are not. Second, they make much more sense from a market value perspective (a swap with a large negative market value would have the coupon fixed below the current swap pair rate for the same maturity). And three, they are in line with the DV01 profile of the fund’s yield curve found in the NPORT-P SEC filings.
In short, this isn’t the end of the world, but it’s pretty sloppy. We have asked PIMCO to correct this, but unfortunately have not received a response. Claim finished.
Have swaps become an earnings tailwind?
Some time ago we discussed the unusual role of interest rate swaps in PIMCO’s CEFs. Specifically, PIMCO’s taxable CEFs use interest rate swaps in various ways. The first is to manage the duration exposure of the fund. This use of swaps is not unusual in the CEF space. For example, most preferred CEFs use swaps to shorten the duration exposure of their portfolios.
PIMCO’s second use of swaps is to gain insight into the level of interest rates, as well as the shape of the interest rate curve. Historically, PIMCO has had a strong opinion on the shape of the yield curve that has become its public comment. This more tactical use of exchanges is not unheard of in the CEF space, but it is quite uncommon.
The third use of swaps by PIMCO taxable funds is to manage your income profile. This can be managed by entering an off-market swap by setting the swap’s fixed rate at some arbitrary (within reason) level. It is also done by entering into an early start swap in which, in effect, the cash flows are interrupted. PIMCO normally does this for swaps that would generate negative income.
The key question we try to assess in this section is how the funds’ current swap portfolios affect their income profile. The answer to this question depends on 3 things. Firstly, it depends on the actual swap position of the fund. Second, it depends on whether the swaps are spot or forward (ie, whether their cash flows are activated or deactivated). And three, it depends on what happened to Libor.
If we look at the largest taxable fund, the Dynamic Income Fund (PDI), what we see is that there are no forward swaps and the DV01 yield curve position is broadly the same steeper profile as the fund. has held for a long time. . This leaves Libor as the deciding factor in the fund’s swap income profile.
The key technical point here is that typically a steeper yield curve will have less positive/more negative carry (ie income) when Libor rises, all else being equal, and vice versa. This is because the shorter term portion of the steeper where the fund receives fixed rate/pays Libor will have a larger notional amount than the longer term portion of the steeper. In other words, on a net basis, the fund will be a Libor payer. So when Libor rises, it detracts from the fund’s overall income.
Based on PDI’s swap book, we estimate that its swap income went from +$15m to -$30m, or a drop of $45m due to the increase in Libor from zero to 4%. A $45 million change in revenue isn’t particularly dire for PDI, which has $4.4 billion of net assets (it’s about 1% of NAV), but it’s not insignificant, as it’s about 7% of the total accounting rate of the background. There are many transfers to the other taxable funds as, apart from PCM, they all tend to have very similar exchange profiles. The main takeaway here is that rising interest rates are a minor drag on PIMCO’s taxable funds with respect to their swap portfolios. However, because the funds hold a significant amount of floating-rate assets, they are likely to be relatively immune to rising short-term rates in general.
Within the taxable series we continue to favor the PDO. The fund’s broader discount to the taxable pool becomes increasingly attractive as fixed income bond yields and short-term rates continue to rise.
This is because higher fixed income yields allow the fund to provide a higher level of return to investors and offset its higher management fee in the suite, a dynamic we discuss here. And rising short-term rates hurt the income profile of funds holding ARPS due to their coupon multiplier which we discuss here. The fund remains vulnerable to further support in Treasury yields and credit spreads, however, the valuation of the broader fixed income space has reached historically attractive levels and PDO is an attractive way to participate in this.