PCK CEF: A Great Reminder That ‘Premiums Matter’ (NYSE:PCK)

Main Thesis & Background

The purpose of this article is to evaluate the PIMCO California Municipal Income Fund II (NYSE:PCK) as an investment option at its current market price. The fund invests primarily in California municipal bonds, and therefore “seeks to provide current income which is exempt from federal and California income tax, as well as the alternative minimum tax.”

This was a fund I had recommended last year but turned cautious on entering Q4. The short-term that resulted after my “buy” recommendation told me to get cautious, especially with inflation and the Fed both pointing to more trouble for bonds. It didn’t take long for this caution to be rewarded, with PCK dropping by over 5% in the last four months:

While the sudden drop in share price is not a great thing for current investors, I see it as a chance to pick up a quality fund at a much better price. I believe the recent volatility is a buying opportunity, and will explain why below.

PIMCO Rattles Muni Funds With Income Cuts

To start, I will take some time to discuss the big development from PIMCO as 2023 got underway. This was the distribution cut announcement – never a good sign. Fortunately, for investors it was limited to muni CEFs. Unfortunately, that is not a great thing for those who own them!

Income cuts are not necessarily new to PIMCO and these cuts were expected – to a degree. The shock (and reason for the big declines in funds) is that the size of the cuts was abnormally large:

As you can see, some of the biggest cuts were in the Cali funds. That explains why there was so much weakness across the sector to start off the year.

The conclusion is this could be a buying opportunity or a sign of things to come. Personally, I see opportunity arising after this sharp sell-off, but not across the board. I will get into why I like PCK in particular compared to some of the other options, in the following paragraphs.

Premiums Don’t Matter? Don’t Make Me Laugh

As readers probably guessed, the income cuts from PIMCO took their toll on the funds. But the real striking takeaway was not all funds dropped by similar amounts. If we look at PCK’s performance this week against its sister funds, the PIMCO California Municipal Income Fund (PCQ) and the PIMCO California Municipal Income Fund III (PZC), we see a tale of two cities on full display. While both PZC and PCK were not immune to the recent turbulence, look at how they fared compared to PCQ, which was an overpriced darling for years (as recently as this month it sat at a premium near 50!):

The end result has been that PCQ saw a drop almost three times as large as PCK and PZC (through close 1/5). This begs the question – why?

The answer rests primarily with valuation. While PCK and PZC were not “cheap”, they sported single digit premiums. PCQ, on the other hand, was trading into mid to upper 40% premium range (depending on the day) and was actually the most expensive PIMCO CEF within its fund universe.

I bring this up because it is clear why PCQ dropped by such a stark amount. This is that valuation matters. Yes, PCQ had the largest income cut in percentage terms, that certainly played a roll. But the premium spread in my belief was the primary driver.

What I find important from this development is a reinforcement of the thesis that “premiums matter” when it comes to CEF investing. This may sound like common sense to some – and to me it does to. But we hear time and again that premiums do not matter, on this forum and on others. When times are good and income is coming in, it can indeed be easy to ignore premiums and the risks they pose. But PCQ’s performance this week should serve as a stark reminder to be very careful with buy-in spots and to not get over-exposed to a fund that is ripe for a massive correction on any bad news.

PCK Now Sits At A Discount

With some of that bad news out of the way, I will move the discussion to why I like PCK at this moment. The recent volatility was certainly unnerving but I believe it gives investors an opportunity in this fund where one hadn’t been present for a while.

Top of mind for me is the re-set of the valuation. PCK was sitting at a slight premium during my September review, and that story got slightly worse over time (the premium widened). Now, on the backdrop of the income cut and the subsequent sell-off, that story has changed dramatically. PCK is now trading at a discount to NAV that I find quite attractive:

This sets PCK apart from its sister peers at today’s price. While PZC offers a modest premium at this point (only .26%), PCQ still sits at what appears to be a very frothy premium of 20%.

I personally have found success investing in muni CEFs (PIMCO or otherwise) at discount over the years. This is especially true for funds that rarely trade at discounts. While PCK has traded at discounts in the past, it is more commonly at a premium. Further, this current discount is wider than anything we have seen over the past trading year – supporting a buy signal in my opinion.

California In Relatively Good Fiscal Shape

Expanding on why I like PCK also stems from how I view the fiscal picture in California. While this state always grabs a lot of headwinds, the truth is it brings in a lot of tax revenue and has a larger “rainy day” fund that most states in the country. While a recession this year will undoubtedly prove a challenge to credit markets (including muni bonds), California appears better positioned than most to withstand it.

According to a recent report from ratings agency Moody’s, California can withstand a fiscal shock and still have cash on hand. Due to federal stimulus and an expanding economy post-Covid, this is true for the majority of U.S. municipalities. But California stands out as being in the top of the pack and well above the national average:

Considering that almost 1/3 of PCK’s assets are directly tied to state and local obligations, this is a positive for the fund:

What I see is a fund backed by state and local governments with strong cash positions and a willingness to tax. This is why I always keep Cali muni bonds on my radar and I generally lean towards a bullish opinion on the funds that hold them.

Munis Supply Has Been Tighter Than Normal

Shifting to municipal bonds more broadly, another attribute that is positive for investors is that supply has been fairly constrained in historical terms. While municipalities still issued quite a large number of bonds in 2022, the amount issued was sharply below what we saw in 2019 – 2021:

The interpretation here is that as new issuance declines, the availability of bonds for purchases does as well. If demand stays constant, or increases as I expect in 2023, this will inevitably push prices higher. This gives me confidence that allocating more cash to munis in Q1 is the right move – whether through PCK or any other quality muni fund.

Bottom-line

The muni market entered 2023 from a relative position of strength. Credit quality is strong and supported by cash on hand, after-tax yields are attractive, and discounts are present in a number of different CEFs. PCK has unfortunately been off to a rough start due to a distribution cut this week. However, I see this as a chance to put cash to work in the fund. The yield remains enticing (especially when adjusted for California’s high tax rate!) and the relative value against its sister funds piques my interest.

Risks certainly exist. Buying after a distribution cut can often result in above-average volatility, so investors should prepare for that. Further, the fund is highly leveraged and could see pressure if the Fed reiterates a more hawkish stance in the first half of the year. But I believe PCK’s merits outweigh these headwinds. As a result, I have upgraded this fund to a “buy”, and suggest readers give the idea some thought going forward.