PCQ: A Lesson In Managing Distribution Stability Risk

This article was first released to Systematic Income subscribers and free trials on Jan. 5.

At the start of January 2023, PIMCO released their anticipated monthly closed-end fund (“CEF”) distributions. PIMCO tends to make 1-2 CEF distribution changes a year, so most months there are no changes listed – no news is good news. However, the January press release greeted investors with massive cuts. Particularly notable was what is likely to be one of the largest, if not the largest, cuts in recent years of 45% for the PIMCO California Municipal Income Fund (NYSE:PCQ) – see the table below. To add insult to injury, the fund fell 14% the following day as disappointed investors fled the fund.

In this article, we use PCQ as a case study and revisit some of the ways investors can manage the risk of large distribution cuts in their CEF holdings.

Ways to Manage CEF Distribution Risk

The most obvious ways to manage distribution cut risk is to simply track distribution coverage. This seems obvious enough however there are a couple of nuances.

One is that distribution coverage tells us something about the fund’s income rather than its total yield generation and the two are not the same. In short, income captures only the coupons that are coming in and ignores the pull-to-par component of bond yields which can be significant. The average high-yield corporate bond has a yield of around 9%, only 6.6% of which is due to its income – the rest is from pull-to-par. Since distribution coverage only tracks the income portion of the overall yield, in the current market environment (when most bond prices are below par) it will significantly understate the total yields that bond CEFs are generating. In 2021, the situation was reversed – total yields were significantly below income yields.

Strictly speaking, for funds that try to match their distributions to their income, this distinction is not very important but it is important for funds that match distribution rates to their overall underlying yields.

The other potential difficulty with distribution coverage is that, unlike PIMCO CEFs, not all funds release monthly updates – many CEFs make do with semi-annual shareholder reports which are too infrequent and stale to be of much use.

Overall, investors who have been tracking distribution coverage of the PIMCO Muni suite over the past year are unlikely to be surprised by these cuts. A snapshot from our CEF Tool is shown below.

Something else we find very helpful in gauging the risk of a cut, particularly for funds that don’t release monthly coverage updates, is to consider the coupon profile of the fund’s assets, liabilities and derivatives. Specifically, it’s a good idea to get a sense of how much of the fund’s holdings are in floating-rate assets, whether its leverage facilities are fixed-rate or floating-rate and whether it carries any interest-rate hedges.

Muni CEFs, by and large, hold primarily fixed-rate assets, have floating-rate leverage facilities and have no interest-rate hedges – pretty much the worst combination for net income in a period of rising short-term rates.

All else equal, a rise in short-term rates will lead to a drop in net income, leading to a drop in coverage and likely cuts. It’s no surprise that the distribution trends of the Bank Loan and Municipal CEF sectors diverged last year. A snapshot from our CEF Tool is shown below.

Another useful way to gauge distribution vulnerability is to pay attention to fund borrowings, specifically, whether it has undergone any deleveraging. While deleveraging can often be discretionary and often prudent (such as when valuations are expensive) it can also be forced on the fund in a period of falling prices since lower asset values mechanically increase the fund’s leverage. A higher level of leverage not only increases the fund’s sensitivity to further price changes but can also bump up against the fund’s leverage mandate. This was the case for PIMCO funds which have been forced to cut borrowings once their leverage levels exceeded 50%. A deleveraging requires the fund to shed income-generating assets, leading to a drop in net income. In short, the PIMCO Muni funds not only experienced a drop in net income from rising short-term rates but also as a result of deleveraging.

Another technique to manage distribution risk is to use the timing of distribution announcements. One version of this technique is to simply rotate out of the fund prior to the announcement and get back in once the risk of a cut has passed. Personally, we actually don’t find this one a slam dunk for a couple of reasons. First, this technique is only really suitable for a tax-sheltered account which limits its use across investors (those who have sizable allocations in taxable accounts) and sectors (tax-exempt funds are unlikely to be in tax-sheltered accounts anyway). Secondly, most CEFs are not particularly liquid and can incur significant slippage which can sum to a greater cumulative loss over time than the potential loss avoided by sidestepping a cut. Thirdly, if a significant number of investors practice this technique, it will make it unprofitable as investors will end up selling low (after other investors have pushed down the price through their selling) and buying back higher. Fourthly, though the CEF market is not completely efficient, it is also not completely inefficient which means that there is a pricing in of various kinds of risks, including distribution announcements. In other words, by avoiding the distribution announcement, investors are also avoiding the likely compensation for bearing the risk of remaining in the fund through the distribution announcement.

One way to partly mitigate the issues above is to use funds with quarterly distribution announcements where announcements are made for three months at once rather than just the upcoming month. While most funds declare distributions on a monthly basis, some fund families do so quarterly such as Western Asset, PGIM, Blackstone, Cohen & Steers, and others.

Another technique is to hold funds with managed distribution policies or MDPs. Sectors like Agency, Global Income, Loans, Equity and others have a sizable number of funds with these policies. An important point is that MDPs are different and not all are “level distribution” policies. Some link the distribution to the last month NAV or a rolling NAV, or even price, average. However, the distribution changes of these funds can be anticipated in advance. It is also worth emphasizing that distribution policies can change so there is no guarantee of their future stability.

As was the case with PCQ the other day, a distribution cut, while painful, is often not the end of investor problems. As many investors know full well a large cut is often followed by a significant price drop as well. This is because many funds with overly high distribution rates enjoy large premiums. And when the distribution is cut the premium deflates as well, handing investors significant, and typically permanent, economic losses. We don’t have to look far afield for examples – a taxable PIMCO CEF, PIMCO Corporate&Income Opportunity Fund (PTY), now trades at a premium 30% below its level that it enjoyed prior to its last distribution cut.

This dynamic highlights one way for investors to position in order to limit the impact of distribution cuts, which is to tilt away from richly valued funds, since a fund with an expensive premium is more fragile to a distribution cut. Its premium will tend to deflate faster than a fund that is reasonably valued, all else equal, leaving less capital for investors to allocate to another security.

Takeaways

The recent massive distribution cut in PCQ and the subsequent price drop contains a number of key lessons for investors in managing distribution risk. One is that a fund with an oversized distribution rate relative to its peers is often not justified. This exposes the fund to not only a larger than expected cut but to a knock-on valuation compression.

And two, investors have multiple tools at their disposal to manage the risk of a distribution cut. This involves tracking distribution coverage, tilting to quarterly-reporting funds and funds with MDPs and, perhaps, most importantly, avoiding funds trading at rich valuations where cuts can lead to permanent economic losses.