PHK: Steady As She Goes – PIMCO High Income Fund (NYSE:PHK)

Main Thesis

The purpose of this article is to evaluate the PIMCO High Income Fund (PHK) as an investment option at its current market price. This is a fund that I continue to express caution with, despite having one of the highest yields in the market today. While the income stream looks attractive on the surface, there are plenty of other reasons I am lukewarm on the fund. One, the premium to NAV on the open market is quite large, which is always a red flag for me. Two, high yield spreads have tightened measurably in the short-term. While this has helped PHK pump out a positive return, it suggests limited upside from here. Three, income production figures are not strong enough to make me forget the distribution cut we saw under a year ago.

While these negative attributes exist, I do expect PHK to hold up well enough in the months ahead. The broad sell-off from the income cut has subsided, and the above-average yield will likely pique plenty of interest going forward. Therefore, I believe a neutral rating is appropriate for 2020 at this time.

Background

First, a little about PHK. It is a closed-end fund whose investment objective is “to seek high current income as a primary focus and capital appreciation as a secondary objective.” It invests a substantial portion of assets in a variety of mortgage-related securities and also high-yield credit. Currently, the fund trades at $7.62/share and pays a monthly distribution of $.061331/share, which translates to an annual yield of 9.66%. I covered PHK at the start of October and maintained a “neutral” rating on the fund. In hindsight, this made sense. While PHK has seen a positive move, the broader market has performed extremely well during the same time period, as shown below:

Source: Seeking Alpha

With 2020 underway, I wanted to do an updated evaluation on the fund, to see if I should change my outlook. After review, I continue to believe a “neutral” rating is appropriate, and I will explain why in detail below.

Yield Spreads Continue To Tighten

To start, I want to discuss the largest sector within PHK’s portfolio, which is the high-yield credit market. In fact, the sector’s weighting has increased a bit since my last review, and now makes up almost 28% of total fund assets:

Source: PIMCO

Clearly, what is going on in the high-yield market has an important impact on PHK, so understanding the current climate is critical to evaluating the fund. Further, I believe an understanding of where this market stands is important to understanding my “neutral” rating perspective.

On that note, investors should recognize that while this sector contains above-average risk, it has been performing quite well in the short-term. In fact, its inclusion in the fund is a key reason why PHK has been able to pump out a (slight) positive return, even after seeing its distribution get cut last year. To illustrate, consider the chart below, which details the 2019 calendar returns for multiple fixed-income asset classes:

Source: Bloomberg

As you can see, the high yield bond sector had a strong year, although, in fairness, so did most of the fixed-income world. While this has been positive for current investors, the reality of such a large return in a short time span has pressured the outlook for future returns.

To gauge how well high yield could perform going forward, I examine current spreads against historical ranges. When we look at current spreads, we see that they are well below the average for the high yield corporate bond sector. While this has been the case for a while, back during my October review spreads were above 455 basis points. Now they are under 400 basis points, which shows a pretty considerable amount of tightening, as seen below:

Source: Yardeni

My takeaway here is mixed, but slanted to the negative. Of course, this exercise shows investors have been very interested in high yield debt, and are willing to pay up to own it. This has helped current investors in the sector, and PHK by extension. However, the current level gives me pause, as it is really testing historical norms. Could spreads tighten further? Certainly. But history suggests it will be unlikely. If the “risk on” trade falters, high yield has plenty of room to move on the downside, and that makes me extremely cautious on opening new positions at this time.

Valuation Story Is Mixed

My next point is one my readers have heard about from me, with regards to PHK, for a long time. Specifically, it is the fund’s valuation, and it continues to be much too pricey for my liking. Currently, the fund’s premium remains high enough that I would have difficult recommending it, although it has noticeably declined in recent months. While a premium above 21% seems a bit crazy, it is actually below the short-term average for the fund, as shown below:

Current Premium 21.3%
Premium in October Review 25.5%
1-Year Premium Average 29.1%
1-Year Premium High 47.7%
1-Year Premium Low 20.1%

Source: PIMCO

As you can see, this valuation story offers both a sign of caution and an opportunity. Yes, the 21% figure is quite high, and would not interest true value investors. On the other hand, it is well within the fund’s normal trading history, and is actually near its 1-year low. This could interest opportunistic investors, who would bet on PHK reverting back to its average levels.

While that would not be the right play for me personally, there is plenty of merit to this line of thinking, especially if we consider the fund’s underlying value price action. Specifically, one of the reasons the fund’s premium has been kept in check is because the underlying assets within the fund have been rising in value over the past year, as shown below:

NAV on 1/23/19 NAV on 1/22/20 YTD Gain
$6.03/share $6.28/share 4.1%

My takeaway here is the underlying NAV story could give investors the support they need to build a position now. While I personally see the premium as too high, given the concerns I have for fixed-income more broadly, I do recognize the potential for a move higher. Therefore, investors need to carefully consider their individual risk tolerance before undertaking this type of trade.

UNII Report – Not Good Enough

My next point centers around PHK’s income production, which is always of critical importance for income vehicles. This is especially relevant for PHK, as the fund saw a steep distribution cut back in April last year, which was responsible for a sharp drop in share price. In fairness to PHK, the fund has maintained its new distribution rate since that time, and the share price has stabilized as a result, which is a good sign. The bad news is, current income figures do not provide a ton of confidence. Specifically, PHK still has a negative UNII balance, and current coverage ratios are not great either, as seen below:

Source: PIMCO

As you can see, PHK’s story is not overly comforting. In truth, UNII figures can change markedly from one month to the next, so investors should avoid gleaning too much from this one month. However, it does show that PHK continues to struggle when it comes to covering its distribution rate. With a history of cuts and an expensive premium, the risk-reward proposition here is only for those who can handle a substantial downside move, in my opinion.

Fixed-Income Investors Should Be Cautious

My final point considers a macro-outlook for fixed-income, but I will also detail why it is important PHK. As my readers are aware, I have been advocating rotating in to fixed-income products for a while, as my preference for equities has declined with the rising markets. However, I have been pushing investment grade credit, whether in corporate or municipal debt, because I want to use these asset classes for safety and to lower my overall portfolio volatility. However, that relates mostly to credit risk, and fixed income investors also have to confront interest rate risk, whether in investment or below investment grade assets.

Interest rate risk relates to the risk investors are taking on if interest rates move (either higher or lower) in the future. It is often calculated by looking at the duration of a fund’s total holdings. Essentially, the higher the duration, the move the fund will be impacted by a movement in rates. This makes intuitive sense because a fund with a large duration would be overweight debt with longer term maturities. If rates were too decline, this debt would become more valuable, assuming investors wanted exposure to higher yielding assets for longer. Alternatively, if interest rates rise, the fund would correspondingly drop more because investors would not want to be locked in to longer term debt that could be yielding less than what the market is now offering.

A common way to measure this risk is called the “Sherman Ratio”, which looks at the yield on a bond (or fund) relative to its duration. For illustrative purposes, consider where the ratio sits for the broader bond market, as shown in the graph below:

Source: Bloomberg

Essentially, this ratio is showing us that the amount of yield investors receive for each unit of duration is at a historically low level. This means it would not take a very large move in interest rates to negatively impact the underlying values for debt products at this time. By using the broad bond index, we see that this is not necessarily specific to one type of product or sector, but for the fixed income market as a whole.

My takeaway from this is investors need to be careful. With spreads at tight levels and interest rate risk rising, moving down in credit quality seems a risky bet at this time. Considering PHK has a lot of high yield debt, investors want to truly understand these risks before taking a new position. Further, interest rate risk is indeed very relevant to PHK, as the fund does have an intermediate term effective duration, as shown below:

Source: PIMCO

My point here is to make investors aware of these risks. The reality is we still live in a low interest rate world, and that is unlikely to change in the short-term. Therefore, spreads could continue to tighten, and interest rate risk could be minimized. But if these outlooks change, the downside potential is quite large given how far we are from historical norms, so investors need to consider this in their analysis before buying or selling.

Bottom Line

When it comes to PHK, the fund’s high yield and regular volatility could make it a viable option for investors looking to take on some risk. With bullish momentum across the fixed-income world, PHK’s underlying value should hold up well, and I would expect modest positive returns by year-end. That said, there is a lot of downside potential, which keeps me from outright recommending the fund at this time. Yield spreads on high yield credit are near multi-year lows and, once we couple that with PHK’s high premium to NAV, upside potential seems muted. While interest rates are not expected to move much in the near term, investors are not being compensated much for the risk they are taking, which means a changing macro picture for rates could leave fixed-income investors with larger losses than they are used to. Therefore, I believe a neutral rating for PHK remains appropriate, and recommend investors carefully consider their risk tolerance before making any purchases at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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