PZC: I Would Expect Modest Gains For This California Muni Fund

Main Thesis & Background

The purpose of this article is to evaluate the PIMCO California Municipal Income Fund III (NYSE:PZC) 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 is my first review of PZC, but it is a fund I have touched on in other articles because I cover its two sister funds, PIMCO California Municipal Income Fund (PCQ) and PIMCO California Municipal Income Fund II (PCK), often. In fact, I wrote a bullish piece of PCK and a bearish article on PCQ within the last few months. As a result, I thought I should give my opinion on PZC since direct coverage of it was lacking.

I think this is timely given the volatile year the fund has had, driven by rising interest rates, macro-economic uncertainty, and a distribution cut for the fund to start off 2023:

In my opinion, PZC is a reasonable play here. I see limited downside, an attractive tax-adjusted yield, and a solid hedge for potential equity volatility. Yet, there are some downsides, such as the fund’s excessive use of leverage. That will sting if the Fed continues on a more aggressive path. Further, there are a host of options that offer similar exposure at discounted prices. This all adds up to a “hold” in my opinion, and I will explain why in detail below.

Valuation Story Supports Positions, To Some Degree

PZC has caught my eye for kind of an unusual reason at current levels. Specifically, the fund is trading exactly at par value. This may seem counter-intuitive to some readers, since ETFs and mutual funds should trade at par the vast majority of the time. But CEFs are different – they trade at discounts and premiums to their underlying value. Sometimes those discounts and premiums get quite exaggerated. But in the case of PZC, its market price is exactly the same its NAV:

This suggests to me that there isn’t a strong argument to “avoid” this fund on valuation alone. Buying something for what the underlying assets are worth is a fair exchange. I prefer a discount, but a 0% premium is not that bad either.

The reason why I don’t see this as a screaming buy opportunity is because other CEFs do exist at discounts. While that does not make them automatically superior investments, they may entice the more value-oriented investor. Further, one such fund is PCK, which has a very similar make-up and the same asset manager. With a discount to NAV in excess of 6%, it seems to me readers would be wise to choose it over PZC. By contrast, PCQ holds a 4% premium at the moment, so I should steer readers in to either fund rather than that one.

The takeaway for me is that PZC is not a glaring opportunity but it isn’t a fund that really scares me either (like PCQ did back in December, and then correspondingly lost almost 30%!). This push-pull dynamic for PZC supports why I have a more modest, “hold” view of the fund for now.

Munis An Option For Those Fearing Recession

I will now take some time to discuss the why behind why I like munis at all. This is relevant for PZC, but also any fund in this realm. This article focuses on PZC, that is true, but let us consider why an investor may want to even be looking at any muni fund in the first place.

For me, the reason is two-fold. One, I like the tax-adjusted income stream this sector offers. I am rarely buying IG corporate bonds. Instead, I have seen more value over time for tax-free counterparts like munis. As a working professional in a higher tax bracket, this makes sense for me. It may not be right for every reader. Two, I think munis often a pretty solid hedge against equity volatility. Last year – this did not pan out – so I will not sit here and tell you this is a sure thing. But over longer stretches of time munis have a lower correlation to U.S. equities than most other sectors. So that means the sector provides some level of stability when / if equities are going bonkers.

I believe this is relevant right now because economic pain looks to be on the way. Markets have started out strong in January, which is the good news, but I believe they are ignoring the upcoming weakness we will see in the second half of the year. The bond market is signaling quite a bit of pain ahead with the yield curve seeing a deep inversion. At this level of inversion, a recession has never been avoided (in modern history). I doubt the first time will be 2023:

I am not trying to be Mr. Doom, but I am trying to illustrate why I believe adding to some equity hedge is the right move here. January has been a great month – that makes it the perfect opportunity to lock in some profits in equities and shift those funds in to hedges. Don’t wait for equities to start selling off, that is when it makes sense to buy, not sell. The time to prepare for the downtimes is during the good times, so I am reducing some equity exposure to wrap up this month and moving that capital to both cash and munis. May I be worrying prematurely? Perhaps. But history suggests a recession is coming. Once it becomes “official”, equities are likely to drift lower.

’22’s Laggards Are ’23’s Winners In Equities; That Could Extend To Bonds Too

Another interesting development in 2023 has been the reversal of fortunes in the equity market. With the exception of Energy, the leaders in 2023 so far in the month have January were some of the weakest performers in the 2022 calendar year. Energy is the exception because it was a leader in both 2022 and so far in 2023, as shown below:

Of course, these are equities, not munis. But the principle here is that the unloved sectors from 2022 have suddenly become to the loved. The equity market moves faster than bonds, typically, so I see this as justification to continuing to rotate in to IG credit as investors look to bottom-feed on the areas that under-performed last year. Munis are top of mind on that front – they had a horrible year. With last year’s ugly ducklings starting to become swans, I think munis are a decent place for a position.

Let’s Talk California

I now want to shift back to PZC specifically. When evaluating this fund it is very important to consider California. After all, this muni fund is predominately a single-state option with the vast majority of its munis originating from that state. It is heavily obligation to GO bonds from state and local municipalities, but it is also well rounded in the sense that it has revenue bonds as well, and from quite a few different sectors:

Holistically, I like this diversified exposure. I like the mix of GO and revenue bonds and I like that no single sector is overly dominant. So PZC gets strong marks from me on this front.

There is a caveat to this. I mentioned above how I like munis as a whole in order to protect against equity volatility. This is true. But investors in California’s munis should hope that things don’t get too dire. The reason being is that the wealthy pay a very large percentage of personal income taxes in that state. This means California is very reliant on their fortunes to spend on discretionary items, fund social programs, and (perhaps most importantly) make good on their muni debt obligations.

To put this in perspective, consider a report from the LA Times that shows just how important the “wealthy” are for personal income tax receipts in the Golden State:

What I am driving at here is that when the market tanks and/or the wealthy are pressured for some other reasons, California has a bit of a problem. Over time, the market trends higher, so generally this over-reliance has worked to the state’s advantage. But the market fell broadly in 2022 – and California is reeling with that impact as it disproportionately hurts those wealthy taxpayers whom the state relies on.

For example, after years of surplus budgets, the 2023 fiscal year is leaving a $22.5 billion hole. This is partly due to expansive social programs, but also because of a decline in tax receipts from high-tax residents I mentioned above.

The broader point here is not to be alarmist. The state still has a “rainy day” fund in the tens of billions that will limit short-term fallout and prevent muni defaults. But it does show that investors in munis, especially in California, need to remain aware to what is happening in the broader market around them and how it impacts state and local government finances. In the case of California, the two often go hand-in-hand.

Defaults Remain Low

The premise here is that PZC is a decent option, but it is by no means a risk-free alternative. The state of California has its troubles to contend with, and investors in PZC should monitor those carefully. Further, the fund is highly leveraged and has a duration above 12 years. This poses quite a bit of interest rate risk if the Fed continues on a hawkish path. That was the case in 2022 and we all know how that turned out. While the market – and myself – expects the Fed to tap out after only a few more modest hikes this year, that is not guaranteed. So make sure to stay within your risk tolerance and manage your entire portfolio’s duration.

On the bright side, these risks are balanced out to some degree by munis historical track record. Defaults in this sector are very rare and when they do happen they tend to be isolated (i.e. Puerto Rico), which skews the numbers for the overall sector. Even considering Covid-19, defaults were minimal, as the federal government will often step in to help:

This track record gives me confidence today, as it has for years. Munis continue to be where I shelter in the fixed-income world and I see no reason for that to change in 2023 given the quality of credit within the space.

Bottom Line

PZC has had a rough 2022 and an uneasy start to 2023. At this juncture, I see some merit to holding or buying a position in this fund, but I’d be careful. The single-state exposure to California poses unique risks, as does the fund’s heavy use of leverage and long-dated assets. The positive traits are that I like munis and California’s debt remains well supported in the near term. However, these trends extend to other muni CEFs that trade at cheaper valuations. This makes me lean towards a “buy” rating for some of PZC’s peers, and a “hold” for this particular fund at this time.