FMD Capital Management

Why I’m Not Adding To The PIMCO Dynamic Income Fund

Written by Michael Fabian, February 13th, 2014

It comes as no surprise the Morningstar fixed-income manager of the year award went to Daniel Ivascyn, as his contribution to the PIMCO Income fund (PIMIX) was instrumental in landing the $30 billion fund near the top of the heap for 2013. What’s even more impressive is when that accomplishment is viewed through the lens of one of the worst interest rate environments in 20 years.

As impressive as his work on PIMIX was, when viewed alongside the performance of the net asset value of the PIMCO Dynamic Income Fund (PDI), you can begin to see the variance of activity, constraint, and tactility. On the surface the two strategies could be viewed as somewhat similar, but upon closer examination, it is clear Ivascyn manages PDI with a flair usually reserved for fixed-income hedge funds or opportunistic credit funds. His team’s ability to implement successful sector, credit, and interest rate strategies is unhindered by daily liquidity restraints and confounding prospectus limits. This makes for a compelling value proposition for future investments in fixed-income with rising interest rates as a lingering risk.

The primary contributors to the fund’s success in 2013 are the heavily concentrated allocations in non-agency mortgage backed securities. In addition, it holds smaller strategic allocations to select corporate high yield credit, foreign developed credit, and emerging market securities. However, allocations to those sectors alone would have made for a sizable pullback during the depths of credit market volatility, especially since PDI is heavily leveraged at 45.45%. To counteract these effects, it was Ivascyn’s position of roughly $200 million in long dated pay-fixed swaps that enabled PDI’s net asset value to hold its ground as rates headed north. Derivatives can be complex instruments, but for investors that are unfamiliar, long dated pay-fixed swaps would be the general equivalent of being short $200 million worth of the iShares 20+ Year Treasury Bond ETF (TLT).

By utilizing the liquidity of treasury and credit-default swaps, he was able to tie up a small portion of the fund to effectively hedge off credit positions that otherwise carry a low duration and therefore a relatively low sensitivity to interest rates. Moreover, using a regression analysis of the NAV, it is obvious that as interest rates became over extended, Ivascyn was able to unwind his hedges over time to take advantage of a supportive credit market in the second half of 2013.

Implementing backward looking analysis gives me full confidence in the management of PDI in nearly any market environment. However, it’s worth asking – at what cost?

I have been a raging bull on PDI since a few months after its IPO in April of 2012. I even was aggressively adding during its pullback in the months following the Fed announcement in May of 2013, as typical retail investors were selling. Yet, the seemingly large amount of interest PDI has attracted as of late has me nervous. Its discount has contracted from a low of 11.42% to near parity at -0.74%. The arbitrage opportunity was a large part of my investment thesis, yet I’m concerned whether or not PDI’s price can carry a consistent premium to its NAV.

Surprisingly it has never been able accomplish that feat even when compared to other PIMCO closed-end fund offerings with lesser NAV returns. Bill Gross has even been adding to PDI for his own accounts, and also recommended the fund as one of his Barron’s roundtable investment picks.

PDI seemingly has everything going for it, but as of today for clients in our Dynamic CEF Income portfolio I’ve halted new purchases. This is primarily due to the fact that it is trading strongly above its trailing twelve month average discount price.

The fact of the matter remains that there are still many funds out there trading at below average discounts that appear more attractive for new capital. Funds such as the PIMCO Dynamic Credit Income fund (PCI) still trade below it’s trailing twelve month average, at a 7% discount, and have exhibited excellent NAV performance. I will continue to watch PDI with a lot of enthusiasm, and hope for success in 2014 as it currently makes up roughly 15% of our portfolio. Moreover, I’m not considering making any sales at this point as I strongly believe the fund will continue to perform well in the current environment.

When it comes to investment strategy, maintaining perspective and discipline will go a long way to ensuring positive changes are executed in a timely fashion. To detail the typed of discipline in our CEF income portfolio, I recently wrote a special report expanding on our investment themes in addition to our selection process.