PIMCO’s Dynamic Income Fund (PDI) is a simple and liquid way to get exposure to Pimco's best credit ideas including rebounding non-agency and subprime mortgage debt. PDI is a $1.28B fixed income closed end fund managed by the well-regarded Dan Ivascyn offering a stable 7.5% yield. PDI also currently trades at a slight discount to its NAV likely due to its more recent listing, while its PIMCO peers with longer histories trade at 5-30% premiums to NAV. The combination of a continued rebound in non agency & subprime mortgage debt, a 7.5% dividend and the likelihood that PDI will eventually earn a premium to NAV create the potential for a 30% total return over the next year with only fixed income-like risk.
PDI is a fixed income closed-end fund managed by a team led by Dan Ivascyn, who has also managed a similar fund, PIMCO Income Opportunity Fund since 11/2007. Ivascyn heads PIMCO’s mortgage credit team and joined PIMCO in 1998 from the Bear Stearns ABS group. The fund is designed to hold PIMCO’s best income generating ideas across various fixed income sectors. Given the portfolio managers mortgage debt expertise, it is likely that mortgage related debt will always make up a significant portion of the fund. The portfolio is currently heavily weighted towards US mortgage debt (122% of AUM), followed by non-US developed market corporate debt (22%) and high yield debt (16%). The fund currently pays a $0.177 monthly dividend (7.5% yield) and has paid that rate since inception. Within the fund’s mortgage allocation, only a small portion is dedicated to agency debt (~5%), which is backed by either Fannie Mae or Freddie Mac. This low level of agency exposure, with its higher prepayments, should result in lower prepays which will keep the fund’s interest income stable.
Like all closed end fund’s PDI can trade at a premium or discount to its published NAV. For most of the fund’s history, starting this spring it traded at a small premium to its NAV (see link below for NAV history). Currently the fund trades at a small discount (1.3%) to its NAV. This is due a recent selling pressure as investors position themselves for an increase in dividend taxes. PIMCO fixed income funds do not typically trade at a discount and PDI’s current discount should be short lived.
PDI is currently the only PIMCO fixed income fund that does not trade at a premium to its NAV. I believe this is due to its more recent launch relative to its peers. Ivascyn has managed a very similar fund (PKO) since 2007 that currently trades at a 4.2% premium and has averaged an 8% premium to its NAV over the past year. Other funds managed by Bill Gross trade at 10-20% premiums, while having a similar dividend yield to PDI. PIMCO’s funds have traded at a premium for a long time as this seekingalpha.com article from 2010 shows. Given their prominence in the fixed income world it is unlikely that this will go away anytime soon.
In response to PDI recently trading at a discount to its NAV Ivascyn purchased 35,000 shares for ~$960,000 on November 15th 2012. He also bought 21,400 shares on 9/25/12 for ~$600,000. Ivascyn currently owns 210,110 shares of PDI, or about $6mln which keeps him aligned with shareholders.
Non-Agency mortgage opportunity:
While the small discount to NAV and attractive yield make PDI a decent investment, the real potential for appreciation comes from its currently undervalued non-agency mortgage portfolio. Non-agency mortgages are any mortgage that is not issued by Fannie or Freddie and thus not implicitly guaranteed by the US government. Many of these securities are pools of lower quality & subprime mortgages that were hit extremely hard during the housing market crash in 2007-08. There are several reasons to be optimistic about the future performance of non-agency mortgage debt:
Collateral trends are improving as the lowest quality borrowers have dropped out of the securitization pools. Mortgage modifications are also helping lower default rates, which have fallen from over 12% in 2010 to under 8% in August 2012. Housing prices are also rising nationally, with the largest rises in the hardest hit areas; this will also continue to improve the credit quality of the collateral.
The supply of non-agency mortgage bonds will continue to fall as there is essentially zero issuance right now due as the mortgage market is being dominated by the GSEs. At the same time demand should rise as returns in the traditional agency market have been compressed by the Fed’s latest round of agency MBS focused QE. As traditional agency investors look for yield they will be increasingly forced into buying a limited supply of non-agency paper, boosting prices.
The weighted average price of PDI’s mortgage portfolio is around 80cents on the dollar, providing significant appreciation potential should market conditions continue to improve. This price represents a free call options on potential refinancing activity or the bonds being put back to the issuing bank at par due to rep and warranty fraud by the underwriting bank. Mortgage bond putbacks are becoming increasingly common as most court rulings so far have favored investors over the underwriters.
These technical and fundamental reasons should continue to provide a boost to non-agency mortgage bond prices. While this trade has already started working this year, given where yields currently are relative to other fixed income investments combined with improving housing fundamentals, it is not unreasonable to assume another 10 cent average price appreciation for PDI’s mortgage portfolio. Given its current weight (122%) that would imply PDI’s NAV rising to $33.10/shr (+15%). Assuming the fund trades at a 5% premium to its NAV, which is less than its sister fund PKO’s average of 8%, PDI would be worth $34.76/shr (+23%). Adding in the 7.5% annual dividend implies a total return of ~30% from its current price of $28.17.
I do not hold a position of employment, directorship, or consultancy with the issuer. I and/or others I advise hold a material investment in the issuer's securities.