Description

PGP is a CEF trading at a crazy 104% premium. While hard to borrow, it still offers a decent return for short sellers as the premium is highly likely to go down over time. PIMCO Global StocksPLUS & Income Fund is a closed end fund that investors are treating like a special snowflake. The thesis is that the premium will compress making PGP an attractive short. The risk is that borrow cost will eat up your return before the spread compresses.

Closed end funds (CEF) are like mutual funds, but are exchange traded with prices that can go below or above NAV. The reason for their existence is the idea that fund managers can realize better returns if they have a permanent capital base and don’t have to worry about daily redemptions. Closed end funds typically trade at a single digit discount to the underlying NAV of their holdings, representing the cost of management fees. They typically pay dividends based on the income of their portfolio investments, with low yields for equity funds and higher yields for bond/credit funds.

For the last 5 years PGP has paid a steady $.1834/sh monthly dividend regardless of portfolio income earned. This equates to a 11.2% distribution yield, a major reason for high premium. PGP’s steady distribution yield and its unique strategy have made it perennially trade at high premiums, averaging 64% over the last 5 years. But the premiums are volatile, varying wildly intra-year.  PGP’s premium has steadily shot up from 18% in September 2015 to 104% today. The premium has likely peaked and is due for a correction. Premium narrowing/ discount widening often happens in times of market stress or decline. The market’s recent risk off mentality coinciding with the Brexit vote could be the catalyst to send PGP’s premium down to earth, especially as PGP is highly exposed to the return of foreign stocks.

Given the high borrow costs, returns will be dependent on how fast the premium declines. While returns will not be spectacular, I think they are likely to be positive given how premiums tend to swing. I think sometime in the next 6 months. PGP’s premium will come back down to 40-50%. While that is still wildly overvalued, it would provide a nice return to the short seller, providing an opportunity for a high teens % hedged return (even at a 40% borrow cost).

PGP’s portfolio is more complicated that the typical CEF or mutual fund. PIMCO’s StocksPLUS strategy is designed to provide an index beating return by buying stock index futures from a collateralized portfolio of actively managed bonds. The fund will also sell calls and buy puts on the index funds. In theory the fund should beat the index by the return on the portfolio less borrowing and transaction costs. While it is rare for stocks and bonds to decline at the same time, it does happen, and hence the strategy is really just a leveraged bet on the markets. PGP’s index is a mix of the S&P 500 and the MSCI EAFE indices. While the fund’s returns have been good, with a 10yr 10.3% NAV return vs. 7.4% for the S&P 500, they are highly volatile with a -48% return in 2008 and a 63% return in 2009. Management fees are high at 1.1% and the fund incurs a lot of trading fees bringing total expenses to 1.7% (excluding interest expense on its leverage).

There is nothing magic about PGP’s portfolio/strategy to deserve a consistently high premium. Investors looking for StocksPLUS exposure or PGP short sellers looking to hedge can just buy PPUAX at NAV. PPUAX is the PIMCO StocksPLUS International mutual fund. While not exactly the same portfolio as PGP, it is awfully similar.

In 2015, 47% of PGP’s $2.20/share distribution was covered by net investment income (but as an added benefit for long holders of PGP, 100% of distributions are taxed as income).  This means that the fund is liquidating itself over time. As the fund has not been issuing more shares above NAV, the distribution policy ensures that NAV declines over time, even if the fund has above average returns. Since the 2005 IPO, NAV has declined from $25/share to $9.57 today. High payouts help the short as a result of losing the premium valuation on the NAV of the liquidating distribution. Assuming a constant premium and underlying NAV price, a closed end fund trading at a premium will decline in total return after making a liquidating distribution. At such a large distribution (23% of NAV) and such a high premium, the liquidating effect will be a sizable headwind to price performance. At a constant 104% premium and flat investment performance, after accounting for distributions, PGP stock will decline almost 1% a month or 12% a year.

If PGP immediately traded at NAV or liquidated itself entirely, the gain would be $10/sh, or 51% on the

$19.57 fund price. Losing the 51% overvaluation x the 23% liquidating distribution each year will create the 11.8% total return headwind.

Due to the combination of a high expense ratio, return of capital distributions taxed as income, and volatile fund performance, I think that PGP deserves to trade at a slight discount to NAV. That is not going to happen, but a decline in the premium from here is highly likely, making PGP a decent short opportunity.

Catalyst

Premiums usual narrow in times of market stress or decline, or when a hot investment sector/style falls out of favor. The market’s recent risk off mentality coinciding with the Brexit vote could be the catalyst to send PGP’s premium down to earth, especially as PGP is highly exposed to the return of high yield bonds and international stocks. If investors continue to reduce exposure to international stocks and leveraged investments, PGP's premium and stock price will likely follow its underlying portfolio down.