PDX: An Unusual Offering From PIMCO, But A Good One

seekingalpha06-03

Travel Ink/DigitalVision via Getty Images The PIMCO Dynamic Income Strategy Fund (NYSE:PDX) is a closed-end fund that income-focused investors can employ as a method of earning a high level of income ...

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As regular readers are likely well aware, PIMCO funds in general tend to have remarkably high yields compared to their peers. However, this one seems to be an exception, as its 6.44% yield is not particularly impressive for a debt fund in today's environment. We can see this quite clearly by comparing this fund's yield to that of its peers:   Fund Name Morningstar Classification Current Yield   PIMCO Dynamic Income Strategy Fund Hybrid-Global Allocation 6.44%   Calamos Global Total Return Fund (CGO) Hybrid-Global Allocation 9.13%   Clough Global Opportunities Fund (GLO) Hybrid-Global Allocation 11.36%   Guggenheim Active Allocation Fund (GUG) Hybrid-Global Allocation 9.49%   Nuveen Multi-Asset Income Fund (NMAI) Hybrid-Global Allocation 13.13%   Virtus Total Return Fund (ZTR) Hybrid-Global Allocation 11.01%   Click to enlarge As we can clearly see, the PIMCO Dynamic Income Strategy Fund has a significantly lower yield than any of these peer funds. Admittedly, part of this may be due to the fact that this fund's share price has substantially outperformed any of the other funds on this list over the past year: Seeking Alpha Shares of the PIMCO Dynamic Income Strategy Fund are up 49.22% over the past twelve months, substantially beating all of its peers by quite a lot. This naturally would have the effect of reducing the fund's yield because yield is basically dependent on the amount of the distribution and the share price. An increase in the denominator will reduce the yield. As such, investors who have been in this fund for a year or so probably do not mind the fact that the yield is much lower than its peers as they have already made a lot of money via the share price appreciation and the yield that they are receiving on their cost is much more attractive than 6.44%. However, for new investors who will not benefit from the strong share price appreciation over the past twelve months, the low yield is likely to be a turnoff. As might be expected, the PIMCO Dynamic Income Strategy Fund was also the top-performing fund of this peer group over the past five years. Its share price has risen by 9.10% over the period, while all of its peers have experienced significant price declines: Seeking Alpha However, one thing that we do note here is that virtually all the fund's share price gains came in the past year. The PIMCO Dynamic Income Strategy Fund was actually underperforming its peer group significantly over the 2020 to 2022 period and was, in fact, only in line with the second-best performing fund (the Calamos Global Total Return Fund) in June of last year. In short, it appears that the market took a liking to this fund in early July 2023 and propelled its share price upward. The other funds in this group did not benefit from such market excitement. If they had, it seems likely that their performance would also be in line with the PIMCO Dynamic Income Strategy Fund. However, one important thing to keep in mind with closed-end funds is that the share price performance alone does not tell us everything. As I stated in a recent article: A simple look at a closed-end fund's price performance does not necessarily provide an accurate picture of how investors in the fund did during a given period. This is because these funds tend to pay out all of their net investment profits to the shareholders, rather than relying on the capital appreciation of their share price to provide a return. This is the reason why the yields of these funds tend to be much higher than the yield of index funds or most other market assets. When we include the distributions paid out by the PIMCO Dynamic Income Strategy Fund and all of its peers in the price performance chart above, we get this alternative chart: Seeking Alpha This does still speak somewhat well to the PIMCO Dynamic Income Strategy Fund, since as we can clearly see, it still managed to outperform all the other funds shown above during the period. However, once again, it only managed to do this because of the very strong share price appreciation that it has delivered since July 2023. The fund was not a particularly strong performer prior to that date. As we are all well aware, the past performance of a fund is no guarantee of its future performance. In the case of this fund, there is a very real possibility that the low yield will prevent it from continuing to outperform relative to its peers, as there is no real catalyst to continue to drive the share price upward. Of course, we should still analyze the fund in order to get an idea of how it is likely to perform over the coming months and years. About The Fund According to the fund's website, the PIMCO Dynamic Income Strategy Fund has the primary objective of providing its investors with a very high level of current income. This strategy makes a great deal of sense considering the fund's overall strategy. As is usually the case with PIMCO funds, the website explains its strategy in great detail:  The fund utilizes an opportunistic approach to pursue high conviction income-generating ideas across global credit markets to seek current income as a primary objective and capital appreciation as a secondary objective. In managing the fund, PIMCO will employ an active allocation among multiple fixed income sectors based on, among other things, market conditions, valuation assessments, economic outlook, credit market trends and other economic factors. With PIMCO's macroeconomic analysis as the basis for top-down investment decisions, including geographic and credit sector emphasis, PIMCO will manage the fund with a focus on seeking income generating investment ideas across fixed income sectors, including opportunities in developed and multiple emerging global credit markets. PIMCO may choose to focus on particular countries/regions, asset classes, industries and sectors to the exclusion of others at any time and from time to time based on market conditions and other factors. The relative value assessment within fixed income sectors will draw on PIMCO's regional and sector specialist insights. As a matter of fundamental policy, the fund normally invests 25% of its total assets in the energy industry. PIMCO will, on behalf of the fund, make reasonable determinations as to the appropriate industry classification to assign to each security or industry in which the fund invests. The fund seeks to achieve its investment objectives by utilizing a dynamic asset allocation strategy among multiple sectors in the global public and private credit markets, including corporate debt, mortgage-related and other asset-backed instruments, government and sovereign debt, taxable municipal bonds and other fixed-, variable- and floating-rate income-producing securities of U.S. and foreign issuers, including emerging market issuers and real estate-related investments. The fund may invest without limitation in investment grade debt securities and below investment grade debt securities, including securities of stressed, distressed or defaulted issuers. The fund may also invest without limit in common stocks or other common equity securities issued by public or private issuers.  This description basically suggests that the PIMCO Dynamic Income Strategy Fund can invest in anything that it wants. However, the description does tend to imply that the fund favors investing in bonds or other debt securities. That is not particularly surprising considering that this is a PIMCO fund and PIMCO funds in general are known for being bond funds. The fact that the PIMCO Dynamic Income Strategy Fund seems to favor bonds or debt over common stocks is something that sets it apart from some of its peers, shown in the introduction:   Fund Name Common Stock Allocation Debt Allocation   PIMCO Dynamic Income Strategy Fund 60.1% 24.2%   Calamos Global Total Return Fund 54.76% 34.48%   Clough Global Opportunities Fund 91.65% 6.85%   Guggenheim Active Allocation Fund 3.51% 94.80%   Nuveen Multi-Asset Income Fund 41.30% 37.20%   Virtus Total Return Fund 105.0% 38.4%   Click to enlarge With respect to some of these funds, the breakdown is not always clear. For example, the Calamos Global Total Return Fund has a significant percentage of its assets invested in convertible securities. I considered those to be debt securities for the purposes of constructing the table, but as convertible securities have performance characteristics that resemble both stocks and bonds, a case could be made that they should not be included in a fixed-income allocation. There were similar problems with many of the other funds shown in this table. For the most part, the common stock allocation includes only common equities. The debt allocation portion includes convertibles, asset-backed securities, leveraged loans, corporate bonds, domestic and foreign debt, and mortgage-backed securities. Overall, we can see that most of the peer funds favor common equities in their portfolios right now as opposed to bonds. The Guggenheim Active Allocation Fund is the sole exception, as its debt allocation far exceeds the common stock allocation. The surprising one here is the PIMCO Dynamic Income Strategy Fund, as the strategy description on the website strongly suggests that this fund invests primarily in debt securities, but it is currently more heavily invested in common equities. The fact sheet confirms this: Fund Fact Sheet We immediately see the 60.1% equity allocation here, confirming the statement made in the chart earlier. We can also see that the credit allocation consists almost entirely of junk-rated debt securities. The fund only has 2.8% of its assets invested in investment-grade bonds. While the fact that the fund is invested primarily in equities is surprising considering that this is a PIMCO fund, it does make sense in the current market environment. As we can see here, equities have outperformed both junk bonds and investment-grade bonds year-to-date: Seeking Alpha Common equities are represented by the S&P 500 Index (SP500) for our comparison chart, and the S&P 500 Index has risen by 10.95% year-to-date. For investment-grade bonds, we are using the Bloomberg U.S. Aggregate Bond Index (AGG), which has declined by 2.75% since the start of the year. For junk bonds, we are using the Bloomberg High Yield Very Liquid Index (JNK), which has been almost flat year-to-date. As we can see, then, the worst-performing asset of the three was investment-grade bonds. Junk bonds outperformed investment-grade credit but substantially undervalued common equities. Finally, common equities were the best performers over the period. Therefore, it would make sense for any fund that is seeking to maximize its total return to have held common stocks and junk bonds year-to-date while maintaining an underweight (or even shorting) investment-grade credit. That is exactly the current allocation of the PIMCO Dynamic Income Strategy Fund. The strategy description on the website specifically states that the PIMCO Dynamic Income Strategy Fund invests a significant proportion of its assets in the energy sector. This might be surprising at first because of the fact that the energy sector has been something of a perennial underperformer in the decade prior to the pandemic. It has since improved, though, due mostly to high energy prices and a change in the business models used by most companies in the sector. However, it does work reasonably well for an income fund due to the high yields possessed by this sector. As of right now, the iShares Global Energy ETF (IXC), which tracks an index of energy-sector companies that are based both domestically and abroad, has a 3.13% trailing twelve-month yield. This is substantially higher than the 1.38% trailing twelve-month yield of the S&P 500 Index. However, this index mostly covers global energy giants like Exxon Mobil (XOM), Chevron (CVX), and Shell (SHEL). Here are the largest holdings in the index: BlackRock The PIMCO Dynamic Income Strategy Fund invests in a different type of energy company, though. Its equity holdings are largely invested in pipeline operators. From the fact sheet: Fund Fact Sheet As we can see, 58.9% of the fund's assets are invested in pipeline operators. These companies tend to have much higher yields than the integrated giants that comprise the global energy index. The PIMCO Dynamic Income Strategy Fund does not provide its largest holdings on the website or in the fact sheet, which is disappointing. However, the semi-annual report provides a list of all of its holdings as of December 31, 2023. Here are all the pipeline operators listed in this report, as well as their current yields:   Company Current Yield   Antero Midstream (AM) 6.14%   DT Midstream (DTM) 4.38%   EnLink Midstream (ENLC) 4.18%   Kinder Morgan (KMI) 5.90%   ONEOK (OKE) 4.89%   Plains GP Holdings (PAGP) 6.50%   Targa Resources (TRGP) 2.54%   The Williams Companies (WMB) 4.58%   Energy Transfer (ET) 8.10%   Enterprise Products Partners (EPD) 7.23%   MPLX (MPLX) 8.36%   Plains All American Pipeline (PAA) 7.47%   Western Midstream Partners (WES) 9.38%   Click to enlarge As we can very quickly see, all of these pipeline operators have significantly higher yields than just about anything else that is currently trading in the capital markets. As such, it makes a great deal of sense for the fund to focus its common equity holdings on these companies, as their high yields provide it with more income than it could obtain from investments in other stocks. In fact, many of these companies have higher yields than most investment-grade bonds as well as offer the potential for capital appreciation, so the fund is obviously better served by having these assets in its portfolio than if it invested in bonds instead. The fact that the fund is invested heavily in pipeline operators could also explain some of the very strong performance that it has delivered over the past year. As I stated earlier, the energy sector was generally an underperformer over most of the past decade. Over the past ten years, the Alerian MLP Index (AMLP), which tracks pipeline operators that are structured as master limited partnerships, has declined by 50.35%. That is obviously far worse than the S&P 500 Index delivered over the same period: Seeking Alpha However, it has been a very different story over the past year or two. Over the past twelve months, the Alerian MLP Index has almost matched the domestic large-cap index: Seeking Alpha If we look at the performance of the two in terms of total return, the Alerian MLP Index significantly outperformed the S&P 500 Index by virtue of its higher yield: Seeking Alpha While the PIMCO Dynamic Income Strategy Fund includes pipeline operators that are structured as corporations and not only those ones that are structured as master limited partnerships, corporate pipeline operators also did pretty well over the past year. Thus, the PIMCO Dynamic Income Strategy Fund's large allocation to pipeline operators appears to have served as a tailwind to the fund's performance over the past several months. This gives it an advantage that most of its peers do not have, and almost certainly provides one explanation for its strong recent relative performance. Leverage As is the case with most closed-end funds, the PIMCO Dynamic Income Strategy Fund employs leverage as a method of boosting the effective yield and total return that it earns from the assets in its portfolio. I have explained how this works in a number of previous articles. To paraphrase myself:  Basically, the fund borrows money and then uses that borrowed money to purchase equities, bonds, and other income-producing assets. As long as the yield that the fund receives from the purchased assets is greater than the interest rate that it has to pay on the borrowed money, the strategy works pretty well to boost the effective yield of its portfolio. This fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates. As such, this will usually be the case. However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage because that would expose us to an excessive amount of risk. I generally prefer that a closed-end fund's leverage remain under a third as a percentage of assets for this reason.  As of the time of writing, the PIMCO Dynamic Income Strategy Fund has leveraged assets comprising 15.58% of its portfolio. Obviously, the fund is well below the one-third of assets level that I would ordinarily deem acceptable. However, we should also compare it to its peers in order to determine if it is appropriate given the fund's specific strategy. After all, a lot of closed-end funds that invested heavily in pipelines lost a lot of money back in 2020 when the bottom fell out of the energy sector. Here is how the leverage ratio of the PIMCO Dynamic Income Strategy Fund compares to its peers:   Fund Name Leverage Ratio   PIMCO Dynamic Income Strategy Fund 15.58%   Calamos Global Total Return Fund 31.46%   Clough Global Opportunities Fund 26.25%   Guggenheim Active Allocation Fund 21.71%   Nuveen Multi-Asset Income Fund 27.50%   Virtus Total Return Fund 30.17%   Click to enlarge (All figures from CEF Data) As we can clearly see, the PIMCO Dynamic Income Strategy Fund has considerably less leverage than its global hybrid peers. This should be a positive sign for risk-averse investors as it clearly tells us that the fund is not employing an excessive amount of leverage given its particular strategy and indeed the fund would probably be okay even if it increased its leverage a bit. As such, investors or potential investors should not need to worry too much about the fund's leverage today. Distribution Analysis The primary objective of the PIMCO Dynamic Income Strategy Fund is to provide its investors with a very high level of current income. To this end, the fund pays a monthly distribution of $0.1133 per share ($1.3596 per share annually). This gives the fund a 6.44% yield at the current share price. Unfortunately, the fund has not been particularly consistent with respect to its distribution over the years: Seeking Alpha At least part of this is due to the fund's significant exposure to pipeline operators. As I pointed out in a previous article on a pipeline-focused fund: As we can see, the fund's distribution has varied considerably over the years, although the long-term trend has been down. The fund has at least been trying to raise its distribution since 2020. This is not especially surprising, as most midstream funds ended up having to cut their distributions in 2020 as the midstream energy industry in general encountered crisis conditions following a fallout in crude oil prices. The market was generally unwilling to finance these companies and so many of them were forced to cut their distributions and restructure their operations in order to survive. That caused the fund to suffer fairly substantial losses, and it was forced to reduce its own payout in order to preserve its net asset value. The PIMCO Dynamic Income Strategy Fund is not a dedicated pipeline fund, so it did not suffer to nearly the same degree as the pure energy infrastructure closed-end funds back when the sector collapsed around the time of the COVID-19 pandemic. However, the fund still has sufficient exposure to the sector for it to have encountered some of the same problems that dedicated funds did around the same time. The fund switched from a quarterly distribution to a monthly distribution last month. That is why it appears that the distribution was cut in the chart above. However, the fund actually went from $0.26 per share quarterly to $0.1133 per share monthly. That is a distribution increase, as $0.1133 per share monthly works out to $0.3399 per share quarterly. This is nice to see given the rising cost of living that we have all been suffering, as the extra money will come in handy for helping us maintain our standard of living. However, it is still less than the $0.40 per share quarterly distribution that the fund possessed prior to the 2020 distribution cut. Let us have a look at the fund's ability to cover and sustain its distribution. For this purpose, we will use the fund's most recent financial report. This is the semi-annual report that corresponds to the six-month period that ended on January 31, 2024. A link to this report was provided earlier in this article. For the six-month period, the PIMCO Dynamic Income Strategy Fund received $10.461 million in interest and $9.362 million in dividends net of foreign withholding taxes. This gives the fund a total investment income of $19.823 million for the period. The fund paid its expenses out of this amount, which left it with $8.636 million available for shareholders. This was not sufficient to cover the $19.671 million that the fund paid out in distributions to its shareholders over the period. Fortunately, the fund was able to make up the difference via capital gains. For the six-month period, the PIMCO Dynamic Income Strategy Fund reported realized capital gains totaling $62.887 million. It also had net unrealized gains of $129.230 million for the period. Overall, the fund's net asset value increased by $181.082 million after accounting for all inflows and outflows during the period. Thus, the PIMCO Dynamic Income Strategy Fund fully covered all its distributions in the first half of the current fiscal year, with quite a lot of money left over. It does not appear that we need to worry about the fund's ability to sustain its current 6.44% yield. Valuation Shares of the PIMCO Dynamic Income Strategy Fund are currently trading at a 12.63% discount to net asset value. This is a much more attractive price than the 10.50% discount that the fund's shares have averaged over the past month. As such, the current price looks quite reasonable as an entry point. Conclusion In conclusion, the PIMCO Dynamic Income Strategy Fund has been a remarkably strong-performing fund over the past year. Despite this, the fund is one of the only PIMCO funds that is trading at a discount to net asset value. This is probably due to the fund's significant allocation to pipeline operators, as these companies are not always popular with investors, and most funds that have energy infrastructure allocations trade at large discounts. This fund does appear to be quite good at what it is, though, as it is a mixture of common equities and bonds that provides a reasonable fully covered 6.44% yield. The mixture of common equities and bonds works well in the current environment due to the simple fact that equities provide better inflation protection than bonds, so are probably better long-term holdings. Overall, this fund might be worth considering if you can tolerate the somewhat low yield for a closed-end fund.  Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. 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