PCN: Modest Outlook Going Forward (NYSE:PCN)

Main Thesis

The purpose of this article is to evaluate the PIMCO Corporate & Income Strategy Fund (PCN) as an investment option. This is a fund I was cautious on as the market recovery got underway, and its performance has exceeded expectations. With equity and fixed-income markets benefiting from increasing levels of investor optimism, staying long funds that have performed well makes intuitive sense. However, I see multiple reasons for caution here.

PCN’s premium has risen to levels where I see little underlying support, and is well above the average PIMCO CEF premium. Further, the fund is heavily weighted towards high-yield credit, which is an area I am lukewarm on going forward. The sector has seen a tremendous rebound, and is enjoying some level of Fed support. Despite this, companies in the space are seeing earnings decline, relative to their interest expenses. Further, the yield curves are inverting, which signals investors are not optimistic about future prospects. While I see merit to buying PCN at a below average price, the current macro-environment does not seem to support new positions right now.

Background

First, a little about PCN. It is a closed-end fund with a primary objective “to seek high current income, with a secondary objective of capital preservation and appreciation.” Currently, the fund is trading at $15.72/share and pays a monthly distribution of $.1125/share, which translates to an annual yield of 8.63%. I have had a neutral outlook on PCN for a while, including back in April. In hindsight, this view was a bit too cautious, as I under-estimated how hard the broader market would rally coming out of the March sell-off. Since that review, PCN has seen a very strong gain, although it lags the equity market by a wide margin, as shown below:

Source: Seeking Alpha

As we approach Q4, I am taking another look at most of the funds and sectors I cover, to see if I should alter my outlook. After review, despite PCN’s short-term momentum, I believe a “neutral” rating is still most appropriate, and I will explain why in detail below.

Valuation Too High For Comfort

To begin, I will touch on the primary reason why I am reluctant to put a buy rating on PCN at this time. Despite a swift rebound off the March lows, as well as short-term bullish momentum, my concern rests largely with the fund’s valuation. As PIMCO CEF investors know, large premiums are not uncommon for these products, so ruling out a fund due to a premium is not necessarily the right move.

However, even for popular PIMCO CEFs, there comes a point when the risk-reward trade-off simply isn’t there. I believe we have reached this point with PCN, as the premium now exceeds 20%. This is high in both isolation and in relative terms, when we consider where the fund was trading at earlier this year, and where alternative PIMCO CEFs are trading at now. To illustrate, see the chart below, which lists a few relevant figures:

Current Premium 20.8%
Premium in April Review 13.5%
Average Current Premium PIMCO CEFs (non-muni) 9.5%

Source: PIMCO

The point here is PCN is nowhere near “cheap,” not by any stretch of imagination. The premium of almost 21% on the surface clearly seems high. Of course, some CEFs often trade at high premiums (or low discounts), so it is important to take trading history into account before deciding if a current price is too expensive or a bargain. But when we look at PCN’s premium just a few months ago, we see it is markedly lower than the current level. Further, PIMCO CEF investors have multiple options to choose from, and PCN’s current price is more than twice the average for the alternative funds focused on corporate and mortgage debt. All things considered, this indicates PCN is a bit too richly priced for my taste, which forces me to leave my prior rating intact.

Income Metrics Did Improve In July

My next point has a more positive slant, and helps support my neutral view, as opposed to a more bearish outlook. Specifically, PIMCO’s August UNII report was just published, and it showed some improvement in PCN’s income production. For a high-yield fund, income metrics are of critical importance, so seeing these figures improve month-over-month is certainly a good sign.

To illustrate, let us take a look at the current UNII report against July’s report, which are shown below, respectively:

Source: PIMCO

As you can see, the coverage ratios have seen sharp jumps, with particular improvement in the three-month coverage ratio. Another good sign has been the elimination of the negative UNII balance, which was worth almost a full month of distributions. While the current level of $.0/share does not inspire much confidence, the short-term improvement is something I view positively.

My takeaway here is the fund’s recent momentum seems partially justified, as the distribution appears safe for now. The income stream near 9% will remain attractive, even if interest rates do tick up a bit later in the year, and the fund appears to be earning enough to cover the stated distribution level. While these figures may not be strong enough to justify a 20% premium price, they do show PCN has solid underlying performance. This helps to support my neutral opinion, as a bearish rating may be too harsh given the UNII metrics.

High-Yield Fundamentals Are Deteriorating

My next point on PCN will discuss the fund’s underlying holdings. For this review, I will touch on the high-yield credit market, as this remains PCN’s largest sector by weighting, as it has been for some time. In fact, the fund’s exposure to this sector has been growing, and has increased by about 2% since my last review, sitting just over 31% currently:

Source: PIMCO

Clearly, this is an area that is extremely important for PCN, and the high reliance on below investment grade debt is a primary reason for the volatility in this fund. Fortunately, high-yield credit is benefiting from some government support right now. Also, the sector has rallied as investors have seemingly overcome their Covid-19 fears by crowding into riskier assets in the past few months. While this has allowed PCN to register a strong return in the short term, investors need to appreciate that much of these gains are being driven by investor sentiment, as opposed to underlying fundamentals. What I mean by this is that the high-yield credit market is showing signs of stress, yet it is generating strong returns because investors seem to believe the market will overcome Covid-19-related challenges.

To understand my point, let us consider corporate earnings on a broad scale. With bond prices climbing higher, and premiums for funds like PCN simultaneously rising, it would be logical to expect corporate earnings are strong. After all, companies need to generate profit in order to pay off their loans and make good on their interest obligations to creditors. However, while U.S. corporations have been holding up reasonably well considering the environment they are operating under, the reality is the high-yield market is under pressure. One way to illustrate this is to examine earnings relative to interest expenses, on a broad scale. As economic lock-downs have pressured both revenues and profits, earnings have declined. Yet, debt has been rising. The result has been a decrease in earnings relative to interest expenses, in both the investment grade and high-yield sectors, as shown below:

Source: Yahoo Finance

The point here is not to suggest that high-yield bonds are suddenly going to all default and/or that investors are going to rotate out of this asset class. But seeing earnings decline relative to interest expenses does raise the possibility there will be pressure on the sector moving forward. However, the graph above also shows current levels are within the longer-term range, so this is not a major red flag for the moment.

Simply, there is a metric to monitor, and to force investors to consider their individual risk tolerance and outlook. If one expects corporate earnings to improve heading into 2021, this particular metric should not be of great concern. But if one expects corporate earnings to remain under pressure, or decline, in the second half of the year, then this could very well be a precursor to further trouble in the credit markets. If the latter scenario does occur, a shift to higher-quality debt, and higher-quality funds, and away from higher-risk funds like PCN, may be the prudent move.

Junk Credit Yield Curves Are Inverted

My final point touches on investor expectations for the high-yield credit markets. As I noted above, there are some indications that high-yield credit could come under pressure in the months ahead. For the time being, investors seem willing to take on this risk. However, there are signs that investors expect some pain ahead, which could mean an above-average rotation out of that sector if conditions do deteriorate. The risk, in my view, is that investors are not confident in the longer-term outlook for high-yield credit, and could generate disproportionate selling activity based on short-term noise.

To get a sense of why this concerns me, let us look at the yield curves for BB and B rated credit, which combine to make up a large percentage of the high-yield credit market. As 2020 got underway, both of these yield curves inverted sharply, and despite a partial recovery, remain inverted as of 8/14:

Source: Guggenheim

Essentially, this graph illustrates that the high-yield market is not functioning normally at this time. When a yield curve inverts, it suggests investors are concerned about future prospects, as they expect longer-term interest rates to fall in the future. In a normal credit market, longer-term bonds or loans would charge higher rates of interest, to compensate for the higher risks of tying up one’s money for a longer period of time. When a yield curve inverts, it signals shorter-term rates are higher than longer-term rates, which means investors expect challenging and/or deteriorating economic conditions in the future.

The implication of an inverted yield curve is that investor’s long-term outlook is poor, and that the yields offered by long-term debt will continue to fall. Therefore, this tells me the current bullish momentum around high-yield debt, and funds like PCN, may not be sustainable. Yes, investors are seemingly blind to credit risk right now, as risk-on trades have been immensely profitable over the past quarter.

With a recovering economy, partial state re-openings, and government support, some level of optimism is understandable. However, the current optimism does not seem to extend to the longer term, as the inverted yield curve suggests. This tells me investors would be wise to be cautious here, and not to chase returns at these levels. The yield curves are telling us that we may see trouble ahead, so taking some risk off the table, rather than adding to it, makes the most sense to me at this time.

Bottom line

PCN’s recent rally has been impressive, but I am concerned about its sustainability. The fund is supported by a continued risk-on mode across both equity and fixed-income markets, and improvement in the fund’s UNII figures helps justify the recent rise. However, the premium to own PCN is much too high, in my view, and ignores the risk profile of the high-yield sector. With earnings on the decline and an inverted yield curve raising a red flag for high-yield investors, I see little reason to be bullish at these levels. Therefore, I continue to hold a neutral rating on PCN, and suggest investors approach new positions very carefully going forward.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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