PFL and PTY: we are entering the final phase of merger

The last time we covered PIMCO Corporate & Income Opportunity Fund (NYSE:PTY) and PIMCO Income Strategy Fund (NYSE: PFL), we explained to you why the funds offered rather poor prospects for returns and investors would be better to look elsewhere for performance. What happened here is rather interesting because our thesis worked out perfectly with regard to the net asset value of these funds. NAVs fell almost identically at an annualized rate of 45% and are now around 7.5% lower than 2 months ago.

Total return, which includes prized distributions, was also negative, but obviously less sore on the eyes.

Although these are the most important metrics, we found price distortion between the two.

The PTY is down only 3% and has stopped tracking the PFL since mid-May. We examine the outlook for these two funds in light of recent economic data.

Wage growth

The core of our thesis since June 2021 (see Abysmal Setups) is that these funds are incredibly expensive relative to their potential and investors are unlikely to see positive total returns for a very, very long time. This of course played a role and the returns were quite poor over this period. Unfortunately, the macro environment has not improved for these funds.

The main concern here is that the Federal Reserve is still struggling with unprecedented inflation. Wage growth has now jumped to 6.5% and that is certainly an outlier.

In conjunction with a strengthened balance sheet from COVID-19 stimulus savings, the consumer can tolerate high inflation for some time. As a result, the amount the Federal Reserve needs to raise has increased further.

CCC spread

US High Yield CCC or Lower Option Adjusted Spread is a measure of distress in the bond market. This is one of our favorite indicators and one where we are also a little surprised at how it turned out. In September 2021, we showed you this graph next to the premium to NAV for PFL.

Our comment at the time was as follows.

But if you are looking for an entry point, look at the adjusted spread of the High Yield CCC option. When that counter explodes and we’ll probably have it in the next 12-24 months, it will pass the 10%. When this happens, you can bet that you will get all those funds with a discount to NAV.

Source: It’s just a flesh wound, so far

Guess where we are today?

The most interesting aspect here is that PFL investors have finally learned their lesson, but PTY investors seem pretty jaded about it.

This puts PTY in the most unfortunate position where investors could easily see a 25% decline simply by another modest drop in NAV and the normalization of that metric.

Triple threat of inflation

The latest core inflation figures rocked markets on Friday. Extremely high inflation is bad for junk bonds from several angles. The most obvious is that higher risk-free rates require even higher garbage rates. A year ago, Centene (CNC) issued junk bonds at 2.45% for 7 years.

Today, the 7-year Treasury yields more than that.

This CNC bond fell 16% and yields 5.5%.

Higher inflation also makes issuing stocks more expensive.

Companies issuing junk bonds will find that issuing equity will be very difficult in this environment.

Finally, higher inflation is crushing margins and this is the most dangerous of the three. High yield issuers have very little cushion and margin pressures can kill them very quickly. When companies like Walmart (WMT) and Target (TGT) can’t maintain their margins, one can only imagine the distress of lower ranks.

Verdict

We don’t see much relief for PFL holders and the most likely way forward is still very low yields. We maintain a hold/neutral rating as the fund is better valued than PTY and we believe positive total returns in the 3-4% annual range are likely from here. PFL also has less leverage than PTY and that also works in its favor.

In PTY’s case, complete disregard for the current environment leads us to downgrade it to a “strong sell”. On medium maturities, PTY offers the worst risk/reward ratio among the PIMCO funds we cover. The bounty stands out as extravagant when thrown into it PIMCO Income Strategy Fund II (PFN), PIMCO Dynamic Income Fund (PDI) or PIMCO Dynamic Income Opportunities Fund (PDO).

While total returns on NAV have led the pack over the past 18 months, the differences have not justified the high premium.

Most of the investors hit at that time were expecting a “Fed Put”, whereas we are getting a completely different message today. The Fed Put became the Fed Collar. We believe we are entering the final months of the selloff and it will likely end with PTY and PFL at a discount to NAV. We would err on the side of caution and look for buying opportunities down the line.

Please note that this is not financial advice. It may seem, seem, but surprisingly, it is not. Investors are required to do their own due diligence and consult a professional who knows their objectives and constraints.