Why PDI's Lofty Dividend Looks Vulnerable

The PIMCO Dynamic Income Fund (PDI) has a passionate following of investors, thanks to an attractive distribution that yields over 12% on top of the fact the payout has never been reduced since the fund's inception in 2012

These attributes are appealing, but sustaining such a high payout over an entire investment cycle is nearly impossible, even for the most skilled portfolio managers.

To achieve double-digit yields, the fund needs to invest in some of the riskiest parts of the public markets, like non-agency mortgage-backed securities (MBS) and high-yield credit, also known as junk bonds.

Non-agency MBS are pools of mortgages not guaranteed by any government-sponsored enterprise and are considered a significant contributor to the Great Financial Crisis.

While today these loan pools contain fewer problematic adjustable-rate mortgages (ARMs), non-agency MBS still have greater exposure to riskier borrowers that, while paying higher interest rates, are more likely to default on their house payments. And these default risks rise during recessions and inflationary periods when borrowers have tighter budgets.

PDI has around a 30% exposure to these recession-sensitive MBS and over a 20% allocation to high-yield credit, which primarily constitutes debt issues from companies deemed speculative by credit rating agencies.

Among these junk bonds are debt securities from Pacific Gas & Electric (~3% of assets) in California, which filed for bankruptcy in 2019 following mounting liabilities from its role in massive wildfires, and Wesco Aircraft Holdings (~4%), which operates under the name Incora.

Earlier this year, bond issues from the latter narrowly avoided default following controversial backdoor agreements, resulting in PIMCO moving ahead of credit rivals in the repayment line.

While this debt restructuring with Wesco demonstrates the size and power of PIMCO to navigate to better outcomes with high-yield credit, this particular situation disadvantaged even bigger competitors like BlackRock and J.P. Morgan. 

It seems unlikely these rivals will always be on the losing end of these credit battles. And more credit repayment fights could be around the corner if the economy tips into recession while the Fed remains committed to monetary tightening to tame inflation.

PDI's aggressive use of leverage amplifies the risk of investing in securities with higher default rates, with nearly 50% of PDI's assets funded by debt. Across the more than 220 fixed income CEFs in our database, PDI's leverage is tied for second-highest.

Because the market has steadily marched upwards since PDI's inception against a mostly benign credit environment, the fund's zealous use of debt has juiced income and supported a demanding distribution.
 
But, when Covid rocked the markets in 2020, the fund's net asset value (NAV), which reflects the value of a fund's assets less its liabilities, had a staggering decline of almost 30% in just one month.

This volatility demonstrates the downside to relying heavily on leverage and the lack of protection provided by a portfolio of securities with subprime credits.

While the fund's NAV fought back as the market recovered, it never reached its pre-pandemic high and has fallen back to 2020 lows since interest rates began rising sharply, reducing bond prices. A recession would further pressure NAV as credit losses mount and are magnified by PDI's leverage.

A sustained decline in NAV indicates that a fund's investment returns have failed to cover the distribution, which may need to be right-sized if performance fails to rebound.

Investment returns consist of both capital appreciation, which is usually less of a factor in the fixed income space, and net investment income (NII), or the interest and dividends earned by the fund less expenses.

PDI's NII has historically covered its distribution with a healthy margin, helping keep NAV fairly stable outside of the pandemic recession and past periods of rising interest rates that caused bond prices in the portfolio to be marked down. 

However, based on the fund's latest semi-annual filing earlier this month, PDI's NII coverage ratio (the percentage of a fund's distribution covered by NII) fell to 106% in the first half of 2022. 

With PDI's variable borrowing costs rising and the potential for a recession to reduce the fund's interest income, NII coverage could eventually drop below 100%. 

In that happens, PDI would need to either return capital to investors to cover the distribution shortfall, which would reduce NAV until performance hopefully recovers, or decrease the payout.

CEFs often have varying degrees of tolerance around how far they're willing to dig into the fund's NAV to support the distribution. But the further NAV declines, the harder it becomes to generate enough income from a reduced asset base to support the original payout.

PDI has defied the odds during its decade-long existence, but the economic headwinds challenging the fund are intensifying.

Rising interest rates and a possible recession are likely to weigh on the fund's collective 50% exposure to non-agency MBS and junk bonds in the years ahead.

As such, we find it difficult to see how PDI can continue to pay such a generous distribution over an entire investment cycle and are reaffirming the fund's Unsafe Dividend Safety Score.

We estimate PDI could reduce the distribution by 10% to 20% in the next year or two if the fund's NAV fails to recover and NII coverage dips below 100%.

The fund may still appeal to income investors with a yield north of 10%. But anyone considering PDI should understand its high-risk, high-reward nature, as demonstrated by the fund's relatively high returns and volatility compared to other fixed income CEFs over the past decade.

We will continue to monitor PDI and provide updates as needed.