Interest Rates May Stay Higher For Longer: PDI And PDO At Risk (NYSE:PDO)

Lately, we have been experiencing consequences of the market recalibrating the interest rate expectations from multiple rate cuts early in 2024 to a more balanced view with more back-end loaded cuts.

If we look at the table below, we can see how the probabilities of the Fed reducing SOFR in March of this year have decreased from 70.2% (last week) to 57.6% now.

As a result, most of the duration-heavy asset classes have suffered relatively notable declines in their valuations.

For example, the overall real estate market has been hurt by the fact that the market is currently pricing in a bit longer period for higher interest rates. Similarly, the long-dated bond universe has suffered quite heavily given its elevated sensitivity to interest rate changes.

While the aforementioned dynamics are indeed of a short-term nature and theoretically do not change the broader picture for long-term investors, there is, however, one concern that is worth underscoring.

All of this implies that companies or investment funds that are currently walking on thin ice and waiting for the interest rates to go down as soon as possible to avoid any adjustments on, inter alia, dividends are in a much worse position than before the start of 2024.

Let’s now explore two PIMCO CEFs that, in my opinion, are subject to “higher for longer” risk with a very limited buffer to shield the current distributions:

• PIMCO Dynamic Income Opportunities Fund (NYSE:PDO).
• PIMCO Dynamic Income Fund (NYSE:PDI).

I will also conclude with my opinion as to which one of these names is safer (on a relative basis) in the context of the ability to accommodate the current distribution levels.

Portfolios

At the core, these two CEFs are rather similar carrying a notable exposure toward high yield and non-agency mortgage securities. As we can see in the sector allocation table below, almost 50% of PDO’s portfolio lies in the two asset classes. The third-largest asset class is CMBS, which also per definition tends to introduce a relatively high risk (especially compared to US Government-related or investment-grade securities).

Then, if we look at PDI’s sector allocation table, the overall situation is similar. Namely, high-yield credit in combination with non-agency mortgage securities represents almost half of the portfolio. While technically the CMBS category consumes a slightly lower chunk of the total exposure and there is a bit stronger emphasis on the non-USD developed segment, it does not really move the needle when it comes to the overall comparison between these two CEFs.

Even the maturity profiles of PDI and PDO credit investments are homogenous. Both Funds have nicely distributed their duration exposures across different types of maturity segments with a somewhat higher skew in the front end of the curve. On an aggregate level, the effective maturities land in a medium-term segment.

As is usually the case with PIMCO CEFs, both PDI and PDO have assumed a huge load of external leverage to magnify the return potential and support double-digit yields.

In this context, the external leverage structures are almost identical as well; i.e., 40% of the total AUM stemming from reverse repurchase agreements.

Risks

Besides the credit risk component, which could introduce a huge headache in the case of economic distress, we have to be cognizant of the following two aspects that might cause PIMCO to revise the distributions of PDI and PDO in the foreseeable future:

1. The effects from floating rate leverage.
2. Distributions exceeding the core net investment income levels.

The first one is rather straightforward, where both PDI and PDO are subject to serious headwinds in the underlying cash profile because of the variable external leverage.

While reverse repurchase agreements do provide some protection from interest rate risk, it is not for long given the short duration profile. Considering that SOFR has already stayed this high for a while (more than 30 days of what is the most common REPO term), we can safely assume that PDI and PDO are already dealing with unpleasant interest rate costs.

Against the backdrop of notable credit risk, on top you add the fact that a significant portion of the total AUM is funded by debt, which is likely to remain this expensive for a longer time, the overall risk characteristics seem rather speculative for both PDI and PDO.

To make matters worse, we can take a look at the table below that encapsulates the second aspect or concern (i.e., insufficient net investment income levels).

The data here are relatively fresh, allowing us to capture the latest situation, when SOFR has likely already percolated through PDI and PDO books.

The key takeaways are the following:

• Both Funds are underwater in terms of their ability to accommodate distributions from the core earnings.
• The trajectory of coverage ratios is unfavorable indicating a constant deterioration of PDI’s and PDO’s ability to cover the distributions in a sustainable manner.
• The shortfalls are extremely deep.

The bottom line

In a nutshell, both PDI and PDO could be viewed as deeply speculative plays from the dividend income investor perspective, who seek high yield in combination with income stability and predictability.

In my opinion, the probability of experiencing a dividend cut in their distribution levels is high and has significantly increased in line with the change in market expectations on the interest rate path.

To maintain the status quo in the current distributions, PDI and PDO have to tap into the asset base by divesting parts of the portfolio, where these proceeds could be used to close the gap between dividends and net investment income. The issue here is not only that this is an inherently unsustainable exercise in terms of shareholder value creation, but also that in the current market context when SOFR is high, it destroys shareholder value as the duration-heavy assets are priced relatively cheaply.

With that being said, we have to remember that both of these funds offer very attractive dividend yields – 14.3% and 12.1% for PDI and PDO, respectively. This means that even with the potential cut, the yields will still be attractive enough for most investors.

Now, the question is which one of these is a better choice given the aforementioned dynamics. From the yield perspective, PDI offers 200 basis points above PDO, but we have to caveat that with the delta in the 3-month rolling dividend coverage ratios, where PDI is clearly in a worse situation. In addition, PDO has a bit longer duration profile, which comes in handy in the environment of declining interest rates.

So, by opting for PDO over PDI investors sacrifice ~200 basis points in yield, while receiving in return a better position from which to capture potential gains from falling SOFR as well as a healthier dividend coverage level.