Monthly Income And 10% Yield: PTY

Co-authored by Treading Softly

August is a unique month on the Federal Reserve schedule because it is one of the few summer months without a Fed meeting. This means that for the next ~6 weeks, there is no question of changes in the rate policy.

You see, we have meetings in May, June, and July. They take a break, and then they return in September, another break, and return for November and December. The Federal Reserve typically meets about eight times a year to discuss the economy and determine if a rate change is appropriate. Summer meetings are consistently frequent. What this means, however, is that in between the meeting in July and the one in September, you have time to digest what’s occurred and make changes to your portfolio.

When it comes to the market, I am a net buyer. This means I am consistently and frequently expanding my portfolio to boost my income. This capital can readily come from the cash received from my holdings via dividends and distributions, and I readily reinvest by following our Rule of 25. This August, I plan on heavily buying one specific fund that I think will greatly benefit from rate cuts, whether that be in September, November, or December, or whether that be further down the road in 2025. Regardless of what interest rates are going to do in the short term, this fund will provide me with excellent income now and position my portfolio for strong capital gains when rates drop in the future.

Let’s dive in!

Buy Now, Soar With Rate Cuts

PIMCO Corporate & Income Opportunity Fund (NYSE:PTY), yielding 9.9%, is my favorite bond fund of all time. PIMCO has a long history of being very friendly to income investors, providing significant income and competitive total returns. PTY is one of PIMCO’s oldest CEFs (Closed-End Funds) and has a proven track record through the Great Financial Crisis.

With interest rates so high, it is a fantastic time to be investing in bonds. Rising interest rates are a negative for the trading prices of bonds, but they are fantastic for the forward returns of investors who are buying bonds. Bond investors will have higher total returns due to high interest rates, compared to if interest rates remained low. How is this possible? First, we need to understand why bond prices go down as interest rates climb.

The reason is that investors have the option to buy newly issued bonds, so the price of existing bonds has to adjust to compete with new bonds. Consider two US Treasury Notes, both maturing on June 30th, 2029. The credit risk and time to maturity are identical. Yet, one trades at $95.8 and the other at $100.39.

The difference between these two notes is that one was issued in 2022 when interest rates were lower, and the other was issued in 2024 at higher rates. As a result, you have a 3.25% coupon and a 4.25% coupon. Why would anyone buy a 3.25% coupon when they can buy a 4.25% coupon that has the same maturity date and the same credit risk? They would only buy the older 3.25% coupon if it was priced lower than the 4.25% note. While the coupons are 100 bps different, the Yield-to-Worst for each is very close.

So, an investor buying Treasury Notes maturing on 6/30/2029 will get a yield of approximately 4.16%-4.18%. What if interest rates hadn’t changed in the past two years? Then 5-year Notes would still be issued at 3.25% and an investor today would only get a Yield-to-Worst of 3.25%. Since the coupon received will be a substantial portion of the total return for debt investors, this is significant.

PTY tends to invest in debt that is higher risk than Treasuries. However, the impact of higher rates on Treasury prices spreads throughout the entire debt world. After all, buying Treasuries is an option available to all fixed-income investors. As a result, any credit risk taken on is always going to be viewed through the lens of the returns available from an investment that has zero credit risk. The pricing of debt can often be understood as the “risk-free rate” plus a risk premium. The risk-free rate is typically measured as a US Treasury that has a similar maturity, while the risk premium is the excess over that rate, which is the market pricing in the risk of default. The price of a debt investment will vary as Treasury rates change, due to the risk-free rate changing.

Rising interest rates have been a primary driver of the decline in debt prices and NAV (Net Asset Value) for funds like PTY. The cost of debt has declined, even as defaults and credit losses have been low. This is great news for income investors because it allows us to buy debt at low prices and enjoy higher yields than we have had available in decades.

Like PIMCO’s other bond funds, PTY is quite diversified, with investments spread across numerous types of debt investments. PTY is most heavily invested in “High Yield Credit,” with over 36% of its portfolio by market value. Non-agency mortgages are a distant second at 13.59% of market value. Source

With its high-yield investments, PIMCO often focuses on what it calls “special situations.” These are borrowers who need to restructure their debt. PIMCO uses its size and scale to purchase meaningful positions at a discount to par, and then flex its muscle to influence the outcome of the negotiations in a way that is positive for its bond holdings. In our prior coverage, we detailed how this strategy worked with Windstream. We expect that PIMCO will continue to find these opportunities and extract above-average returns from corporate bonds. While several of PIMCO’s bond funds benefit from this strategy, PTY with the highest allocation to this strategy, is the greatest beneficiary.

Historically, PTY has been able to run well ahead of high-yield bond indexes like the ETF and HYG.

PIMCO’s ability to identify opportunities and turn them into realized value is truly special. Investors in PTY have benefited from it for over two decades, and I intend to continue benefiting from it for a couple more decades.

Conclusion

With the PIMCO team’s ability to capitalize on credit markets in all situations and having a multi-decade history of outperformance versus other readily available peers, we can sit back after buying into PTY and enjoy the great income for decades. Consider this: at a 9.9% yield, PTY will provide you 100% of your capital back to you within ~7 years. PTY has an excellent history of drawing benefits from different market environments. This is a time when fixed-income allocations should be boosted because we expect it’ll be harder to find great bargains once interest rates fall. Take advantage of discounts now instead of having to pay full price or premium prices later.

When it comes to retirement, the goal for your portfolio should be to have it generate the income you need to meet the expenses that you can’t avoid. You could do this by selling shares and reducing your overall ownership, slowly dismantling your nest egg. Or, you go about it like we do: collect income from the market in the form of dividends and distributions so you can maintain your ownership and enjoy great income. The need for cash is the same. How you approach it can dramatically change the outcome of your retirement and the comfort of the lifestyle you lead. Holding PTY and buying more this August can provide you additional comfort and enjoyment in your retirement. It’s just that simple.

That’s the beauty of my Income Method. That’s the beauty of income investing.