Every week, we’ll profile a high yield investment fund that typically offers an annualized distribution of 6-10% or more. With the S&P 500 yielding less than 2%, many investors find it difficult to achieve the portfolio income necessary to meet their needs and goals. This report is designed to help address those concerns.
With high yield bond prices at least temporarily on the rise again and attainable yields of 9% or more, investors may be thinking of tempting fate once again. Sure, high yield spreads are back down again and that means investors, in general, don’t think junk bonds are quite as risky as they were before, but that doesn’t mean that the long-term landscape has changed any. Bankruptcies are on the rise. Bad trucking loans just took down Citizens Bank. Even the outlook for U.S. government debt just got downgraded again. It’s a dangerous time to be pushing further out on the credit risk spectrum.
The PIMCO Dynamic Income Opportunities Fund (PDO) is a good example of that. It’s basically going all-in on a rally in lower-grade debt - not just based on the composition of the portfolio itself, but the fact that it layers on an extraordinary degree of leverage in order to go for the moonshot. Even in good times, this approach may or may not work out. In a tough environment, such as the one we may be entering, it could be the equivalent of setting cash on fire. PDO’s history has demonstrated exactly how things can go wrong and the future might even be worse.
Fund Background
PDO utilizes an opportunistic approach to pursue high conviction income-generating ideas across both traditional and alternative credit markets to seek current income as a primary objective and capital appreciation as a secondary objective. The managers employ a dynamic asset allocation strategy across multiple fixed income sectors based on, among other things, market conditions, valuation assessments, economic outlook, credit market trends and other economic factors. The fund will normally invest at least 25% of its total assets in mortgage-related assets issued by government agencies or other governmental entities or by private originators or issuers. The fund also utilizes leverage in order to enhance yield and total return potential.
The problem with PDO doesn’t lie in the fund’s strategy, which on the surface seems pretty reasonable and well thought out. It lies in the use of leverage, which overextends the portfolio on risk and makes the fund egregiously expensive to own. The fund’s current total effective leverage level is at 45%, making it one of the most leveraged products in the entire CEF marketplace. With interest rates significantly higher today than they were two years ago, that makes the cost of implementing any leverage costly. For a fund that borrows more than $1 billion in market exposure, it makes it nearly impossible to stay ahead of a target benchmark over any appreciable length of time. PDO’s total expense ratio excluding the cost of leverage is 2.11%, a number which qualifies as above average on its own. Add in the cost of leverage and the fund’s total expense ratio rises to an unfathomable 5.75%! Can you imagine needing to make up nearly 6% a year just to try to keep up with an unmanaged benchmark index? Neither can I.
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