PDI: As credit markets tumble, losses may be permanent (NYSE:PDI)

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In February, I warned investors about the credit market tightening in “PDI: Credit bleeding is accelerating towards a ‘global credit crunch’.” At the time, it seemed that when the Federal Reserve ended its asset purchase program, it had it would be a broad decline in market liquidity and a potentially sharp increase in credit risk yield spreads. Since then, the fund (NYSE:POI) has experienced continued declines while the US economy has entered another contraction. More recently, there have been sharp declines in global stock and bond markets, indicating a substantial probability of a further contraction in the credit market.

In my opinion, the popular PDI high yield mutual fund has excessive risk exposure to a tight financial market. The fund has attracted a lot of investor interest due to its high dividend yield of 11-12%, but looking at its assets, it appears some investors may not understand its potential downside risk. That said, PDI is now trading back near its 2020 lows, causing many investors to view the fund as a potential buying opportunity. While this appetite is understandable, looking at the data, it seems to me that the fund may have a significant downside ahead of it. Of course, the PDI picture has changed since February, as there have been considerable declines in the debt market, so it seems like a good time to look at the fund to better assess its risk and reward potential.

Mortgage market collapse

Although PDI owns a variety of assets, it is highly concentrated in mortgages (30% of MV) and high yield credit (24.5% of MV). Nearly all of their mortgage assets are “non-agency,” meaning they are not protected in the event of widespread mortgage default, putting them at significantly higher credit risk. In many cases, non-agency mortgages are “jumbo loans,” which are non-conforming and have a higher loan-to-value ratio. In particular, there doesn’t need to be an increase in defaults for those assets to go down, as it will only require an increase in “default risk” (due to a recession or housing market tightening) to go down.

Considering that non-agency mortgages are the largest segment of PDI’s assets, the tightening of the housing market is the most important risk factor facing PDI. At this point, a housing market contraction is virtually guaranteed, as the massive increase in mortgage rates has sent pending home sales and home affordability quickly back to low levels. See below:

30-Year Mortgage Rate, US Pending Home Sales Index, and US Fixed Home Affordability Index.
Data by YGraphics

Most non-agency mortgage assets decline in proportion to rising mortgage rates. Troublingly, as mortgage rates rise, home sales (and likely prices) often fall as well. If national home prices decline and sellers struggle to find buyers, mortgage default risks are likely to rise, causing credit spreads on non-agency mortgages to rise as well. Simply put, a significant increase in mortgage rates can quickly cause a “fatal loop” in the non-agency mortgage market. This type of scenario was last experienced between 2006 and 2010 and led to catastrophic losses for those holding non-agency mortgage-backed securities.

The situation today is different, but housing affordability is almost as low as it was then, and given the rapid pace at which mortgage rates have risen this year, it is I might be worse today than it was then. Furthermore, in the late 2000s, inflation was so low that the Federal Reserve and the US government were able to quickly apply moderate stimulus policies that prevented the mortgage market from collapsing. With inflation much higher than 8%, it is unlikely that the government will be able to rescue the market again without causing an even worse hyperinflation crisis.

Corporate credit crumble

Aside from non-agency mortgages, the second largest position in PDI today is high-yield credit. These are bonds and other debt assets backed by companies with credit ratings below “investment grade” territory, meaning they have higher yields and higher risk of default. Looking at the POIs industry exhibition, it is clear that no single industry is over-allocated within the corporate credit space. However, non-investment grade credit assets generally fall more during economic downturns. As you can see below, there has been a noticeable impact on low-grade credit rates this year:

PIMCO Dynamic Income Net Asset Value
Data by YGraphics

As with mortgage rates, as high yield credit rates increase, PDI’s net asset value decreases proportionally. For one thing, higher credit rates boost PDI’s dividend yield. On the other hand, higher rates equate to higher risk of bankruptcy/default, which could result in permanent losses for PDI. Generally speaking, an economic downturn will result in significant defaults causing permanent losses for PDI as some debts will never be paid in full. While there are many companies and industries in PDI’s debt portfolio, the current ultra-high level of corporate debt-to-GDP implies significant potential stress on corporate credit in an ongoing economic slowdown. See below:

Corporate debt to GDP hit record levels in 2020 and has been falling ever since

Nonfinancial Corporate Debt to GDP (Federal Reserve Economic Database)

Nonfinancial corporate debt-to-GDP ratio was at typical “peak business cycle” levels in 2019. Typically, when corporate debt-to-GDP is at ~50%, most companies are so heavily indebted that they are likely to your cash flow and profits give up. However, in 2020, the Fed’s push to boost the market through rate cuts and QE and other stimulus efforts greatly helped businesses and allowed them to refinance at lower rates. This effort led to a massive ~$2 trillion increase in non-financial corporate debt issuance, with many of those bonds due to mature in the next few years.

The immense accumulation of corporate debt since 2011 has been aided by continued declines in lending rates through 2021. The era of ultra-low rates allowed many companies to issue shorter-dated bonds and repay them by reborrowing at interest rates. lower interest. For the first time in years, interest rates are now firm and substantially higher, so businesses will need to refinance at significantly higher rates (which they may not be able to afford) or find the cash to pay off debt (which most does not have). ). Of course, companies that do not have investment grade status (ie those owned by PDI) will almost always have a worse ability to repay these loans due to poor cash flow and high debt.

Add in the impact of rising inflation and a slowing economy, and it seems very likely that we will soon see a rise in corporate credit defaults which will likely lead to some permanent losses for PDI as companies are unable to meet their obligations. This risk factor relates to PDI’s high yield credit assets and its emerging market, CMBS, and likely some of its non-USD developed market debt assets. Around the world, there has been a colossal excess lending in the last decade fueled by low rates. As rates rise as the global economy slows, many companies are likely to find themselves “swim naked at low tide.”

High cost of playing with fire

In general, the PDI portfolio is increasingly precarious in the current economic environment. While it is true that PDI performance has increased to the 11-12% level, I do not consider it a “high performance” given the current inflation rate of 8-9%. After inflation and taxes, PDI offers minimal real returns to investors and substantial and immediate downside risk. To make matters worse, PDI is still trading at a 4.75% premium to its NAV as its NAV has decreased at a rapid rate in recent weeks.

It is true that if the tide turns, the PDI could see a strong rebound as credit markets return to previous levels. Generally speaking, this seems unlikely when looking at current economic trends, valuations and debt levels. At some point, probably after a recession, the PDI could bottom out. Still I personally I doubt this will happen until there is a significant increase in corporate and potentially mortgage defaults. Such defaults could generate irreversible losses for PDI, since the bankrupt entities cannot pay the debt.

In the past, such as in 2020 and 2008, the Fed had the wherewithal to create a substantial amount of new cash to “save” the financial market, causing strong and rapid rebounds for PDI (in 2020). However, with inflation so high, the Fed may not be able to bail out credit markets again without risking hyperinflation. Therefore, those who plan to wait for rescue and recovery may not find help.

The fund also has 46% effective leverage, which substantially magnifies your losses. In my opinion, borrowing money to “invest” in debt at heavily indebted companies is hardly investing and more akin to playing with fire. This is understandable for those with a strong tolerance for risk, but it’s probably a faster way to lose wealth than to keep it. Of course, we must bear in mind that the PDI comes with an excessive 2.8% expense ratio between your borrowing expense (which will increase with the fed funds rate) and your total spending ratio of 2.04% (before interest). In my opinion, that is a high price to pay for a fund that has seen its NAV decline since its inception (in 2013), particularly considering that there have been stellar returns on most other assets from 2013 to today.

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