Investment hypothesis – Leveraged Fixed Income Fund
I’m considering investing into PIMCO’s GIS Income Fund and am setting out some thoughts and consideration in evaluating this investment. A snapshot of the key commercials:
- Instrument: PIMCO GIS Income Fund Class E (“PIMCO”)
- Distribution yield (pre-leverage): ~4%
- Leverage multiple: 2.5x
- Borrowing rate: 0.5% fixed spread + 1 month SIBOR. Current rate at (Feb 2021) 0.751%
- Distribution Yield (current) with leverage: ~12%
- Other associated costs:
- Upfront sales charge: 0.5% of total instrument value
- Management fee: 1.45% of total instrument value (implied into trading price)
The key motivation for this investment is (1) to take advantage of low interest rates; (2) gain exposure to the fixed income allocation; while (3) not compromising yield. Some preliminary guiding considerations first before diving into the numbers:
Why exposure to fixed income, and why now
Generally, allocation. I don’t have a fixed income allocation in my portfolio yet, so I would like to have a component to anchor that allocation.
Why fixed income now is a good question, and something that I am grappling with at the moment. Inflation (which the FED is aiming for) is traditionally not good for fixed income, and with i/r at record lows, the only way is up (which is a two barreled risk I discuss later on). The only defensible reason why now is the possibility that the road to recovery isn’t going to be all smooth sailing. If any shock event happens again which leads to investors fleeing to safety once again, the fixed income market is likely going to pick up.
Basically, this somewhat goes back to the principle of allocation – if there’s a roaring recovery, gains from my equity should more than make up any loss here. And in any case, I still have yield – given PIMCO’s low standard deviation (ie. volatility ie. risk), if I hold this in the medium to long term, I don’t need to realize any loss.
Why PIMCO (and not some other fund)
To be honest, I haven’t done a full comparison. But with my limited knowledge and expertise of the fixed income market, I am generally comfortable with PIMCO as a whole. PIMCO is a medium to low risk fund, which has a strong allocation in US T-bills and US Mortgage-backed securities. I cover some technical details/historical returns of the fund later, but Endowus has a good quick description of PIMCO and their rationale for including it as one of their investments:
The PIMCO GIS Income Fund (the “Fund“) is an actively managed portfolio that utilises a broad range of fixed income securities that seek to produce an attractive level of income while maintaining a relatively low risk profile, with a secondary goal of capital appreciation. The Fund taps into multiple areas of the global bond market, and employs PIMCO’s vast analytical capabilities and sector expertise to help temper the risks of high income investing.
The Fund is benchmarked against Bloomberg Barclays U.S Aggregate (SGD Hedged) Index, and is suitable for investors who are looking for a competitive and consistent level of income without compromising long term capital appreciation; are looking for a diversified exposure to global fixed income markets and are willing to accept the risks and volatility associated with investing in such markets, including emerging markets and non investment grade securities; and have an investment horizon over the medium to long term.
…Endowus have selected the PIMCO GIS Income Fund because of its strong management team and its superior long returns relative to its peers with modest volatility. In addition, the ability to access the Fund’s institutional share class makes it a more worthwhile choice for those looking for diversified exposure of global fixed income with a focus on income generation. The management team have leveraged PIMCO’s bountiful — and growing — human and analytical resources, including mortgage and real estate specialists, and newer staff focused on special credit situations, and the strategy has posted long-term returns among the category’s (Global Flexible Bond Morningstar category) best with modest volatility
Source: Endowus
If you want more information, you can refer to their fact sheet here as well as their annual report here – yes, I went through their schedule of investments to have an idea of their underlying instruments.
The other alternative I looked at with the Fullerton SGD heritage income fund. It has a higher yield, but some exposure to the SG REIT Sector. Higher yield means slightly higher volatility, and since I already have my own REIT component, is duplicative.
Risk factors and sensitivity analysis
There are four risks I see in this investment:
- Risk of borrowing bank reducing my margin
- Risk of NAV loss (leading to loss in principal)
- Risk of increased borrowing cost
- Risk of reduction in distributions
I’m not going into an in-depth discussion of the first risk, because that relates more to restricting my choice of when I need to liquidate this investment – if the bank suddenly reduces the margin multiple and I can’t maintain it, I’ll have to liquidate at least part of the investment. Nonetheless, this risk is still manageable because:
- The bank has not changed the LTV (leverage multiple) for this instrument ever
- I have up to a 4x leverage multiple with this instrument, so have some buffer even if this is reduced.
And now to the more exciting and relevant risk – loss of principal, increase in borrowing rates, and reduction in distributions.
Risk 1 – loss of principal
Not accounting for the flash fall in March 2020, PIMCO has generally traded on a standard deviation of 2.3%, with NAV ranging from 9.7 to 10.5. Assuming I execute the trade at 10.25 and taking the worst case scenario of 9.75, I face a potential principal loss of 4.88%. With the leverage multiple, this is increased to ~17% of my principal. This works out to slightly less than 2 years of the yields return. What are the chances of the worst case scenario? Taking the above hypothesis (and general proven history) that the bond market is inversely correlated with rising interest rates, it would stand to reason that so long as interest rates remain low, the chances of a loss to NAV will be lower. I’ve compared the 1-mth sibor rates (see rates here) to the PIMCO NAV, and you will see that PIMCO has historically traded above par (10) in periods of interest below 1%. This stands to reason that so long as interest rates remain low, the risk of loss of principal remains relatively manageable.
If really required, I can also actively manage this instrument, since there is no lock-in at all. If interest rates really move against me, I can move to liquidate the investment if really needed.
Risk 2 and 3 – increase in borrow costs/reduction in yields
To estimate the potential impact on the investment, I’ve run a sensitivity analysis of the yield vs the borrowing cost (interest rates):
What is the likelihood of PIMCO reducing their distributions per unit? I think the answer is, extremely low. Since July 2013, PIMCO has paid a consistent monthly distribution of 0.034 cents per unit. The most likely case is therefore that this is going to remain the case, so we are looking at the pre-levered yield of 4% What is the likelihood that interest rates increase? Nobody knows, but the answer is definitely going to be yes, at some point in time. What we do know is that at least for the near-term, the FED has been very clear that rates are not going to increase.
Market consensus is that this is likely to be the case for the next 1-2 years.
Even if it does increase, how high can it increase? Taking a look at the 1-mth SIBOR chart:
The worst case scenario in the last 10 years would be the highs of 2019, at about 1.95%. To put some figures into perspective from the sensitivity analysis table above:
| Borrowing rate (1mth SIBOR+0.5%) | Yield |
| 0.75% (0.25% 1 Mth SIBOR) – current | 12.13% |
| 1.75% (1.25% 1 Mth SIBOR) – median rate | 9.63% |
| 2.5% (2% 1 Mth SIBOR) – highest case | 7.75% |
Even taking the historical high of the last 10 years, I am looking at an yield range of 7.75% to 12.13%, which still remains a very attractive yield for an instrument of this nature.
Concluding thoughts
The key risk for this investment appears to me to be the risk of interest rates rising, which will have a double barrel effect of reducing my yield and potentially impacting the NAV leading to a loss in principal. Taking the worst case scenario if PIMCO goes back to its historical lows (and assuming a correlated rise in borrowing cost), I will need 2.5 years to recover the investment. In the median case where the principal returns to par, I will need just above 1 year to recover the investment.
My investment thesis for this can therefore be summed up in the following actionable steps:
- A close watch of the moving interest rate environments, and being ready to liquidate to protect capital loss if needed; and
- Distributions to be received in cash, not units, to reduce exposure to loss of principal.
- Considering tranche investments into the principal to average the NAV
I will be continuing to evaluate this investment opportunity, and please feel free to reach out if you would like to know more and exchange further thoughts.