PIMCO Dynamic Income Fund: 14% Yield, But Risks Are Rising (Rating Downgrade) (NYSE:PDI)

Closed-end funds can play a very important role in asset allocation, income generation and diversification. One closed-end fund that I valued highly was the PIMCO Dynamic Income Fund (NYSE:PDI) which presently provides passive income investors with a 14.2% dividend yield.

I am modifying my stock rating on the closed-end fund from Buy to Hold, however, for two reasons. The first reason is that the PIMCO Dynamic Income Fund is now selling for a close to 10% premium to the ETF’s net asset value and the second reason is that the PIMCO Dynamic Income Fund may not see as fast an expected decline in short-term interest rates as I anticipated for 2024.

The inflation flare-up in December tilts the odds in favor of a slow pace of key interest rate decreases which may delay a broader re-rating.

My Rating History

My view on the PIMCO Dynamic Income Fund has been generally positive in light of receding inflation and despite a considerable amount of short-term pain for the fund.

The closed-end fund has been volatile in 2023, primarily because of the central bank’s push to hike key interest rates aggressively that year.

The central bank did say last month that it is on track to deliver three rate decreases in 2024, which would help PDI’s net asset value grow, but stronger-than-expected inflation numbers in December could throw a wrench into the investment thesis for the PIMCO Dynamic Income Fund.

Solid 2013 Performance Year, Despite High Volatility

PIMCO Dynamic Income Fund ended the 2013 year on a positive note. The fund reported a 2013 return of 13.08% which exceed the 10.50% average return it achieved since its inception. The consequence is that the closed-end fund is now selling at a double digit premium to net asset value which I think makes a Buy not particularly attractive at the present moment.

Inflation Flare-Up In December 2023 Poses A Headwind For The Closed-End Fund

The last inflation reading for the month of December showed that the inflation problem is not yet resolved. Inflation ticked up 3.4% on an annualized basis which in turn counters my argument that I made in my last article on the PIMCO Dynamic Income Fund.

This article essentially stated that the inflation trend benefited closed-end funds that had strategic asset allocations in the bond sector. The prices of mortgages and bonds depends to a large extent on short-term interest rates, meaning the end of the present rate hiking cycle was set to benefit the valuation of bonds and mortgage.

This is primarily the case because bond and mortgage values are negatively correlated to interest rates, so a decline in key interest rates boosts the value of such assets.

This still true of course, but I did not account for the fact that we might see an inflation flare-up, which we indeed did in December. Robust inflation strongly tilts the odds in favor of the central bank taking it real slow when it comes to slashing short-term interest rates and thereby the central bank might delay also a catalyst for a repricing of the underlying mortgage and bond assets contained in its investment portfolio.

The majority of the closed-end fund’s portfolio assets as of December 31, 2023 were government and corporate bonds.

Passive Income Investors Are Now Paying A Rich 10% Premium For PDI’s 14% Yield

As to the second point I touched upon earlier, valuation, closed-end funds can sell at either premiums or discounts to the last reported net asset value.

In the case of the PIMCO Dynamic Income Fund, the net asset value as of January 19, 2024 was $17.04 per share which reflects back to us a large 10% premium to net asset value, which is a rather big premium in a historical context.

PDI’s premium is now at its highest point since August and may reflect overly optimistic expectations about the speed of the central bank’s short-term interest rate cuts.

I think that the inflation flare-up in December might be a good reason for the central bank to take its time with its policy shift in 2024 which would remove, or at least delay, a re-rating catalyst for PIMCO Dynamic Income Fund’s underlying fixed income assets.

Interest Rate Risk And Investor Optimism

Interest rates are the key determinant for the performance prospects of the PIMCO Dynamic Income Fund. This closed-end fund, which primarily invests in mortgages and bonds, is poised to perform well in a falling-rate environment as interest rates and mortgage/bond values move in opposite directions.

With that being said, though, the central bank may delay its anticipates rate rates way into the second half of the year which would imply that the prospects for net asset value growth are not as bright as they looked in December.

The 10% net asset value premium also signals, in my view, a high level of optimism which suggests that passive income investor are overpaying for PDI right now.

My Conclusion

The PIMCO Dynamic Income Fund should profit from lower short-term interest rates because it is a leveraged closed-end fund with a considerable amount of rare-sensitive bonds and mortgages in its portfolio. These assets will react to lower short-term key interest rates in an inverse fashion, meaning their values will rise in a low-rate environment.

Recent inflation data, however, at least puts a question mark behind the question as to when the PIMCO Dynamic Income Fund’s net asset value could profit from this re-rating tailwind.

Furthermore, the fact that the PIMCO Dynamic Income Fund is now already priced at a rather large 10% premium to net asset value implies that passive income investors may be too optimistic as to the speed of the 2024 rate cuts.

Thus, I think it is appropriate, from where I am standing, to lower my expectations about a net asset value re-rating and modify my stock classification to Hold.