PIMCO Municipal Income III: A Solid Closed-End Fund Holding (NYSE:PMX)

In this article, I cover the PIMCO Municipal Income III Fund (NYSE:PMX) and use a 14-factor framework to evaluate the fund.

Factor #1: What is the distribution rate?

In the current market, there are three “tiers” of national municipal bond closed-end funds. There are higher-risk leveraged funds that have distribution rates in the 5.0% to 6.0% range. The middle tier lower risk leveraged funds yield in the 4.0% to 5.0% range. The safer, low-volatility funds, which are mainly unleveraged and of higher quality, may yield 4% or less.

PMX falls in the middle range tier and currently has an NAV distribution yield of 4.89%. But because it trades at a 10% discount, its market price distribution yield is 5.43%. It pays a regular monthly dividend of $0.033 per share or an annual distribution of $0.396.

Factor #2: What is the likelihood the fund can raise its monthly dividend?

To determine this, I look at the Average Earnings/Current Dividend Ratio. This ratio tells you whether or not a fund is earning its current dividend. If the value is well above 100%, it means the fund can easily afford to raise its distribution rate.

For PMX, the three-month average earnings NII ending 12/31/2023 is $0.047, which is higher than the most recent monthly payment of $0.033. The Average Distribution Coverage ratio is now 142.4%. This is quite attractive.

I also like to see a positive value for “Undistributed Net Investment Income” or UNII. This is the life-to-date balance of a fund’s net investment income less distributions. For PMX, the Average UNII per share as of 12/31/2023 is -0.110 which is somewhat negative. But I’m not too troubled by this since the rolling coverage ratio has been trending higher. The 6-month rolling coverage ratio is 82.91%, while the 3-month rolling coverage has increased to 86.85%.

Factor #3: What is the Expense Ratio?

The Baseline expense ratio does not include leverage costs. PMX is a medium-sized CEF with common net assets of $278 Million and total managed assets including leverage of $487 Million. The fund management fee is 0.71%. PMX has a baseline expense ratio of 1.22%, which includes all non-interest expenses and is about average for a leveraged fund. This factor is neutral for PMX.

Factor #4: What is the discount to NAV?

PMX is currently selling at a -10% discount to NAV which is significantly more than the one-year average discount of -5.5%. On a longer-term basis, PMX actually traded at a 3% average premium over the last three years. The one-year Z-statistic is -1.11, or about one standard deviation below the 12-month average discount. Overall, this factor is a strong positive for PMX.

PMX- Five Year Discount History

Source: cefconnect

Factor #5: How much leverage is used, and what is the preferred share asset coverage?

The following data is from December 31, 2023:

Effective Leverage: $188 Million or 40.33%

Types of Leverage:

• Auction Rate Preferreds (ARPS)
• Variable Muni Preferred (VMTP)

Average Leverage cost: 5.35%

Asset coverage: 247%

The cost of leverage is about average for muni bond CEFs.

Factor #6: What is the AMT exposure?

There are two parallel income tax systems in the United States- the ordinary income tax and alternative minimum tax (AMT). The AMT disallows some deductions that are ordinarily allowed. Taxpayers must calculate their tax under each system, then pay whichever is higher – ordinary or AMT.

Many “private activity” municipal bonds – for example, those that fund stadiums, airports, or more businesslike enterprises – may be subject to AMT. If you have to pay AMT and hold such a bond, your interest income would generally be taxed at the applicable AMT rate – which could be 26% or more, if you’re in the AMT exemption phase-out range. Effectively, that means the after-tax yield on a municipal bond paying 4.00% would drop to 2.96%.

In 2019, the AMT impacted only 0.1 percent of households overall. This includes 0.2 percent of households with income between $200,000 and $500,000, 1.8 percent of those with incomes between $500,000 and $1 million, and 12.5 percent of households with incomes greater than $1 million.

(Source: Tax Policy center)

PMX may invest up to 20% of its total assets in investments where the interest is subject to the federal alternative minimum tax.

Factor #7: What is the credit quality?

Investment Grade bonds are at least 80% net assets, at the time of investment. The fund may also invest up to 20% of its net assets in municipal bonds that are, at the time of investment, rated BB or lower or that are unrated but considered equal quality by PIMCO’s management team.

Here is the credit ratings breakdown for PMX as of 12/31/2023:

Click to enlarge

Source: cefconnect

PMX is a fairly safe fund with an average credit rating around A. I normally like to see the lowest rating category (BB & Below) less than 10%, and PMX passes this test.

Factor #8: What is the interest rate exposure?

PMX has an average leveraged-adjusted effective duration of 13.87 years. If interest rates go up by 100 basis points or 1%, the net asset value of PMX would drop in price by about 14%.

In the current environment, it seems unlikely that interest rates will spike upward by much, in the near future. And if interest rates drop by a few percent, the high interest rate sensitivity can be beneficial.

Overall, I view this factor as a slight positive, since I think interest rates are more likely to trend lower than higher.

Factor #9: What is the call exposure?

In some ways, owning a callable bond is similar to owning a stock and writing a covered call against it. But with the callable bond, the option is embedded instead of external. The call option is owned by the issuer and has the effect of taking away some upside potential when interest rates decline significantly.

Here is a table with the upcoming call date structure for bonds in the PMX portfolio as of December 31, 2023:

Click to enlarge

PMX has some call risk over the next few years if interest rates drop a lot. Keep in mind that call risk does not mean you lose money. However, it does reduce upside potential and can lead to distribution cuts in the future if the replacement bonds have much lower coupons.

Factor #10: For a national fund, what is the breakdown by state?

Here is a breakdown by state for the PMX portfolio (top 5)

Click to enlarge

The Other category refers to Puerto Rico along with a small amount of non-Agency mortgage bonds.

Some states I look carefully at are New Jersey and Illinois. I do not like to see the Illinois or New Jersey percentage exceed 10% unless the bonds are highly rated (A or better) or for critical services like the water supply for Chicago. The Illinois percentage for PMX is 8.91%, and most of the bonds held there had good ratings or were for critical services. There were two very small holdings that were somewhat in distress based on price.

Most of the Puerto Rico holdings were also quite solid. A few smaller holdings seemed somewhat in distress, but not enough to affect the overall portfolio in a material way.

Factor #11: How good is the trading liquidity?

PMX has an average daily volume of 157,000 shares and an average dollar volume of $1.1 million. The bid-asked spread is usually only one cent, and you often can get price improvement on small market orders.

Factor #12: What percent of the portfolio is in Housing-Multifamily bonds?

I like to avoid funds where Housing sector bond holdings are above 10%. PMX only has 2.92% of the portfolio in the Housing Revenue sector.

Factor #13: Fund Management

PMX is dual-managed by David Hammer and Kyle Christine. David is a managing director in the Newport Beach office and leads municipal bond portfolio management. Kyle is a senior VP and muni bond portfolio manager. Prior to joining PIMCO in 2017, he was an institutional high-yield and taxable municipal bond trader at Morgan Stanley.

Factor #14: Other Analyst Coverage

As of December 13, 2023, PMX was not covered by the Merrill Lynch closed-end fund team. Its “sister” fund (PMF) was rated underperform because of lower model scores on distribution stability, duration, and credit quality. But PMF trades at only a 1% discount, while PMX trades at a 10% discount.

Morningstar gives PMX a Three star rating out of five.

Based on the above 14 factors, I believe that PMX is an attractive holding now when available at a discount to net asset value above 8%.

Overall, I believe this is a very good time to look for well-run leveraged municipal bond CEFs trading at higher discounts than normal. PMX certainly meets this criteria.