PML: We Still Need To Be Careful With Leverage

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Main Thesis & Background

The intent of this article is to measure nan PIMCO Municipal Income Fund II (NYSE:PML) arsenic an finance action astatine its existent marketplace price. This fund's objective is to put astatine slightest 90% of its nett assets successful municipal bonds whose liking is exempt from regular national income taxes and nan money invests astatine slightest 80% of its nett assets successful bonds that astatine nan clip of finance are finance people value - bonds that are unrated but of akin quality.

When 2023 sewage underway I was a muni bull and opted to urge PML (and bargain it) for a number of reasons. Over nan past period and a half this thesis played retired arsenic I hoped pinch nan money seeing immoderate gains:

Fund Performance

Fund Performance (Seeking Alpha)

While this is not a ample summation by immoderate means, it was good deserved aft seeing nan broader muni assemblage dropped consistently past year. While PML could person plentifulness of room to run, I deliberation a much cautious outlook is warranted. I would look astatine these gains not arsenic a momentum play but arsenic a logic to beryllium much selective pinch immoderate caller positions. I spot immoderate headwinds connected nan sky that show maine a standing downgrade to "hold" makes consciousness - and I will explicate them below.

Yield Curve and Leverage - Risk Remains

The first constituent I request to make erstwhile explaining nan merit for be aware has to do pinch leverage. Specifically, nan costs of having truthful overmuch of it. PML, and different PIMCO CEFs, usage leverage extensively. This tin activity good successful bully times and amplify nan output and return. But it tin besides activity to its detriment astatine times, arsenic 2022 showed america rather clearly. While nan caller twelvemonth has started disconnected better, I want to stress to enactment wrong a comfortable period pinch respect to this money and others that usage leverage. As nan output curve has inverted moreover much sharply successful caller weeks, this makes nan costs of leverage much costly successful comparative position compared to what nan money tin gain successful nan output "pick-up" connected nan longer extremity of nan curve:

2-10 Year Yield Curve

2-10 Year Yield Curve (Charles Schwab)

What this intends is, nan fund's borrowing costs are rising much swiftly than nan output it earns from nan securities it is utilizing that leverage to buy.

Now, this is not new, but I americium repeating it present because it is easy to place this consequence now that nan marketplace has rebounded and stabilized. This is simply a bully motion overall, but nan output curve inversion is truthful wide that I americium very concerned for what nan early is going to hold. With PML's extended usage of leverage, it is difficult to enactment excessively bullish connected this option:

Fund's Leverage

Fund's Leverage (PIMCO)

The a bottom-line present is this is simply a caller twelvemonth but an aged consequence is present. So negociate your consequence accordingly.

Valuation No Longer As Enticing

A 2nd cardinal logic for my downgrade relates to nan fund's valuation. This is existent some successful isolation and successful narration to its sister funds, which are nan PIMCO Municipal Income Fund (PMF) and nan PIMCO Municipal Income Fund III (PMX). Back successful early January, PML was trading conscionable complete par worth and had a discount compared to nan different nationalist muni costs from PIMCO. Today, that communicative has shifted a bit. PML's premium is not outrageous, but it is getting pricey. Further, it is nary longer nan cheapest but sits successful nan mediate of nan pack:

Fund January's Premium to NAV Current Premium to NAV
PML 0.1% 4.2%
PMX 1.5% 0.7%
PMF 5.6% 7.5%

Source: PIMCO

This is not meant to beryllium alarmist but alternatively to bespeak nan bargain awesome I saw successful January related to nan fund's premium has evaporated to immoderate degree. Will this mean nan money is going to driblet for illustration a rock? Of people not. But it does mean to beryllium connected nan hunt for down days aliases a agelong wherever nan NAV holds up and nan stock value declines. This will unfastened up a amended worth opportunity since presently nan communicative present is mixed.

Income Metrics Don't Inspire Confidence

Another logic for be aware relates to nan fund's distribution. This is ever important but particularly existent since PML precocious saw a distribution trim (along pinch different PIMCO muni CEFs). The bully news is that moreover post-cut nan money still sports an charismatic income stream, particularly connected a tax-adjusted basis:

PML's Distribution

PML's Distribution (Seeking Alpha)

The bad news is we won't cognize for judge if PIMCO tin support this level of payout going forward. I already mentioned nan leverage headwind and that is simply a very captious constituent to maintaining this 5% yield. There are signs we whitethorn not beryllium wholly retired of nan woods either, since PIMCO's February UNII study shows each 3 nationalist muni CEFs are under-earning what they require to support their distributions steady:

Income Metrics

Income Metrics (PIMCO)

We don't typically spot cuts from PIMCO successful accelerated succession, truthful this is not an contiguous consequence successful my view. But it does mean if location is different income trim later this twelvemonth that investors should not beryllium excessively amazed arsenic they person clip to prepare. Income sum was anemic owed to higher rates/leverage and that backdrop continues to this day. Whether investors tin withstand nan volatility that comes from this reality is up for them to decide.

January's Momentum Could Continue

I person displayed a reasonably antagonistic reside successful this reappraisal and I don't want to wholly bash this fund. The reasons present are multi-fold. One, I ain it and spot merit to owning it. The 5% income watercourse yields maine rather a spot aft taxes and if nan Fed pumps nan brakes a spot later this twelvemonth fixed-income will rally broadly. So I perfectly want to return advantage of that imaginable by having immoderate muni enslaved exposure.

Further, aft a horrible 2022, munis saw 1 of their champion Januarys successful complete a decade. This could awesome weakness up aliases it could beryllium nan commencement of a multi-month bull tally for nan sector:

January Returns (Muni Sector)

January Returns (Muni Sector) (PIMCO)

Where nan assemblage will spell from present is anyone's guess. Short-term momentum tin awesome much gains aliases a apt breather ahead. What will March and Q2 clasp for munis, and PML by extension? I wish I knew for sure. When nan outlook is mixed err connected nan broadside of caution. That supports my clasp rating.

PML Is Well-Diversified

A logic I for illustration and clasp PML is because nan money is good rounded. Not only is it a nationalist muni money (and truthful not beholden to only 1 individual state), it is besides not over-weight immoderate 1 peculiar sector. In fact, its largest underlying assemblage (Hospital-backed gross bonds) only makes up 16% of nan fund. Each different assemblage has an allocation little than this wrong nan fund:

PML's Sector Exposure

PML's Sector Exposure (PIMCO)

When we are successful a difficult situation for illustration this one, staying diversified is cardinal to my strategy. Still, PML is going to beryllium impacted by nan hospital/health attraction sector, truthful a look astatine this area individually is worthwhile for prospective buyers of this fund.

I will commencement pinch a chat connected what these bonds moreover are. The constituent of favoritism present is these are revenue bonds. These disagree from General Obligation (GO) bonds successful that they are not backed by authorities aliases section authorities taxing authority. Rather, they are tied to circumstantial gross streams. In this case, these are bonds typically issued to finance nan building aliases description of hospitals (i.e. a caller building, caller wing, etc.). The gross is past generated from providing wellness attraction services - typically coming successful nan shape of reimbursements from security companies, nan governments, or, successful immoderate instances, from patients directly.

There are immoderate opportunities here. I mostly position this assemblage arsenic rather stable. But nan Covid-19 pandemic changed that a spot and made nan assemblage look riskier. It is that mindset that offers nan opportunity successful my opinion. The thought present is that nan number of insured Americans has continued to turn and an aging organization intends much of nan citizenry is covered by Medicare and Medicaid. Whether aliases not this is "good" depends connected your perspective, but it is almost surely bully for owners of muni indebtedness backed by infirmary revenues. The logic being I spot security companies and nan authorities to salary disconnected their policyholder's infirmary bills because having a functioning infirmary strategy is cardinal to each community.

I bring up nan Medicare facet because this is cardinal to infirmary revenue. This has been existent for years and is only going to beryllium much concentrated successful nan years to come. As Americans inclination older, hospitals will beryllium much reliant connected Medicare for reimbursement - but they are already rather reliant connected it today:

Reliance connected Medicare

Reliance connected Medicare (KAISER Foundation)

The conclusion I tie present is that nan caller nationalist projections by some Republicans and Democrats successful Congress that location will not beryllium cuts to societal information aliases Medicare mean that revenues are going to support flowing successful to infirmary systems astir nan country. This gives maine assurance that holding a muni money pinch vulnerability to this assemblage is not overly concerning.

In addition, I position nan truth that nan mostly of nan state is presently insured arsenic a comforting sign. With ostentation and firm layoffs dominating nan news, it is starting to look for illustration nan user situation is going to beryllium challenging. But infirmary bills are little astatine consequence of this backdrop since security companies (or nan government) are responsible for a bully chunk of what is billed. With complete 90% of nan state relying connected much than conscionable savings to salary their aesculapian bills, nan consequence is mitigated:

Insurance Stats (United States)

Insurance Stats (United States) (Congressional Research Service)

What I americium getting astatine is I americium bully pinch owning GO muni bonds and gross bonds from nan correct sectors. I would statement that I would debar wellness attraction related bonds if they are tied to backstage nursing homes and assisted surviving facilities. Those person not recovered from nan pandemic yet. But accepted hospitals are not successful nan aforesaid vessel and PML should spot gains from them.


PML CEF has been a victor of precocious and that could continue. The muni assemblage has been ripe for a rebound and nan fund's holdings are dispersed retired evenly crossed a number of areas. However, I do person immoderate concerns. The premium has expanded, nan income metrics are weak, and leverage is not ever a friend. These competing factors show maine a move to "hold" is nan due decision. Therefore, I propose readers attack caller positions selectively astatine this time.

Editor: Naga

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