PCK: Pay Attention To Duration, Tech And The Debt Ceiling

The PIMCO California Municipal Income Fund II (NYSE:PCK) contains exposures to various securities that have financed various public works in California. PCK is exposure to this portfolio through common stock, where these funds also issue preferred shares.

There is a decent case for munis, but we see some idiosyncratic issues, although only as speculative factors, for California. Moreover, the debt ceiling is another more general speculative issue that investors need to respect for fixed income. Financing conditions aren't that great in the muni space either, and while it doesn't affect incomes it does affect values. Finally, investors should be aware of the duration risks for PCK, although duration could be desirable for a Fed pivot bet. Also distributions have been cut for this fund. Overall, with the added fact that there isn't much of a discount to NAV and the expense ratios are high, we don't really see the appeal here of PCK given forces going against fixed income, even if munis have some relative benefits.

PCK Basics

Let's start with the key information that has lately affected this fund: the distributions have been cut. This has triggered some selling, even if it isn't of fundamental concern.

The duration of the munis within this fund are long, with the effective maturity at 14.8 years. expense ratios are pretty high at almost 1.3%, with more expense including leverage employed by the fund which is variable for a total of 5.3% management fees and interest expenses. The big allocations are to state and local governments, hospitals and pollution control, accounting for over 50% cumulatively of the allocations. Current discount to NAV is around 8%.

Munis

Municipal bonds are the name of the game here, and there are some positives we can start off with that concern the general asset class. Muni funds are generally yielding high, over 4% as PCK does, and tax equivalent yields are looking pretty strong relative to similar credit-rated institutions. California is around AA rated in general, which means ordinarily risk-premia will be pretty low. Munis are actually quite attractive, and have been trading systematically cheaply for some months now. PCK in particular trades at a discount to NAV. But there are some datapoints that investors should consider that may explain relative indifference by markets towards munis.

Firstly, banks that work with muni bond issuances reported that the sometimes high-yielding elements in the sector has meant lower primary issuances and primary investor demand. California in particular also has slightly higher credit concerns of late, with the tech layoffs and the faltering of major employment ecosystems like startups. Another issue is that major pension systems are under pressure in California due to the higher rates and deadened PE markets.

Major sources of capital gains tax like investments but also real estate where velocity of transactions are falling due to unfavourable real estate market dynamics aren't helping matters either. Banking fragility exacerbates the issues.

Finally, the debt ceiling is something that can impact local governments. Part of the impasse around the debt ceiling concerns government spending considered to be more discretionary, and many of these will impact municipality finances. California is a big spender and is in the crosshairs. In the even worse case scenario where no good resolution is met in due course and the credit situation of the U.S. becomes a greater concern all fixed income is at risk in the U.S. Regardless, the financial situations of municipalities and their financing conditions are not incrementing in a positive direction.

Bottom Line

Munis are probably structurally a little undervalued. What's more is that PIMCO California Municipal Income Fund II trades below its muni NAV, adding another layer of discount. The yields are good too. But ultimately there is duration risk, and the fund's income will perform poorly as rates continue to rise a little bit. There are good reason to suspect that fragility in the financial systems may lead to a sooner pivot, in which case duration will work positively for the fund, but there is an inherent volatility and certainly more scope for the dividends to eat way at the asset values and cause some value decay. More distribution cuts will scare income investors away, and cause lessened total return. Also, while munis may be cheap, financial conditions are likely to worsen for municipalities, possibly more than for households.

It's hard to be bearish, but there are certainly speculative factors that could intensify and impact intermediate values for PIMCO California Municipal Income Fund II. We'd be careful with this one.

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