PCQ Still Looks Overpriced To Me (NYSE:PCQ)

Main Thesis

The purpose of this article is to evaluate the PIMCO California Municipal Income Fund (PCQ) as an investment option at its current market price. PCQ has struggled in the new year, and I see that struggle continuing throughout the rest of 2020. The fund is still quite expensive, with a premium in excess of 17%, which makes me reluctant to recommend positions. Further, the income production metrics remain under pressure, with PCQ seeing its UNII balance continue its consistent decline. Finally, PCQ has about one quarter of its assets directly tied to the revenues of both hospitals and the transportation sector, which are areas heavily impacted by Covid-19. Within the muni market, these are two sub-sectors whose total returns have lagged most other areas.

Background

First, a little background about PCQ. The fund “invests primarily in California municipal bonds, and therefore seeks to provide current income which is exempt from federal and California income tax, as well as the alternative minimum tax.” Currently, the fund is trading at $16.55/share and pays a monthly distribution of $.065/share, which translates to 4.71% annually. I had a neutral outlook on PCQ at the start of the year, based on concerns about the fund’s recent income cut and high premium to NAV. In hindsight, this outlook was vindicated, although perhaps not bearish enough, as PCQ has seen a sharp drop since publication:

Source: Seeking Alpha

As we push deeper into the second half of the year, I felt now was a good time to reassess PCQ to see if I should change or maintain my rating. After review, despite PCQ having a noticeably cheaper price than it had the last time around, I am still reluctant to give this fund a buy rating. I see multiple reasons to maintain a “neutral” outlook, and I will explain them below.

Premium Has Come Down, But Still Lacks Value

My first point touches on the fund’s valuation, which is a concern I have had regarding PCQ for a long time. While PCQ’s sister funds, the PIMCO California Municipal Income Fund II (PCK) and the PIMCO California Municipal Income Fund III (PZC), often trade at single-digit premiums that offer value (in my view), PCQ can hardly ever say the same. The fund has consistently traded at a high premium, and typically at levels where I would find it very difficult to argue for buying it. While the fund did touch on a single-digit premium back in the March sell-off, this metric has shot up quickly since then, meaning investors would have had to act fast for that opportunity. As a result, the current price for PCQ is certainly not cheap, with a premium in excess of 17%. In fairness, this is well below levels the fund has traded at in the past, but it is also much higher than its low, as seen in the following chart:

Current Premium to NAV 17.1%
YTD Premium High 41.0%
YTD Premium Low 3.5%
Premium in February review 30.1%
Current Premium – PCK 3.2%
Current Premium – PZC 5.6%

Source: PIMCO

As you can see, the current premium is down markedly from its February level. Similarly, it is well off its high for the year. In that light, PCQ does offer a better value now than it did at other points this year. However, the fund’s history also shows it can trend much lower. While it never hit discount territory like so many PIMCO CEFs did back in March, the single-digit premium of 3.5% is substantially lower than its current level. Additionally, the premiums of its sister funds, PCK and PZC, illustrate that those funds trade at a marked discount to PCQ. When we consider those factors, it is difficult to come up with a bullish case for PCQ. The fund has significant downside risk if it re-tests its short-term lows, and there are PIMCO options with similar holdings that cost well less than what PCQ does to own. My takeaway here is to remain cautious on PCQ, as I feel the fund is simply too richly priced to get excited about.

UNII Figures Do Not Inspire Confidence

My second point discusses the fund’s income production. As my readers know, this is an area I have expressed concern about, with respect to the PCQ, for a while. Unfortunately, this concern was well founded, as PCQ did indeed face a distribution cut back in January. While this did bring the fund’s current income more in line with what it pays out as a distribution, the sad reality is the fund still lacks enough income to cover its distribution, even post-cut.

Clearly, this is a problem. PCQ has seen its coverage ratios hover in the 70-80% range for a long time. However, the fund had been able to hold off on cutting its distribution until earlier this year because it had built up an impressive UNII balance, which it used to cover income shortfalls. On the bright side, PCQ still has a positive UNII balance, which means another distribution cut will probably not occur in the short term. The bad news is this balance has been falling steadily for quite a while, and recent figures show that decline continues to this day. To illustrate, take a look at PIMCO’s UNII report for PCQ back in January, followed by July, as seen below, respectively:

Source: PIMCO

The takeaway here is PCQ continues to underearn what it needs to in order to meet its stated distribution. While the positive UNII balance provides a buffer, by the end of the year this will probably have evaporated, based on the trend of PCQ losing $.01-02/share each month. Once that happens, the fund’s breathing room is gone, and its 80%-range coverage ratios will suggest another distribution cut will be in the cards in early or mid-2021. While this leaves PCQ with plenty of time to turn things around, it begs the question on why someone would pay a 17% premium in the hopes things turn around. If PCQ traded at a discount, or a more reasonable premium, it could be worth the gamble. But the fund is already priced for near perfection and, in my view, it is nowhere near perfect.

PCQ Has Exposure To Some Hard-Hit Areas

I now want to dig into the underlying holdings of PCQ, because this will give us an idea of how the fund is likely to fare in the months ahead. As a California-focused muni hold, PCQ does not offer investors much diversity in terms of geographical location. However, the fund is quite diverse in terms of sub-sectors within the California muni market. PCQ does have about 22% of its holding in the typical state and local general obligation bonds, but the rest of the portfolio is made up of revenue bonds in a multitude of different areas:

Source: PIMCO

My first takeaway is I like how diversified PCQ is, especially for a single-state muni fund. Obviously, PCQ is heavily exposed to California’s economy, but this broad exposure means investors can take some comfort in the fact that if one particular area sees some turbulence, the fund can still perform well over time.

Fortunately, as it happens, this diversity is critically important right now. One reason for this is because not all muni sectors are created equally, and the Covid-19 pandemic has disproportionately impacted the bonds in specific areas. Two of the hardest-hit have been healthcare and transportation, which is not a surprising reality given the virus’ impact on the U.S. healthcare system and on travel demand. While PCQ does have plenty of exposure to other areas, healthcare and transportation combine to make up about 25% of total assets, so that is likely a key reason for PCQ’s lackluster performance in 2020 thus far. To understand why, let us consider how the muni market has performed this year. While essential services and general obligation bonds have held up relatively well, within the revenue bond space there have been notable out-performers. Unfortunately, those out-performers do not include either the healthcare or transportation sectors and, in fact, those are two of the worst-performing sectors year-to-date, as shown below:

Source: CNBC

Ultimately, I do not view PCQ’s exposure to those areas well. While hospitals, and the Healthcare sector in general, have been receiving government support, these areas are clearly under pressure. This sector is directly impacted by the pandemic, and the resulting high number of cases means that elective surgeries have been put on hold, which are a key source of revenue for the healthcare providers. Further, travel plans have been put on hold, with demand dropping off for both consumers and businesses. This means transportation-backed bonds, which could mean airports or toll roads, etc., are in a precarious position.

Compounding on this reality is the fact that the situation in California is not very good right now. After the easing of some lockdown restrictions, new cases spiked, leading to the possibility that those restrictions could be put back in place, as shown below:

Source: LA Times

If so, the strain on revenue bonds, especially in areas like transportation, are not set to see strong performance any time soon. This provides further support that the premium price for PCQ is hard to justify at the moment.

Bottom line

I remain committed to muni bonds as a core sector holding, but PCQ is not a fund I would recommend as a way to play it. The fund’s premium is not attractive, nor are the income metrics. Further, as California faces a difficult Covid-19 climate, the underlying bonds in PCQ’s portfolio may continue to underperform. Therefore, I continue to believe investors should carefully consider their risk tolerance before buying any positions at this time.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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