PML Remains Too Expensive For My Taste (NYSE:PML)


Main Thesis

The purpose of this article is to evaluate the PIMCO Municipal Income Fund II (PML) as an investment option at its current market price. As my readers know, I continue to like the municipal bond space, but I am advocating being very selective with new entry points for the time being. With uncertainty clouding the market, I am looking for value, and PML does not offer it. The fund trades at a high premium, which is markedly more than its sister funds, as well as a host of other options in the muni sector. Further, PML has seen both an income cut and a drop its in underlying value in 2020, neither of which inspire confidence. Finally, while I view market volatility as a reason to hedge with assets like muni bonds, the sector faces a significant headwind if further stimulus measures are not passed in the short term. This makes selective buying even more important right now.

Background

First, a little about PML. It is a closed-end fund with a primary objective “to seek current income exempt from federal income tax.” Currently, the fund trades at $13.17/share and pays a monthly distribution of $.059/share, which translates to an annual yield of 5.38%. I reviewed PML for the first time at the start of the year, and I cautioned investors away from the fund, primarily due to its expensive valuation. In hindsight, I was right to avoid this investment option. However, I was perhaps not bearish enough, as PML has seen a negative total return of almost 11% in the interim:

Source: Seeking Alpha

As we approach 2021, I wanted to take another look at PML to see if the fund’s poor performance this year has opened up a buying opportunity. After review, I continue to believe PML is not the best option for this environment, and I will explain why in detail below.

Why Buy Munis Now? Volatility Has Spiked

To begin, I want to touch on the broader macro-environment, and discuss why investors may even want to be considering muni bonds right now. With an on-going pandemic, contentious election cycle, and economic uncertainty, investors have got to be feeling uneasy at the moment. While bonds normally provide a buffer against economic downturns, munis have come under unique pressure this year due to the toll felt on the local and state levels. As businesses close, workers telecommute, and consumers hold back on in-store purchases, state and local government revenues are taking a big hit. This may lead some to question the wisdom of buying munis during our current crisis.

While these are all valid concerns, I continue to believe munis play an important role for many types of portfolios. For one, tax-exempt income remains a primary concern for many, despite the heightened potential for capital losses. Two, the Fed has put in place a municipal liquidity program, which should prevent any major defaults in the short term. Three, once the election passes and we hit 2021, the expectation is we will see more stimulus from Congress. As a result, investors could find some comfort that short term risks will be addressed over the next few quarters.

With that in mind, I continue to use munis as a core income holding, even with the present risks. While I believe in the fundamental story behind muni bonds, I remain drawn to fixed-income as a whole primarily because market volatility is spiking. With equities coming under pressure, I appreciate the stability munis can provide, even when facing significant headwinds. To understand why this is relevant now, consider that volatility was relatively low going in to October, only to spike in the last few weeks to a level not seen since June:

Source: Bloomberg

Clearly, investors are starting to grow uneasy, and that reinforces the merit behind having hedges in place. When volatility spikes, having assets like bonds, gold, or even cash, allows for a smoother ride.

While this has been the case for my personal portfolio, the same cannot be said for PML. This highlights the need to be especially critical of what positions are used as equity hedges. While PML does deliver tax-free income, it has failed as a short term equity hedge, which is the other half of the equation. To illustrate, let us compare the one-month return of PML against the S&P 500, as well as the Nuveen AMT-Free Quality Municipal Income Fund (NEA) and the BlackRock Muni Holdings Quality Fund (MUS). I selected these two muni CEFs because those are investments I own, and ones I have reviewed and recommended to my readers. Throughout the volatile month of October, NEA registered a slight gain, while MUS saw a 1% loss. By contrast, PML has fallen around 3%, which is in-line with the drop of the S&P 500, as shown below:

Source: CNBC

My takeaway here is simple – when looking for equity hedges, not all muni funds are created equal. While funds like MUS and NEA provided some cover during the recent sell-off, PML has not. Its performance in 2020 has been quite disappointing, and October’s drop shows that it may continue to lack merit as an equity hedge in the coming months.

Market Premium Has Dropped, But Is Still Too High

As the prior paragraph discussed, PML has been struggling recently. Therefore, it is worth examining why this might be the case. While state and local governments face a host of challenges right now, that is true for the municipal market as a whole, and does not explain PML’s under-performance in relative terms. To get a sense of why PML has failed to return to pre-crisis levels, an examination of the fund’s valuation is warranted.

As readers of my January review may remember, a principle reason for my cautious outlook on the fund had to do with the premium to NAV. At the time, PML had a premium price almost 23% above its NAV, which seemed unjustifiable, in my opinion. The Q1 sell-off vindicated that outlook, but now PML has a much cheaper valuation. As a result, investors may be looking at PML as a value opportunity, given its premium has come down to less than half what it was before.

While there is some merit to that line of thinking, I would caution against it for now. Yes, PML’s premium has dropped, but it still sits above 10%, which still seems much too high. Aside from being high in isolation, investors should consider that PML is just one of a host of options investors have when looking at the muni space. In fact, PIMCO offers two other CEFs that are very similar to PML, yet have markedly lower premiums. These are the PIMCO Municipal Income Fund (PMF) and the PIMCO Municipal Income Fund III (PMX). I view both as better options right now, primarily because of their valuation disparity. Further, the other funds I highlighted earlier, MUS and NEA, actually trade at discounts, making PML’s relative valuation seem even worse. For a comparison of the current valuation of these five CEFs, see the chart below:

Current Premium – PML 10.6%
Current Premium – PMF 1.5%
Current Premium – PMX 2.9%
PML’s Premium in January 22.7%
Current Premium – NEA (7.6%)
Current Premium – MUS (7.8%)

Source: PIMCO

The ultimate takeaway is, despite PML’s premium coming down significantly throughout the course of 2020, it still seems too expensive. Yes, the fund could certainly trend back to its prior range, opening up the potential for a strong total return. But this is certainly not a guarantee, and PML’s premium seems out of whack compared to its direct alternatives, PMX and PMF. Further, with a plethora of options in the muni CEF space, one has to wonder why it makes sense to pay a double-digit premium at all, when there are so many options at discounted prices. Simply, the current valuation seems unjustifiable and prevents PML from piquing my interest at this time.

NAV Story Not Encouraging

Expanding on the above point, an unfortunate reason why PML’s premium has remained stubbornly high has to do with the performance of the underlying assets in the portfolio. Specifically, PML’s NAV has seen a decline in 2020, which explains why the premium persists, despite a drop in the market price. While the decline has not been significant, especially once we consider the distributions paid, it is still a cause for concern. To illustrate, the chart below shows PML’s NAV at the start of the year, compared to now:

NAV on 1/1/20 NAV on 10/30/20 YTD Gain
$12.50/share $11.91/share (4.72%)

Source: PIMCO

The point here is PML has seen its NAV come under pressure in 2020, and that limits my appetite for the fund. While it is justifiable considering the macro-environment, it reiterates why investors need to be selective here. With the fundamentals of the muni market having deteriorated significantly since the year began, investors may want to focus on funds traded at cheaper, or discounted, prices. PML does not meet this requirement, supporting my cautious view going forward.

The Good News – Income Metrics Are Strong

Through this review, my take on PML has been quite negative. Therefore, investors may be wondering why I am “neutral” on the fund, as opposed to “bearish”. While a valid question, the principle justification for not downgrading my outlook has to do with the income metrics for the fund. While many of PIMCO’s CEF options have seen their UNII figures deteriorate significantly in the past few months, the same cannot be said for PML. In fact, PML, along with most of PIMCO’s muni CEFs, has actually seen its income coverage ratios hold up extremely well. The most recent report, which came out in mid-October, shows PML with a positive UNII balance and coverage ratios in the upper 80% range, as shown below:

Source: PIMCO

My takeaway here is two-fold. On the one hand, I believe this story limits the downside to PML, which is why I did not feel it was appropriate to give it a bearish rating. The fund has almost two months worth of income in reserves, and its coverage ratios imply fundamental soundness. This means the income stream should remain steady, a key concern for income investors. However, despite these positive attributes, a look at the UNII figures for PMX and PMF shows this story is not unique to PML. While those funds do not register a positive UNII balance, they have stronger coverage ratios, implying their distributions are also safe. When I couple these metrics with the smaller premiums of PMX and PMF, I fail to see the merit to buying PML over them.

Bottom-line

Despite continuing to build on my municipal bond position, PML will remain on my avoid list. The fund’s valuation is not in-line with alternative options, and the performance in 2020 does not inspire confidence. While the income metrics are a bright spot, this is not a strong enough reason to favor PML over alternative options. The fund has seen its underlying value decline this calendar year, and its validity as an equity hedge is questionable given the drop in October. I expect the muni sector to see some uncertainty post-election, but ultimately believe further stimulus measures, tax hikes, and the resumption of economic activity in 2021 will improve the macro-outlook. Therefore, I will keep an eye on PML going forward, and will revisit this fund when a better opportunity presents itself.

Disclosure: I am/we are long NEA, MUS. 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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