In my recent quest to uncover high-yield fixed income funds, I recently stumbled upon an intriguing player: PCM Fund Inc. (NYSE:PCM), a credit fund tucked away within the Pimco stable. Its enticing 9.7% distribution yield initially caught my eye, but upon delving deeper into its nuances, certain red flags began to emerge.

Distribution Yield: A Deceptive Mirage
PCM Fund’s allure is partly attributed to its commendable 9.7% distribution yield. However, a closer inspection reveals that this figure disguises a concerning aspect. The actual distribution yield is a whopping 14.3% on NAV, significantly outpacing the fund’s historical earnings performance. This discord raises questions about the sustainability of such a high distribution yield relative to its actual earning capacity.

A Risky Premium Proposition
Trading at an eye-popping 47.5% premium to its Net Asset Value (NAV), PCM Fund’s unit price stands precariously. The substantial premium, while not an imminent threat to an overnight collapse, poses a long-term risk, particularly for steadfast investors. The example of Pimco’s High Income Fund (PHK) serves as a cautionary tale, as a previously hefty premium eventually dwindled due to unitholders’ departure following distribution cuts.

Peering into PCM Fund’s Core
PCM Fund Inc., a modest closed-end fund (CEF), resides within Pimco’s domain. Its primary objective is to generate substantial current income through a diverse portfolio of credit instruments, encompassing agency-backed mortgage-backed securities (MBS), high yield corporate bonds, investment-grade corporate bonds, and more.

As of June 30, 2023, PCM Fund boasted $81 million in net assets, combined with a 45% effective leverage. Its total expense ratio tallies at 2.3%, positioning it within a reasonable range.

The Portfolio Landscape
The fund’s holdings are spread across various sectors, with non-agency MBS (51.9%), high yield bonds (23.0%), and commercial MBS (11.4%) taking center stage. PCM Fund’s investments largely gravitate towards shorter durations, with an adjusted duration of 3.9 years. However, a notable drawback arises from the lack of a comprehensive credit quality breakdown, impeding a thorough risk assessment.

The Performance Saga
PCM Fund’s performance journey has witnessed its fair share of fluctuations. While its recent years returned only modest gains, the fund’s trajectory took a dip in 2022 due to a lackluster performance, a consequence of the Federal Reserve’s interest rate hike. However, considering the broader credit market context, these losses align somewhat with similar credit investments such as the iShares MBS ETF (MBS) and iShares iBoxx $ High Yield Corporate Bond ETF (HYG).

Distribution Dynamics
PCM Fund’s allure is amplified by its attractive monthly distributions, equating to $0.08 per month and a promising forward yield of 9.7% based on market price. However, the allure falters when scrutinizing the fund’s distribution coverage. The latest ‘UNII report’ highlights that the fund’s distribution isn’t entirely backed by its net investment income (NII), with coverage ratios standing at 77.2% for a 3-month period and 87.4% for the fiscal year to date as of June 1, 2023.

The Strain of Premium to NAV
Perhaps the most alarming facet of PCM Fund is its sizeable 47.5% premium to NAV. This premium accentuates the forward distribution yield to an astonishing 14.3%. When weighed against the fund’s historical 10-year returns of 5.7%, an evident disconnect between earnings and yield arises. This discrepancy hints at the possibility that PCM Fund is functioning as a ‘return of principal’ fund rather than truly earning its distribution.

A Shrinking Historical NAV
A deep dive into PCM Fund’s historical NAV performance further confirms this suspicion. Over the years, the fund’s NAV has experienced a gradual shrinkage from over $11 per share in 2013 to a current $6.71. While the market price’s decline is less pronounced, it’s crucial to note that this is primarily due to the escalating premium to NAV, which has surged from near NAV levels in 2013 to its current 50% premium.

Cautious Optimism and Concluding Thoughts
While I’m not suggesting an immediate precipitous fall in PCM Fund’s premium to NAV, the situation warrants vigilance. The fund’s historical performance, coupled with the discord between distribution yield and earnings, urges a prudent approach. PCM Fund, once a modest credit fund with commendable total returns, has cast shadows of doubt due to its distribution dynamics and premium vulnerability. I would personally choose to sidestep PCM Fund and explore alternatives with a more robust alignment between earnings and yield.