Is PIMCO Income Getting Too Big?

The following is our latest Fund Analyst Report for PIMCO Income PIMIX.

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PIMCO Income boasts a world-class team, process, and performance record. It has grown at an astonishing rate, though, which partly explains its Morningstar Analyst Rating of Silver.

Dan Ivascyn and Alfred Murata make effective use of PIMCO's bountiful human and analytical resources, including a very large group of mortgage and real estate specialists. The evidence is long-term returns near the top of the multisector-bond Morningstar Category as of April 30, 2018, and below-average volatility.

After a modest loss in 2008, the fund proved resilient during trouble in late 2011 and summer 2013. It has leaned on several areas, including exposure to falling global government yields and corporates.

The fund's nonagency residential mortgages have been a cornerstone, though, and have included a mix of prime, Alt-A, and subprime residential debt. It has been shrinking in size, but the fund has kept exposure in the 25% to 30% range since early 2013 despite white-hot asset growth ($212 billion across vehicles as of March 2018), and it was its biggest contributor to performance in 2017. That said, the fund's allocation there totaled 24% at the end of March 2018, down from 31% two years earlier.

The pair has tools to backfill as RMBS get harder to find. Ivascyn and Murata slashed agency mortgages to 9.4% as of March 2018 from 45% at the end of 2011 and, in turn, have focused more on emerging-markets debt, a mix of high-yield and investment-grade corporates, and non-U.S. developed markets ex-Japan. As of March, they were aggressively shorting Japan's debt.

PIMCO still likes nonagency mortgages given their still-promising returns and modest volatility, but the allocation will be difficult to maintain. PIMCO is focused on its broader opportunity set, though, and is confident the fund can still meet its goals well; it is not expecting to close the fund. That's understandable, and there's plenty to suggest the fund will remain among the elite of its peers, but we'd prefer to see the firm consider sheltering the fund's allocation from dilution.

Process Pillar:

Positive | Eric Jacobson 05/23/2018

Like all of PIMCO's funds, this one relies on numerous top-down and bottom-up calls. Thanks to its income focus, the fund has weightings in higher-income areas, such as high-yield corporates and non-U.S. bonds, and has for years had a strong taste for nonagency mortgages relative to the multisector-bond category. This also means that while the fund will reflect PIMCO's macro themes when implementing its strategy, the portfolio will diverge meaningfully from siblings such as

The fund sets a monthly dividend and attempts to stick with it for at least a year. Prudence demands that number be set lower than what the fund's holdings actually produce each month to avoid a shortfall, and there's usually undistributed income at each year-end, which is paid as an extra dividend to avoid running afoul of IRS tax rules. There was a bit of deviation after the fund's launch, but all of its share classes (other than C) have kept a monthly dividend of roughly $0.05, paid end-of-year bonuses, and have not returned capital to investors. That last part is crucial: It means the fund hasn't been paying out higher dividends than it has earned in portfolio income, which would otherwise translate to principal erosion over time. The balance and quality of that effort earn the fund a Positive Process rating.

The fund has been adept: Unlike some siblings, it made up for shorting the rallying Treasury sector in the third quarter of 2011 by leaning more heavily on agency mortgages and high-quality corporates. The fund waded through 2013's summer yield spike with a more modest duration than the broad U.S. market (and many PIMCO peers') and rode the strength of its nonagency residential mortgage and high-yield holdings. That resilience made the fund's 2012 run all the more impressive; in particular, the residential nonagency stake began 2012 at 30% of assets and was on fire most of the year.

PIMCO supported the managers' efforts by pouring resources into nonagency mortgage research (as many as 50 people). That exposure totaled 24% as of April 2018, including senior structures from a mix of subprime, prime, Alt-A, and option-arm debt. It's impressive that the fund has been able to maintain that high of a weighting, given that the strategy's growth across vehicles has been explosive--it more than doubled to $212 billion over the 16 months since 2016--while the sector has been shrinking. The team also slashed agency mortgages to 9.4% by April 2018 from 45% at year-end 2011. In turn, the fund has focused on non-U.S. developed markets (12% before factoring in a 19% short in Japan), emerging-markets debt (19% plus 1% in short paper), and a mix of high-yield (11%) and investment-grade corporates (6%).

Performance Pillar: Positive | Eric Jacobson 05/23/2018 This fund has set a high bar, with long-term returns among the multisector-bond category's best through April 2018, modest volatility, and delivery on an income mandate for fat yields without returning capital. That has helped earn the fund a Positive Performance rating. That narrative starts with a modest 2008 loss that placed in the group's best decile, and the fund has been resilient in other times of stress, such as late 2011 and the summer of 2013. That's notable given the difficulty that PIMCO's macro positioning triggered for others in the complex during those stretches and given that this fund typically carries some leverage.

The fund has picked up help from several areas in recent years, including, at times, exposure to falling global government-bond yields, rallying corporates, a strong U.S. dollar, and effective yield-curve positioning. Its emerging-markets allocation has had mixed results but has made healthy contributions since 2015. But while the fund hasn't always carried the most optimal overall duration exposure, it has managed its yield-curve exposures well and has banked contributions from its rates exposures during most years since its inception.

All that said, the fund's nonagency mortgage exposures have been healthy contributors to its success in recent years, almost without fail. The sector has not only posted strong returns but also comparatively little volatility.

People Pillar: Positive | Eric Jacobson 05/23/2018 Dan Ivascyn has called the shots since the fund's 2007 inception and heads PIMCO's mortgage credit effort. His profile soared in 2014, first named a deputy CIO following Mohamed El-Erian's departure in January, and then group CIO (effectively PIMCO's top investor) when Bill Gross resigned in September 2014. Moreover, Alfred Murata remains on the fund. He joined PIMCO in 2001 and became a comanager on this fund in March 2013. The duo won the 2013 Morningstar Fixed-Income Fund Manager of the Year award. The pair's mortgage efforts are supported by roughly 50 nonagency mortgage specialists.

Gross' departure introduced uncertainty to PIMCO on several levels, but the prior addition of Ivascyn and other sector specialists to the Investment Committee in January 2014 added useful balance. Things have stabilized since then under Ivascyn's leadership, though, and the size and depth of the firm's mortgage desk have been crucial to this fund, in particular, given the esoteric nature of that market's subgroups and structures. It will be important to monitor how PIMCO manages that resource, but no less so the others this fund will eventually need to rely on as the nonagency mortgage sector continues to vanish. Of course, PIMCO has plenty of other strengths, and this fund's management is still indisputably among the industry's best. The fund earns a Positive People rating.

Parent Pillar: Positive | Eric Jacobson 04/04/2017 PIMCO has endured rocky waters, including the late-2014 departure of co-founder Bill Gross. Outflows soared at the firm thereafter but slowed in 2015 and 2016; the firm returned to net inflows in January 2017.

The firm continues to benefit from a standout investment culture. Dan Ivascyn has been successful as comanager of

We have historically taken the firm to task for failing to pass along economies of scale in pricing, but its overall expense profile is reasonable if not notably attractive. That said, PIMCO has never closed a fund to new investors. That is an issue of import given that assets managed in, and using the same strategy as, PIMCO Income grew to more than $100 billion of assets at the end of 2016. We've yet to see evidence drawing a direct line between asset size and performance, but we continue to evaluate the situation.

On balance, PIMCO has many more pluses than minuses and has earned a Positive Parent Pillar Rating.

Price Pillar: Positive | Eric Jacobson 05/23/2018 Even after an October 2018 fee hike, this remains one of PIMCO's most fairly priced offerings; now at 0.50%, its Institutional share class still merits a Morningstar Fee Level of Low relative to others of its type. In fact, 99% of its assets are in share classes ranked as Below Average or Low relative to their peer groups. It thus earns a Positive Price rating.