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Fund Spy: Morningstar Medalist Edition

PIMCO Income Remains a Bright Spot for the Beleaguered Firm

These may be PIMCO's most difficult hours, but PIMCO Income has only thrived.

Former PIMCO chief investment officer Bill Gross' exit on Sept. 26, 2014, was a blow to the firm, and the firm has suffered big outflows. But  PIMCO Income's (PIMIX) atypical-for-PIMCO yield focus, its heavier-than-usual reliance on sectors less tied to day-to-day macro decisions, and its strong resources (including group head and fund manager Dan Ivascyn) have helped isolate it from those troubles. The fund has been pulling in assets hand over fist at a time when its favorite markets are shrinking, though, which is partly responsible for keeping its Morningstar Analyst Rating at Silver and not higher.

Marrying PIMCO's Big-Picture Process With a Special Set of Weapons
Like all of PIMCO's funds, this one relies on numerous top-down and bottom-up calls. Thanks to its income focus, this one has weightings in higher-yielding 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 Morningstar category. This also means that while the fund will reflect PIMCO's macro themes when implementing its strategy, its portfolio will diverge meaningfully from siblings such as  PIMCO Total Return (PTTRX). The fund also typically employs some leverage, which has occasionally spiked as high as the mid-double-digits, mostly via derivatives, though the deftness of management has kept it modest at the right times and kept the fund from feeling much painful volatility.

Given its income mandate, 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 in order to avoid a shortfall that would disappoint investors, 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 those end-of-year bonus dividends, and have not returned capital to investors.

That last feature 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. We don't see that as often these days, but such practices were a scourge of the bond-fund marketplace in past periods, during which fund companies cynically fed voracious investor appetites for income. The balance and quality of that effort earn have earned the fund a Positive Process rating.

Thrust Into the Spotlight, But No Newbies
Dan Ivascyn has called the fund’s shots since the fund's 2007 inception and heads PIMCO's mortgage credit effort. His profile soared in 2014, first when he was named a deputy CIO following Mohamed El-Erian's departure in January and then named group CIO (effectively PIMCO's top investor) when Bill Gross resigned in September 2014. Moreover, Alfred Murata has remained on the fund. He joined PIMCO in 2001 and became a comanager here in March 2013. The Ivascyn-Murata duo won Morningstar's Fixed-Income Manager of the Year award in January 2014. 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 some useful balance. PIMCO has also supported Ivascyn and Murata's efforts by pouring research resources into nonagency mortgages (as many as 50 investment professionals). 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 research effort, but no less so the others this fund will eventually need to rely on if its favored corner of the mortgage sector continues to shrink. For now, however, its management is still indisputably among the industry's best, and the fund earns a Positive People rating.

Adept at Handling Both Challenges and Opportunities
Ivascyn and Murata have set a high bar for the fund, which boasted a five-year annualized return that placed near the top of the multisector-bond category at the end of May 2015 and displayed a level of volatility below its peers'.

After a modest loss in 2008, it proved resilient during market trouble in late 2011 and the summer of 2013. Unlike some sibling funds that famously faltered, this one 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. Meanwhile, the fund waded through 2013's summer yield spike with a more-modest duration than that of the Barclays U.S. Aggregate Bond Index (and many PIMCO peers) and also rode the strength of its nonagency mortgage and high-yield holdings. That resilience made the fund's 2012 run all the more impressive; in particular, its nonagency mortgage stake began 2012 at 45% of assets and was on fire for most of that year. That allocation has included exposure to commercial mortgages and a mix of prime, Alt-A, and subprime residential debt. Despite its huge rebound since the financial crisis, a lingering perception of sector toxicity among investors, as opposed to what is easily arguable acceptable risk, has left few investors active in the sector. Rejecting that market perception--and in fact capitalizing on it--this fund had a nonagency allocation totaling 43% at the end of April 2015.

Ivascyn and Murata have kept that exposure in the same ballpark over the past few years despite the fund's white-hot asset growth--roughly 50% since the end of 2013--but they acknowledge that the pool of outstanding residential bonds is shrinking. The pair argue, however, that PIMCO has tools to pick up the slack. They slashed agency mortgages to 3% as of May 2015 from 45% at the end of 2011. In turn, they've inched up non-U.S. developed-markets debt (16% of assets in April 2015), emerging-markets debt (20%), and high-yield corporates (20%).

A Relative Bargain
This is also one of PIMCO's most fairly priced offerings; 0.45% for its Institutional share class merits a Morningstar Fee Level of Low relative to others of its type. In fact, all of its other share classes are also ranked as Below Average or Low relative to their peer groups.

Will It Always Shine as Brightly?
The fund’s topnotch 9.5% and 10.6% three- and five-year annualized returns, respectively, rank among the category's best. The fund has also delivered on an income mandate for fat yields without returning capital, earning it a Positive Performance rating. Meanwhile, it has displayed levels of volatility close to or below its peers'.

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 market stress, such as late 2011 and the summer of 2013. That's notable given the difficulty PIMCO's macro positioning famously triggered for other funds in the complex during those stretches and the fact that this fund typically carries some leverage. Its 2013 showing was also impressive despite modest debt holdings in the now-bankrupt Brazilian oil concern OGX.

Neither this fund nor most of its category peers had nearly as much sensitivity to the mostly rallying long end of the U.S. Treasury curve in the past couple of years as the broad U.S. market. But while its nonagency mortgages had a positive impact, the fund has leaned strongly on other areas for balance, including exposure to a rallying U.S. dollar and falling government bond yields in other developed markets. Emerging markets were a drain during 2014, but in early 2015 they helped the fund make up for weakness in its U.S. rate positioning. As such, its returns in 2014 and for the year through May 2015 soared past most of its peers.

The fund’s strategy and management remain intact in the post-Gross PIMCO, and the mortgage effort at the firm is among the most elite and well-resourced. However, with shrinking nonagency opportunities and this fund's ballooning assets, it's fair to ask what the future holds. Though PIMCO is faring far better than many would have anticipated, the firm’s overall outflows and evolving post-Gross management structure bears watching. Those uncertainties are the reason the fund bears a Silver rating rather than Gold.

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Eric Jacobson has a position in the following securities mentioned above: PTTRX. Find out about Morningstar’s editorial policies.