I had a position a while back in PCN -- PIMCO Corporate Income Fund -- a bond fund. It appreciated 60% in a matter of weeks and I sold it. It dropped and it hasn't recovered since. Nonetheless, it still trades for a whopping 18% premium to NAV.
Today, I took another look at it to see what's going on and whether or not it still is a good investment, despite the ugly premium. Its yield is certainly attractive: 14%.
My first concern about it was whether or not it was eating into principal in order to support its high yield. Many closed-end funds do that. Of course, that's not a sustainable strategy nor is it profitable for the investor.
So I took a look at its most recent quarterly report (note: I only trust the report on the SEC website). And as usual, I also went back to its previous quarterly report.
I was flabbergasted by what I found out.
Care to take a wild guess why? Search on both reports for "Fair Value Measurements". The fund recently adopted FAS 157 and switched the bulk of their portfolio fair value estimation to Level II.
Level I determines that securities are valued on the basis of market prices (mark-to-market, if you will). Level II uses "other significant observable inputs" and Level III is pure witchery.
Why would they adopt FAS 157?
One reason is the market dried up for corporate bonds. However, is this really true? There are still bid and ask prices out there for almost all securities, certainly more than 0.97% of their portfolio, which is the amount they claimed they could use Level I quotes for, and 98.6% for Level II and the rest for Level III.
Does this seem reasonable to you?
My brokerage still shows me quotes for most of PCN's portfolio, including widely traded bonds such as those of GE, C, F, GS.
Even worse is the fact that they report $33 million in Treasury Bonds which accounts for 5.5% of the portfolio. How can treasury bonds not be quoted at Level I?
Something smells fishy.
To be sure, using Level II doesn't mean the securities became more risky, it only means they became harder to value. And while I can believe that the current market environment doesn't make things easy, I strongly doubt using Level II for 98% of a corporate bond's portfolio is warranted, especially when there are such large positions in very liquid securities.
I also checked IQC, a California Muni fund I currently own. They too adopted FAS 157 recently and switched the bulk of their portfolio to Level II. CIF, another popular corporate junk bond fund, has been on Level II for a few quarters now.
Given that I don't understand why the radical switch nor why Level I quotes are impaired, I prefer to stay away from these funds for now. I will need to make a decision about my IQC position soon.