PMX: This Muni CEF Still Looks Attractive (NYSE:PMX)

Main Thesis & Background

The purpose of this article is to evaluate the PIMCO Municipal Income Fund III (NYSE:NYSE:PMX) as an investment option at its current market price. This is a fund I keep on my radar screen because I am an avid investor in the muni space, and I have held muni CEFs from PIMCO in the past. This particular CEF has an objective to “seek current income exempt from federal income tax”, which is precisely what most would want out of a muni fund.

When Q1 got underway this year, I saw some relative value in PMX and recommended it as an option for muni investors. In hindsight, it hasn’t really worked out as well as I would have hoped. The fund’s total return has been meager and fixed-income across the board has run into challenges:

Clearly, PMX has not been the best place to park cash thus far in 2024. But it hasn’t been terrible either, as investors can do a lot worse than a flat return!

Still, with cash paying 5%, one has to be fairly critical of fixed-income positions at this moment. In my view, if you aren’t beating cash right now, you are in the wrong place, and PMX has certainly been lackluster. This led me to reconsider whether or not the “buy” rating on PMX should remain in place going into the second half of the year.

While I will be disappointed if current performance continues, I see a couple reasons why PMX may have brighter days ahead. This suggests a reinforcement of “buy” is still the right call for me – and I will explain why in greater detail below.

Valuation Still Beats Its PIMCO Peers

As a starting point for any muni CEF (or any CEF for that matter!) I always consider valuation. This was a supporting factor for me back in Q1 when I last covered PMX and the good news is that it remains an attractive quality today. This is true both in isolation and in relation to its sister funds – options that I would wager most investors in PMX should consider as alternatives. For clarity, here are the current discounts to NAV for each of the funds I am referring to:

Click to enlarge

Source: PIMCO

As you can see, PMX clearly offers a much cheaper buy-in point for the time being. While is not a guarantee by any means for positive future returns (or even that it will beat out PMF or PML going forward) it does offer some level of comfort to myself as a value-oriented investor. As long as this story remains in place I will likely view PMX as the best buy of the three given the similarity of the portfolios.

Income Metrics Are Favorable

Sticking with this relativity theme, PMX also wins out in the short-term in another important category. When it comes to income production, many leveraged CEFs have taken it on the chin in the last couple of years. The yield curve inversion and elevated borrowing rate environment has made income cuts a way of life for many funds. Suffice to say, we aren’t completely out of the woods yet. While Fed rate cuts are closer to a reality, they still haven’t happened yet and inflation remains high. So keep this in mind when considering any leveraged income play right now – plenty of risk remains.

The good news for PMX is that income production has been pretty solid recently. More to the point, income metrics for this fund beat out the metrics for PML and PMF according to the PIMCO UNII report for April:

This means that PMX has the wider discount and the best income metrics at present. Hard for me to make an argument to buy PML or PMF at the expense of these facts and this supports me keeping the “buy” call in place.

Why Munis Anyway?

Shifting to a more macro-focus, let’s discuss why one would want to consider munis right now. After all, PMX is offering a yield of just over 5%:

This rivals what cash is offering (via savings accounts, CDs, and money market funds), so why would one want to take on the risk of owning bonds through a leveraged product?

The first reason has to do with tax savings. As an owner of PMX, you have exposure to mostly (if not all) tax-exempt securities. For those in higher income tax brackets that can mean significant savings. For those who don’t pay income tax or are in the lowest tax brackets, this attribute might not mean a lot. So it is up to each individual to assess if it is right for them.

Beyond the tax savings there is the case for hedging the equity market. As we sit near all-time highs in the US and other developed markets, many readers are probably getting a bit uneasy about opening new equity positions. This presents an opportunity for investors to dive into the muni sector given this is an arena that has a low correlation to the domestic (US) equity market:

Why is this important now? Because aside from being at record levels, equity investors are also extremely optimistic about forward returns. While this can be good for momentum plays, it should also have contrarian alarm bells ringing. When the majority of investors think one way (in this case, that equities are going to keep rising), the market has a way of making the opposite happen:

This is not meant to be alarmist but it is meant to be a word of caution. When everyone is a bull, the bears might have the right idea. The prevalence of bullish attitudes have me contemplating whether or not I need to be amplifying my muni positions rather than equities and that is keeping PMX on my radar in a big way.

New Supply Has Been Modest

Another macro-factor helping support the muni sector is the supply story. In my view, stable and declining supply can boost prices as long as demand remains intact and I believe it will. Flows into the sector have been positive in 2024 thus far and there isn’t anything major on the horizon that is set to alter that. This means this demand-supply dynamic could be a tailwind for PMX and other muni funds in the months ahead.

For support, consider total bond issuance for the sector. After peaking in 2021, both 2022 and 2023 saw declines from that level. While 2023 saw an uptick from the prior year, it was modest, keeping new supply tight:

Again, this is favorable as long as demand is resilient. It helps support the prices for the underlying securities in PMX’s portfolio because a lot of new supply is not hitting the market – and therefore creating scarcity for the bonds that do exist. All things being equal, this is a net-win for muni funds as a whole.

Texas A Good Source For Muni Bonds

Another factor to consider when looking at PMX is the fund’s make-up. While many CEFs are heavy on the “big 3” as I call them – California, New York, and Illinois – given their dominance in the muni issuance market, PMX is actually top-heavy with bonds originating from the Lone Star state:

I like this because it balances out other muni funds that likely don’t have as much Texas exposure. Further, I view bonds originating in the Southwest and Southwest (Texas is arguably in both) as having a bright future ahead. That is because more people are moving to both regions and bringing their incomes with them. As more people migrate to a state and/or as a state’s personal income level increases, so too will the demand for munis within the state.

Take Texas as a perfect example. In the short-term, personal income growth is growing steadily and the state has the second highest number of tax filers claiming income above $500,000:

What I am getting at here is I like the theme of population growth and/or rising incomes in a state for munis. This is likely to drive in-state interest in those munis and can provide diversification benefits to those out-of-state. Those out-of-staters can also profit from rising in-state demand in the form of higher prices for those munis in the future.

Bottom-Line

PMX hasn’t been off to a strong start in 2024 but I expect this reality will improve going forward. The fund’s discount to NAV remains attractive, income metrics are solid, and muni demand remains strong – especially in states like Texas that are experiencing population and income growth.

I also like the idea of placing some equity hedges given that markets are at all time highs and confidence amongst investors is rising on that backdrop. This doesn’t mean sell and go away, but it does mean to be a bit more selective and patient on equity positions. Going long munis is a way to get paid while exercising that patience. Therefore, I believe the “buy” rating on PMX remains justified and I’d encourage my followers to give the idea some consideration at this time.