When Bond Funds Change Investment Objectives (PHK)

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It is no secret at all that the bond funds, particularly closed-end funds, have had a hard time in the latest credit mess.  Yet today marks perhaps a new change for closed-end funds, and if others follow suit it will become ever-important to "know what you are investing in" when you purchase these funds.  The PIMCO High Income Fund (NYSE:PHK) has revised its investment policies to remove its current limits on investment in illiquid securities (currently 20% of net assets) and the use of derivatives for non-hedging purposes (currently 25% of total assets).

The Board of Trustees approved the changes to "provides additionalinvestment flexibility to respond to changing market conditions andbetter aligns the Fund’s policies."

The fund will now be able to increase its use of credit default swapsand other derivative instruments.  This will include interest rateswaps, futures and options as an efficient means to gain investmentexposure to high-yield and other debt obligations.

What is interesting is that this says that the fund’s use of derivativeinstruments involves risks different from, or possibly greater than,the risks associated with direct investments in securities, includingilliquidity risk, leverage risk, correlation risk and counterpartyrisk.  The illiquid securities may trade atdifferent terms than its traditional investments and be more difficultto value.  This may also tie up the fund’s cash and assets for longerperiods of time and the fund noted that these investments may have muchless liquidity.

This is the downside of a closed-end fund in the current climate.There are almost no new issuances.  The volume trading injunk bonds and investment grade bonds has been very small.  When you have "A" rated paper trading at double-digityields fund managers feel more like they are selling bonds to a bookiethan they are participating in a marketplace.

This is going to complicate the calculation of the fund’s Net Asset Value even further.  The new N.A.V. may start to become a "theoretical value" which becomes widely disputed.

Jon C. Ogg
December 26, 2008