Chris Dialynas, Lisa Kim
After a generally strong start in 2012, the financial markets have wavered lately and volatility has increased once again. Despite the efforts of central banks around the world, the developed markets still face serious structural problems, and growth in some emerging economies, notably China, has slowed. Below, portfolio manager Chris Dialynas and product manager Lisa Kim discuss the global, political and economic conditions and PIMCO’s Unconstrained Bond strategy.
Q: What are the key factors in the global economy that you are thinking about as you manage the Unconstrained Bond strategy? And how does the strategy address the current environment?A: We see a new level of uncertainty today, in part because proactive policymakers have driven market activity. Central bankers, in particular, have expanded their policy tools to include very large direct purchases of securities in coordination with governments and regulators globally in an effort to create economic growth and promote the appearance of financial stability. This, in turn, has engineered a world of credit creation and risk-taking as reallocations of capital occur and assume perpetual government support.
At PIMCO, we spend a lot of time on the monetary economics of central banks and their reaction function to macroeconomic developments and markets. We have witnessed monetary authorities morphing into fiscal agents, accumulating the largest postwar stock of debt. In the process, policymakers have put U.S. public finances on a debilitating path of unsustainability, in effect borrowing from future generations and transferring wealth from creditors to debtors and substantially increasing the uncertainty in the medium term.
In this unusually uncertain environment, we believe flexibility is the key to investing successfully, and that’s what the Unconstrained Bond strategy can offer.
Q: Can you tell us more specifically about the developments in the global economy that PIMCO is thinking about?A: In response to economic crisis, central banks have taken unprecedented policy steps. They may not understand all of the implications, and their efficacy is likely to be impaired by other factors.
The Federal Reserve has embarked on massive buying of financial securities in the open market. In doing so, it has altered market clearing prices and substantially lowered the term structure of interest rates and suppressed risk premiums. In addition, the Fed’s theoretic portfolio rebalancing has led to higher stock market valuations with the hope that, via the “animal spirits” channel, it can induce real economic activity. However, in our view, the linkages are weak, the externalities great and, as a consequence, the efficacy poor. In reality, the Fed is providing very low cost funding to an over-indebted nation and simultaneously facilitating even more debt creation.
Unfortunately, the Fed, unlike real fiscal agents, cannot solve the real underlying problems of the U.S. economy. The Fed cannot deal with the deindustrialization that is progressing. It cannot directly realign exchange rates nor can it retrain and re-educate the marginalized portion of the workforce. The Fed may choose to reconsider its actions as the cost of externalities more than offsets the presumed benefits from policy actions. As a result of central bank activism in the private markets, it is now a mistake to make inferences about the real economy using “market” prices.
In Europe, policymakers still have not addressed the fundamental structural challenges of highly levered economies and inefficient labor markets with persistent high unemployment. Europe continues to face a deteriorating economy with high deficit forecasts and high debt levels. Most recently, we saw the distress in Spain from rising defaults and shrinking credit, which have eroded the quality of banks, driven up the government’s borrowing costs, and taken unemployment to depressionary levels. The second quarter, in particular, is bringing a host of event risks, including changes in government after the Greek and French elections.
Market uncertainty is further exacerbated by the imbalances and stresses among Europe’s Economic and Monetary Union (EMU) countries. The structural, financial and real economic differences among the common currency countries are great. Much of Europe is saddled with excessive debt and an overpriced or unemployed pool of labor. The main exception is Germany, which has a very competitive, well-balanced economy. The problem for most of Europe outside of Germany is how to escape the heavy burden of debt and become more competitive absent control of the currency that they would otherwise aggressively devalue. The lack of political integration makes it very difficult for one country to underwrite the problems of another. And it is very unlikely that full fiscal union will be achieved, given that the area is crippled by lack of policy resolve despite significant central bank support.
The European Central Bank (ECB) under its new leader Mario Draghi has departed from the strict inflation-suppressing central bank that it was under former president Jean-Claude Trichet and become a more aggressive liquidity-providing central bank. In its newly found religion, the ECB has provided over €1 trillion to the European banking system in an attempt to mitigate the problems caused by high debt and asset deflation. But in doing so, the banks in Italy and Spain have increased holdings of their sovereign debt, probably increasing the risks in Europe. So, we expect recession in much of Europe to feed upon itself as the continent attempts to resolve its imbalances and over-indebtedness. The EMU countries need a lower euro and wage deflation to work out of a pretty big hole.
Elsewhere in Europe, both the U.K. and Switzerland have been weakening their currencies with the hope of improving growth prospects. Unfortunately, we can’t all devalue at the same time and the country that needs to revalue most, China, has been slow to do so. Meanwhile, Japan continues to battle a deflationary weak economy with a relatively strong commitment to monetary easing through zero-level rates and asset purchases. The prolonged period of low interest rates that promote national debt creation has exacerbated financial imbalances; the Bank of Japan joins the ranks of global central banks on a relentless march to expand public balance sheets to 30% of GDP.
Given all these unprecedented developments and significant changes in the global economy, we believe the Unconstrained Bond strategy is well-suited to today’s market environment. The strategy is not tied to a bond index, which can present several potential advantages: We can tap into opportunities across sectors and regions of the bond and currency markets as they arise. We can also be agile, shifting exposures in anticipation of, and reaction to, policy decisions, economic developments and, of course, changes in the financial markets.
In addition, we can reduce the absolute risk in the strategy to a greater degree than traditional benchmark-oriented products. The strategy can invest in an effort to capitalize on deteriorating situations, with potential to produce positive returns even when the outlook for bonds is challenging.
Q: So how is the Unconstrained Bond portfolio currently positioned? A: Our strategy reflects our basic view that global rebalancing needs to occur. High-debt nations need to delever and cut spending while low-debt nations need to save less, consume more and implement fiscal policies appropriate to their growth rates. In a nutshell, substantial adjustments are required in exchange rates and labor markets.
Currently, our Unconstrained Bond strategy is positioned to offer marginal exposure to overall interest rate risk. We have limited our sovereign bond exposure in the developed economies to those we see as the strongest, namely Germany, Canada and Australia. We are also looking to add allocations to select emerging market countries. Our long-term, positive view on emerging markets remains intact. We like Brazil, particularly in short-maturity local interest rates. In the fixed income credit sectors generally, we have pared down allocations to corporates, moving up in the capital structure while going short the lower rung of the quality spectrum. The key driver is one of differentiation between credits in terms of default risk as we see default risk rising.
Agency mortgages continue to represent an important source of high quality yield. While current valuations generally are fair to full, this sector exhibits attractive risk-return dynamics relative to low-yielding cash and corporate credits.
The strategy is also currently long municipal bonds and bank loans.
Q: How do you view municipal bonds now in light of the U.S. fiscal cliff at year-end, when tax increases and federal spending cuts will likely take effect?A: The municipal market has recovered from its weakness in late 2010 and early 2011. During that period, large investor outflows and very significant issuance of taxable Build America Bonds cheapened municipal valuations. At that time, we increased our purchases of municipal bonds with the belief that fundamentally, the municipal market remained sound, with low underlying default rates and reasonable risk-adjusted returns. Flows into municipal bond mutual funds turned positive year-to-date and the paucity of new issues has caused yield spreads to tighten back to levels last seen before the weakness two years ago. As a result, we have selectively reduced exposure as long duration, taxable and tax-exempt municipal bond holdings have increased in value materially.
Q: Do you see any other potentially attractive sectors now?A: We still like non-agency securitized bonds. Current valuations provide attractive hold-to-maturity, loss-adjusted returns. We have been actively taking advantage of the inherent price volatility and limited liquidity in the market to add to our position. These assets are subject to numerous housing-related risks such as deterioration in mortgage credit fundamentals, changes in the housing process and public policy developments, as well as idiosyncratic risks such as servicer behavior.
We also like inflation-linked assets like Treasury Inflation-Protected Securities, or TIPS. TIPS will likely be supported by inflationary pressures that build from abundant liquidity and the monetization of Treasury debt.
Q: Recently we have seen signs of economic recovery in the U.S. What do you make of these?A: Indeed, some data has corroborated the view that the U.S. economy has improved, but we remain cautious on real growth. The employment picture and housing recovery have not yet gained solid footing once adjusted for several factors. For example, we see the influence of unseasonably warm winter weather in the jobs and housing numbers. Real income growth remains soft, and more troubling still, the underlying calculus of the declining unemployment rate relies on a deteriorating labor force; the labor force participation rate, or the total number of workers looking for jobs, has been falling from its historical average for some time. Additionally, there are very important contractionary fiscal issues looming that require political resolution.
Q: In light of the recent downshift in growth expectations for China, what are you doing in the Unconstrained Bond strategy?A: Over the next year or so, we expect the Chinese yuan to appreciate in real exchange rate terms. China continues to be the exporter to the global consumer. While China’s trade account appears to be in better balance, that is largely because it is also the importer of real assets vital to the production process. China is also indirectly hedging the Fed’s monetization of Treasury debt. Global trading partners will nevertheless insist on a continued currency revaluation, in our view. As a result, the Unconstrained Bond strategy is positioned with a fairly large allocation to the yuan, albeit partially hedged.
Q: How should investors think about the Unconstrained Bond strategy in the context of an overall portfolio? Is it an alternative investment or a core bond holding?A: Although the strategy is designed to help meet a variety of portfolio goals, many investors have been interested in it because of its absolute return orientation. Those looking for strategies that rely on the portfolio manager’s skill, or alpha, as the driver of returns – without embedded market beta – have tended to put the Unconstrained Bond strategy into their alternatives allocation. This is particularly true for investors who’ve gone beyond the traditional asset allocation of 60% stocks and 40% bonds and want to add alternative investments to help diversify risk in their portfolio. Because of its absolute return focus, some investors are using it as a “hedge fund light” strategy.
Lately, we’ve also been seeing interest in the strategy as a bond strategy complement, or flexible extension of a core fixed income holding. We think that makes sense because the Unconstrained Bond strategy aims to provide many of the same potential benefits of a typical bond portfolio: capital preservation, liquidity and income, low correlation to equities and high credit quality. But unlike a traditional core fixed income portfolio, which tends to be dominated by interest rate risk, the Unconstrained Bond strategy has the flexibility to diversify risk beyond interest rate risk and to alter the portfolio’s interest rate risk very significantly.
So investors who are very concerned about the potential for rising interest rates and do not want their core bond allocation to carry structural exposure to pure interest rate risk can consider the Unconstrained Bond strategy as an investment option. However, it is important to note that the strategy guidelines provide the discretion to manage the interest rate risk across a fairly wide range, all the way from negative three years to positive eight years of duration. So we won’t always have neutral to negative exposure to interest rates; our duration position will be a function of PIMCO’s cyclical and secular economic forecasts and the corresponding interest rate forecast. Today, the strategy’s duration is about one year.
Q: So should investors think of it as really more akin to a hedge fund strategy?A: The Unconstrained Bond strategy offers some of the characteristics of hedge fund strategies, such as targeting attractive returns in a variety of markets and in different market environments. But it also mitigates many of the concerns often associated with hedge funds. Unlike many hedge funds, we do not require investors to stay in the strategy for six months or a year. In addition, we have no inherent bias to holding long or short positions. We try to add value through fixed income and currencies, which is a function of yield, price change and potential price variability. The concentration of long and short positions in our strategy will most likely be a result of our overall interest rate strategy – a bullish forecast for lower yields will likely result in a mostly “long” portfolio, and a bearish view on interest rates may support a mostly “short” portfolio. The ability to invest in both long and short positions allows us to isolate specific risk factors in the bond or currency instrument.
Q: Although the strategy does not track an index, it does have a benchmark: U.S. three-month LIBOR. Does that benchmark affect how investors should view the strategy in their portfolios, both over short and longer time frames?A: We look at the benchmark from various angles. From a return perspective, we feel that a cash rate like U.S. three-month LIBOR reflects the absolute return orientation of the strategy. We also look at market indexes as a proxy for overall volatility in the strategy at any given time.
Over time, we believe our risk focus can result in attractive return potential for investors. And it bears repeating that we manage this strategy for the long term – based on the careful work that we do in developing our global secular forecasts. A high level of conviction means that we’re comfortable missing opportunities if we believe the risks are excessive, or willing to take a position early if it could potentially benefit investors down the road.
Q: How quickly can the Unconstrained Bond strategy react to market shifts?A: The strategy, with its high degree of flexibility and access to the full toolkit, can implement quickly and directly the views of PIMCO’s Investment Committee. As the primary portfolio manager, Chris Dialynas is responsible for implementing the Investment Committee’s views and ongoing maintenance of the strategy.
Q: Even though the strategy is “unconstrained,” it has investment parameters. Can you explain why?A: The investment parameters of the Unconstrained Bond strategy are designed to help ensure that the quality of the portfolio and its risk profile are more bond-like than stock-like. During periods of market stress, we have observed correlation relationships among assets breaking down, and traditionally uncorrelated asset classes that were meant to diversify an overall portfolio became highly correlated. In studying this tendency, we have learned that many assets have equity-like characteristics and can therefore behave similarly under certain circumstances. By ensuring the Unconstrained Bond strategy maintains its bond-like characteristics, we believe the strategy has the potential to help diversify a portfolio, damp portfolio-level volatility and mitigate downside risk.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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