Portfolio Manager Chris Dialynas has written and spoken extensively on the many changes taking place in the global economy. Here, Dialynas and Product Manager Lisa Kim discuss why PIMCO’s Unconstrained Bond Strategy may be well suited to today’s changing market and how the strategy might fit into an investment portfolio.
Q: How does PIMCO’s Unconstrained Bond Strategy address the current environment?
A: First, the current environment is one of change; there is quite a bit happening in the global economy and on the policy front. In our view, the most significant event unfolding now is the end of the Federal Reserve Bank’s second and very substantial asset purchase program, which has effectively bought most of the U.S. government’s debt issuance lately. We believe the end of the program should lead to higher interest rates globally, but particularly in the U.S. The financial problems in Europe are also very significant: The weak periphery countries almost certainly require debt restructurings, wage adjustments, and potentially an exit from the euro currency to become competitive and fiscally stable. And the earthquake and tsunami in Japan have imposed a major slowdown in the world’s third largest economy just as others in the region are tightening policy in response to accelerating inflation. Finally, we can add the larger, macroeconomic trend underway: Emerging economies, with China at the core, will likely be the main drivers of global growth in the coming years.
Given all these changes, we believe flexibility is the key to investing successfully, and that’s what our Unconstrained Bond Strategy has the ability to offer. The strategy is not tied to a bond index, which we believe presents 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. By having the ability to invest more defensively, we have the potential to produce positive returns even when the outlook for bonds is challenging.
Q: So how is the strategy currently positioned?
A: Our strategy reflects our basic view that global rebalancing needs to occur. High-debt nations need to de-lever and cut spending while low debt nations need to save less, consume more, and implement fiscal policies appropriate to their growth rates. To promote this global rebalancing, the currencies of large debtor countries need to weaken against those of surplus countries.
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. In the fixed income sectors, we intend to selectively invest in corporate bonds, emphasizing financials and banks. We see value in U.S. agency mortgage pass-through securities and distressed residential mortgage pass-throughs. The strategy is also currently long municipal bonds and bank loans.
In light of our broader view on currencies, the strategy is currently short the U.S. dollar, euro, sterling and yen. We are long currencies from China, Korea, Canada, Singapore, Malaysia and Mexico.
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 can 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 fund 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 expected 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.
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 forecasts.
Q: Would you expand on the idea of the strategy as a complement to a core bond holding?
A: Most investors still need and desire a core bond position in their portfolios – meaning they want some exposure to bond duration, or interest-rate sensitivity. The Unconstrained Bond Strategy intends to offer bond-like risk, but it may and in fact has had a negative duration. And while all of PIMCO’s strategies reflect the views of our Investment Committee, the Unconstrained Bond Strategy is one of the most direct expressions of our long-term, or secular, outlook. This is one of the reasons why you may see the strategy’s performance deviate from more traditional core bonds that typically track a benchmark such as the Barclays Capital U.S. Aggregate Index (BCAG).
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 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. We also provide daily liquidity, daily market valuation and a high degree of transparency. 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, a cash rate like U.S. three-month LIBOR reflects the performance objective of the strategy: to deliver positive, risk-adjusted absolute returns. 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. One recent example of this is our move to reduce duration for the reasons I mentioned earlier. Our secular view has run into what we see as an unsustainable drop in yields as Treasuries have rallied, but we believe that the fundamentals will reassert themselves and thus we have positioned the strategy accordingly.
Q: How quickly can the Unconstrained Bond Strategy react to market shifts?
A: The strategy has the flexibility to allow us to react quickly. With its high degree of flexibility, it can implement directly – within its investment parameters – 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 downside risk are more bond-like than stock-like. During periods of market stress, seemingly different asset classes have historically tended to be highly correlated. By studying this tendency, we have learned that many assets have equity-like characteristics and can therefore behave similarly under certain circumstances. Equity risk, then, tends to be the dominant risk in a multi-asset portfolio. One of the primary issues for investors as a result is that true diversification and by extension, effective risk management, can be elusive. By ensuring the Unconstrained Bond Strategy maintains its bond-like characteristics, we believe the strategy has the potential to help diversify a portfolio, dampen portfolio-level volatility and mitigate downside risk.
Q: Earlier you mentioned financials. Given the uncertain economic climate, what makes banks attractive?
A: PIMCO’s cyclical outlook – the next six to 12 months – for the U.S. economy is supportive for the banking sector. Although housing prices are still under pressure and inventory remains a concern, we are seeing a gradual improvement in banks’ earnings, fewer write-downs, better reserve ratios and increases in Tier-I capital – all leading to stronger balance sheets. The upcoming Basel III and Dodd-Frank regulations should lead to further improvements in capital. Also, we expect U.S. banks will likely issue fewer bonds next year due to shrinking loan portfolios, which would be a positive technical factor.
We favor large U.S. banks and a handful of European banks that appear to offer investors attractive fundamentals and technicals, as well as relative value.
Q: Do you see any other potentially attractive sectors now?
A: We are looking selectively at emerging market corporate debt that offers investors strong asset coverage, low leverage and attractive valuations. We like companies with strong balance sheets, healthy top-line revenue growth and low cost structures in high-growth emerging market countries with improving credit. In terms of industries, we find the most opportunities in energy, pipelines, metals and mining, and banking.
Thank you, Chris and Lisa.