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Seeking Income in a Low-Yield World
Daniel J. Ivascyn
With central bankers in certain developed nations holding down key interest rates and several economies lacking momentum, it may be challenging for investors to find ways to sustain and enhance their income streams.
In the following interview, senior portfolio manager Dan Ivascyn discusses markets and how the PIMCO Income Strategy pursues attractive income, while also seeking total return and focusing on careful risk management.
Q: Amid concerns by some economists that global growth may be slowing, do you anticipate low global bond yields to be the norm for the foreseeable future?Ivascyn: From a fundamental perspective, one should expect bond yields to be low due to the combination of expectations of slowing global growth and potential excess economic capacity from the emerging markets. Further reducing bonds yields are the technical factors of policymakers attempting to spur economic growth by maintaining extremely low policy rates and quantitative easing, and from a flight-to-quality bid away from risk assets in a world of substantial uncertainty. Although we expect this combination of fundamentals and technicals to keep rates low for an extended period, we are also cognizant of the potential of brewing inflationary pressures in the long run.
Q: What does this low-yield world mean for investors who seek income for retirement or other goals?Ivascyn: In the current low-yield world, investing solely in U.S. government securities may not provide sufficient income for retirement, while following a traditional income strategy that relies on credit or a combination of equity and credit may expose an investor’s principal to substantial risk. Although we do find select opportunities in the U.S. high yield corporate sector, we believe that it makes sense to look into other sectors of the fixed income market and outside the U.S. for opportunities to generate income without taking excessive risk.
The PIMCO Income Strategy has the ability to invest in various government bonds, inflation-linked bonds, agency mortgage backed securities, non-agency mortgage backed securities, commercial mortgage backed securities, investment grade corporate bonds, high yield corporate bonds, bank loans from around the globe and emerging market bonds. We believe that this investment flexibility may allow for the generation of attractive income while focusing on limiting risk relative to an essentially single-sector investment strategy of investing in high yield corporate bonds.
Q: Shifting gears to focus more on the PIMCO Income Strategy, what sectors and strategies do you find attractive in this environment? And is the “roll-down” trade, long employed by PIMCO, still potentially beneficial?Ivascyn: Regarding roll-down, or the concept that all else being equal a fixed income security becomes more valuable as it nears maturity (rolls down the yield curve), we think it is a strategy that still makes sense because it aims to produce an attractive level of income while holding higher quality assets. However, we believe that the yield curve will modestly flatten as the Fed implements Operation Twist (selling short-term Treasuries and buying longer-term ones). This may slightly reduce return prospects for this high quality bond strategy, but we believe it could still generate consistent income for portfolios when implemented properly.
Uncertainties in Europe and concerns about a weaker global economic environment have led to several other interesting potential income generating opportunities. Europe has been in the headlines, and there is much concern about what may happen in that region. However, recent performance in that market has lagged behind the rally in high quality bond markets and, in some cases, moved in the opposite direction, creating dislocations that we may be able to take advantage of in our income strategies.
We have focused on structured products such as non-agency mortgage backed securities and commercial mortgage backed securities. Although we have a negative view on residential and commercial real estate fundamentals, and expect weakness in the U.S. economy going forward, we believe that current trading levels of these securities already incorporate negative views on the underlying fundamentals.
Recently, we have added floating-rate bank loans, which banks make to companies at generally senior positions in the capital structure relative to high yield corporate bonds (companies receiving such loans generally do not qualify as investment grade). While providing attractive return opportunities in an improving economic environment due to the floating-rate coupon (which should be expected to increase along with market rates in an improving economic environment), these loans may also provide a potential downside hedge in a negative economic environment (potentially resulting in defaults) due to access to collateral and a senior position in the corporate capital structure.
We also are seeing opportunities in emerging markets. Recently, there have been significant outflows from emerging markets dedicated strategies, resulting in forced selling. We see favorable long-term dynamics in emerging economies, including lower levels of indebtedness than the developed world and public policies supportive of domestic industry and infrastructure development. In addition, we see attractive valuations in emerging markets corporate credits.
Q: Briefly, could you expand on the appeal of floating-rate bank loans amid recent market volatility? Ivascyn: Earlier in the year, a large segment of the floating-rate bank loan investor base had flocked to the sector as a supposed “safe haven” against rising interest rates (given the floating-rate coupons). Instead of a rising rate environment, bank loan investors were confronted with a falling rate environment (which meant the floating-rate coupons generally also declined), and a specter of a depressed economic outlook and potential corporate defaults. As a result, the floating-rate bank loan market has experienced substantial investor withdrawals and forced selling.
We argue that the market has now overshot to the downside – thus, we are selectively targeting these instruments. We are looking at senior secured bank loans, at the top of a company’s capital structure that generally have significant asset coverage. While we are confident the credit exposure we hold in floating-rate loans is of sound quality, in an adverse economic scenario resulting in bankruptcy we feel we would be well positioned given the seniority of these loans. Of course, investors should note that floating rate bank loans contain more credit risk and are more volatile than government bonds, given that loans are generally rated below investment grade. Also the bank loan market may not have the same level of liquidity as the markets for government bonds or stocks. All things considered, we see interesting opportunities in floating-rate loans, which are offering yields of about 6.5% according to the Credit Suisse Leveraged Loan Index as of October 31, 2011.
Q: How are you managing the PIMCO Income Strategy to address the current environment as well as PIMCO's long-term outlook? Ivascyn: This is an important point, which differentiates us from our peer group. The Income Strategy is focused on applying PIMCO's long- and medium-term outlook of global economies and fixed income markets. Each quarter, investment professionals from PIMCO’s North American, European and Asian offices meet to discuss the macroeconomic outlook for various regions around the globe either with respect to the medium-term or longer-term outlook. Based upon the consensus that is reached with respect to the macroeconomic outlook, portfolio managers from various specialty desks present on relative value opportunities in their respective sectors.
Given a negative economic outlook relative to market consensus, the PIMCO Income Strategy is currently structured with a bias for higher quality, focusing on securities with which we do not expect to have substantial downside in a deteriorating economic environment.
Q: Could you elaborate on potential risks to the strategy? Ivascyn: We have an overweight to senior non-agency mortgage backed securities. Although we believe that these securities already price in a negative economic outlook and weak mortgage credit fundamentals such as housing price changes or public policy developments, it is possible for either fundamentals to be worse than expected, or technical selling to lead to mark-to-market price declines even if the underlying fundamentals are inline or better than expected.
A resolution to the European sovereign debt crisis has yet to be achieved. In the event that a successful conclusion is not reached, this could lead to increased global economic weakness and could also lead to a sell-off in risk assets.
A key manner in which we are managing these risks is via very careful security selection. We have more than 100 investment professionals committed to the analysis of mortgage securities, as well as PIMCO’s more than 40 global credit analysts. Geographically, we are limiting our holdings of peripheral European sovereign debt as well as holdings of core European financial institutions that have exposure to peripheral Europe. Also, we are actively managing duration and exposure to other key risk factors.
Q. How do you evaluate the risk-return tradeoff of different sectors and securities from an income perspective?Ivascyn: Our primary filter is to assess the income-generating ability of each potential investment – we look at the amount of income that is likely to be generated across a variety of economic scenarios. A second, though critically important, filter is to assess how an investment opportunity might relate to the strategy’s total return performance. We believe it is possible to generate robust income while also providing investors with attractive total return potential.
To clarify, we view our clients in the strategy as generally income focused, but that does not necessarily mean they are willing to meaningfully sacrifice principal to arrive at an income objective. One of the biggest dangers is the risk of getting into a situation where in your base case, for example, you may earn a yield that appears very appealing, but under more negative states of the world that we assign a meaningful probability to, that yield becomes deeply negative. Thus, we are very focused on avoiding such pitfalls and believe stress testing is critical.
Q: Finally, how have you adjusted the strategy to address various market environments?Ivascyn: The most notable, perhaps, was when we became more defensive going into 2008, including underweighting credit exposure while emphasizing exposure to the government sector. Also, this year we are focusing on senior secured loans while moving out of high yield amid the potential for a global economic slowdown or even recession.
As I mentioned, we routinely analyze the potential performance of instruments from various segments of the market and regions of the world, testing them in a variety of economic scenarios. A related point, with an eye to achieving greater diversification, we look at our exposure to key risk factors. For example, high quality bonds may have significant duration risk, while credit investments may have greater sensitivity to the broader economy and how the equity market is performing.
At the end of the day, we put together a portfolio of what we view as our best ideas, including the potentially most resilient investments in periods of weak economics and positions that may retain some total return potential in economic recovery scenarios. I am not saying we get everything right, but we focus on achieving consistent performance and delivering an attractive total return while seeking to maintain a stable dividend.
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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