The primary application for PIMCO’s investors is to use long duration portfolios to closely match the interest rate sensitivity of long-dated liabilities. PIMCO’s recommended approach begins by systematically analyzing liability cash flows – usually in consultation with the client and client’s consultant or actuary. The objective is to understand how the present value of the cash flow stream responds to a wide variety of potential changes in the yield curve. Within the scope of client guidelines, the asset portfolio is constructed to take advantage of relative value opportunities among assets and other tactical opportunities afforded by the breadth of PIMCO’s market presence and expertise. Active portfolios are generally managed with the acknowledgment that the duration match may drift slightly from its target when the potential rewards make it worthwhile. The focus is on adding value within the appropriate risk constraints.
Many of PIMCO’s long duration clients have chosen duration matching with active management. In general, clients have considered the opportunity costs of the absolute matching required for total immunization to be high given the level and structure of the long-end of the yield curve. An active strategy enables clients to take full advantage of PIMCO’s skills in active management.
Investors may also desire to increase exposure to longer duration assets because they historically have had a different return profile than intermediate maturity fixed income portfolios. In addition, they may also assume more exposure to longer duration to take maximum advantage of certain economic trends, such as low inflation and moderate economic growth, which may provide heightened benefit to longer duration bonds. |
PIMCO’s long duration investment philosophy is an extension of the approach we have employed for over 35 years:
Long-Term Focus
Major shifts in portfolio strategy are driven by longer-term trends. Strategies are deployed with a macro view of the portfolio driven by 1) our secular outlook of the forces likely to influence the economy and financial markets over the next three to five years and 2) our cyclical views of one- to four-quarter trends. Through PIMCO’s annual secular forum, we forecast the global financial and economic outlook over the next three to five years, and assess their impact on the fixed income markets. Our investment process utilizes both “top-down” and “bottom-up” strategies. Top-down strategies focus on duration, yield curve positioning, volatility, and sector rotation. Bottom-up strategies drive our security selection process and facilitate the identification and analysis of undervalued securities. Here, we employ advanced proprietary analytics and expertise in all major fixed income sectors. The objective is to combine perspectives from both the portfolio and security levels to consistently add value over time within acceptable levels of portfolio risk. Our fundamental objective is to maintain levels of risk that are tailored to the needs of our clients. This objective is to achieve a profile that has both acceptable levels of portfolio risk and risk that is consistent with that of portfolio benchmarks.
Active Management
We strive to produce consistent, above-benchmark returns by adding value through a broad range of investment strategies. The Long Duration portfolio construction process is focused on adding value utilizing PIMCO’s core strengths. These include duration, yield curve positioning and sector allocation with a particular focus on spread product. The strategy formulation process also takes advantage of specific security liquidity issues, the firm’s view on volatility, and expertise in issue selection throughout the broad spectrum of fixed income asset classes.
Our basic approach is to actively manage duration and curve positioning strategies in an effort to maximize total return. Yield curve management is crucial to achieving strong relative returns for long duration portfolios as yield curve shape may change markedly and its impact on Long Duration portfolios is magnified. In addition, sophisticated proprietary software assists in the evaluation of sector opportunities and in the valuation of specific securities. Importantly, we limit risk taking by focusing on managing excess return versus tracking error and by seeking to minimize the volatility of portfolio excess returns in relation to their benchmark. Determining portfolio price sensitivities to curve twists and rotations, which do not involve simple parallel yield shifts, requires sophisticated management tools which can address how specific curve changes influence relative values across fixed income sectors.
Innovation
PIMCO believes in continuous innovation and conservative execution. Our drive for innovation has resulted in the development of advanced proprietary analytics that have enhanced our understanding of security values and portfolio structure under a variety of interest rate and credit scenarios. It has also allowed us to be front-runners in utilizing new asset classes such as real return bonds in an effort to provide above-benchmark return for our clients.
We have many tools specific to long duration and liability-driven accounts, including a proprietary tool, the PIMCO Optimizer,™ that improves our understanding of the risk characteristics of our clients’ liability profiles. The PIMCO Optimizer™ enables us to develop and tailor customized benchmarks that reflect specific liability cash flow profiles and client objectives. This allows PIMCO to manage a portfolio more closely to a specific liability profile instead of a market-based index where necessitated by client requirements.
Sources of Value Added
We approach individual security analyses from a “bottom-up” perspective. We believe proprietary modeling, internal credit research and cost-effective trading can add value to our client portfolios. Where permitted, PIMCO utilizes all sectors of the fixed income market, including governments, mortgages, corporates, real return, derivative, and hedged international fixed income in an effort to derive above-benchmark performance. Our proprietary modeling assists in dissecting the price and return behavior of securities under various interest rate scenarios. Credit research focuses on factors, such as company fundamentals, capital structures and industry economics, to anticipate potential credit ratings actions. Cost-effective trading is important in brokered markets where bid-ask spreads and other transaction costs can vary widely. As one of the largest fixed income managers, PIMCO has the influence to negotiate execution prices and leverage market opportunities along the whole yield curve.
An active investment strategy provides a higher level of opportunity for effective tuning of asset-liability management under constantly changing circumstances. In order to reach an optimal solution, asset portfolios must be compared against liability or funding profiles. Through focusing on proprietary analytics, PIMCO has consistently demonstrated ability in understanding the risk characteristics of fixed income securities. This same proprietary expertise used to analyze bonds is applied to model asset behavior against expected liability forecasts. |
Risk management has been a core concern at PIMCO since our inception in 1971. As new technologies and financial instruments develop, we strive to ensure that our risk management procedures remain effective and that we stay ahead of our competition. We dedicate significant financial and intellectual resources to address risk management.
PIMCO limits interest rate risk by maintaining a portfolio’s duration within a moderate range around the benchmark’s duration. Operating within a moderate duration range may provide opportunities to add value relative to the benchmark without duration being the sole determinant of performance.
Average credit quality has varied within a limited range, depending upon our outlook for the economy, interest rates and credit quality spreads. We believe that there are substantial opportunities for excess returns without exposing long duration portfolios to substantial credit risk as many of these portfolios seek to maximize return while always maintaining a focus on capital preservation.
We combine various measures in assessing the interest rate risk to which a long duration portfolio may be subjected. Simple dollar duration does not fully encompass the various price sensitivities emanating from changing prepayment speeds, credit spreads and yield curve shifts. PIMCO has developed extensive internal modeling which addresses duration in its many forms: bull and bear durations (rate shifts of given amounts); total curve durations (changing yield curve shapes); credit spread durations; and mortgage spread and prepayment durations.
PIMCO systematically analyzes each security’s cash flows, using several valuation techniques and subjecting each valuation methodology to a series of stress tests to understand how a security will react under a broad range of interest rate scenarios. Combining this analytic process for multiple securities, PIMCO gains a full understanding of the risks inherent in a portfolio’s cash flow stream and how these risks affect value.
PIMCO also has extensive policies and procedures for managing derivatives and counterparty risk exposures. As these can be useful tools when allowed by client guidelines for long duration portfolios, a solid platform for derivatives portfolio and risk management is essential. PIMCO has dedicated legal, operational, trading and risk management personnel with decades of combined experience on both the buy and sell side to oversee these important areas.
A portfolio of assets can be constructed to track expected liability values under a variety of interest rate scenarios. In concert with client guidance, assets are actively monitored versus liabilities to ensure that an intended hedge or fully immunized portfolio remains effective through time and that our active approach adds value while maintaining appropriate risk constraints. |