Our focus on longer-term (three- to five-year) trends recognizes that secular considerations such as demographics, political factors, and structural changes in the domestic and international economy exert powerful, sustained influences on interest rates. Thus a secular outlook updated annually determines a general duration range for the portfolio in relation to the market. Short-term, cyclical economic considerations determine shifts within this range.
Interest rate volatility forecasts are crucial to bond portfolio management. Volatility affects the relative performance of bond market sectors. Increases in volatility benefit non-callable bonds such as Treasuries, whereas declining volatility favors callable instruments such as corporates and mortgages. Volatility also determines maturity structure. A portfolio consisting of a mixture of long and short bonds will perform differently than a pure intermediate portfolio with the same duration, depending on volatility. In addition, volatility influences choice of coupon, quality, the use of futures and options, and the pricing analysis of the more complex securities emerging daily in the fixed income markets.
Average portfolio credit quality may vary from A to AAA depending upon our outlook for interest rates and quality spreads. All holdings are subject to thorough internal credit analysis, enabling us to distinguish more accurately between levels of quality published by the outside rating services.
Futures and options can enhance the investment process. Futures on various types of securities, such as Treasury bonds and notes, provide effective substitutes for their cash market counterparts and are used when undervalued. Options provide a means to capitalize on changes in market volatility. Both futures and options can be used to hedge portfolios when appropriate.
Research conducted at PIMCO, which is consistent with a large body of academic work, highlights the attractive risk/return characteristics of low duration investing. A second observation is that longer maturity issues had similar returns but with significantly higher return volatility.
What explains these results? At the short end of the interest rate curve this phenomenon is generally thought to be the result of a “liquidity premium” effect. Liquidity premia reflect the willingness of certain investors to accept a substantial reduction in yield in exchange for the perfect price stability obtainable with the shortest maturity instruments. This liquidity premium effect is thought to be a key determinant of the typically positive slope of the yield curve.
Another way we seek to add value in low duration portfolios is through use of mortgage securities. Mortgages traditionally provide higher relative yields than treasuries and corporates. This higher yield exists to compensate for the option risk inherent in mortgage-backed securities. Short duration mortgage pass-throughs and derivatives provide additional opportunities within low duration portfolios. PIMCO’s proprietary quantitative analysis is critical to evaluating securities within the mortgage sector.
We believe risk manifests itself in two main forms – investment and operational. Effective investment risk management begins with the identification of client objectives and their level of risk aversion. From there, a set of appropriate investment guidelines and effective risk measures are developed. Advanced proprietary analytics allow us to model securities under a multitude of scenarios including best and worst cases. We believe the decision to hold a security is just as important as the decision to buy. As a result, portfolio holdings are priced and re-evaluated on a regular basis.
Operational risk is equally as important as investment risk. Operational risk encompasses problems or errors that may arise during day-to-day operations of the firm. Our organizational structure is designed to cope with this organizational risk. This is accomplished by segregating responsibilities for portfolio management, account management, and investment support monitored by an independent compliance group. At PIMCO, we have embraced this methodology from our inception and it has benefited both our clients and the organization as a whole. Our system has clearly defined checks and balances to provide reasonable assurance that all risk exposures are handled in an appropriate manner.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. PIMCO strategies utilize derivatives which may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. There is no guarantee that this investment strategy will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. Diversification does not ensure against loss.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.
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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