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Many investors have been surprised and encouraged by the dramatic rebound in risk assets since March. With economic and business conditions still weak, however, we at PIMCO believe the rally in stock and bond prices will soon lose momentum.

Looking beyond the current run-up, investors need a longer-term strategy for the challenging years to come. The financial markets are undergoing a major shift toward a new economic reality of slower growth in the developed economies, less leverage, and greater regulation.

Credit Spreads: As If Lehman Never Happened
Investor risk appetites have returned in recent months as systemic risks have subsided; credit markets have benefited greatly from this shift in risk appetites. Previously sidelined money has poured into the credit markets, and securities marked down by indiscriminate selling in the fourth quarter of 2008 were bid up by liquidity-driven buying in the first half of 2009.

Amid strong demand for higher yielding assets, spreads across most credit sectors now stand roughly where they were before the collapse of Lehman Brothers in September 2008, as shown in the chart below. Spreads between global investment grade bonds and comparable sovereign issues have tightened by nearly 300 basis points since mid-March, providing investors with a return of over 14%.1 Emerging markets and high yield bonds have offered even more impressive returns during this time of about 20% and 40%,2 respectively.

This remarkable recovery raises important questions: how much further can risk markets run, and can investors just continue to own the market “beta” and expect the good times to continue? 

At PIMCO, we would argue probably not. The rally thus far has been due largely to the drop in systemic and liquidity risk premiums, which were extreme. Although we believe some opportunity still exists for spread tightening, credit markets are far more likely to be influenced by fundamentals going forward. In our view, those fundamentals remain challenging. The rebound phase of the business cycle has not yet begun. With companies still cutting costs, unemployment is likely to remain high, and any potential recovery will lack momentum as long as consumers are not spending and demand remains weak.

Investing for the New Normal
Once the current rally ends, PIMCO expects a more volatile investment climate as we continue on the long-term journey to a new economic and financial reality - what we call “the New Normal.” This new reality includes: a shift in economic growth to emerging countries, such as China and India, and away from more developed economies, such as the U.S.; continued deleveraging by banks, corporations and consumers; and greater regulation as well as continued government intervention aimed at resolving the financial crisis and global recession.

Investment opportunities will arise along this road, but they may come and go rapidly. For example, government intervention in the U.S. has given rise to new securities, such as FDIC-guaranteed bonds issued through the Temporary Liquidity Guarantee Program, which have offered attractive – but temporary – investment opportunities. In addition, as the new financial reality emerges, some companies, perhaps even some countries, will falter while others flourish, creating the potential for both investment gains and losses.

This environment will require investment strategies to be active across the credit landscape and take an opportunistic, flexible approach to capitalize on the opportunities in this environment. Traditional asset allocation strategies, which rely heavily on historical relationships and patterns – including returns, spreads, P/E (price/earning) ratios, and correlations – are likely to disappoint as opportunities in the New Normal may not necessarily be defined by traditional asset class categorization.

Introducing Sector Rotation
One investment strategy that has long provided investors with both broad exposure and flexibility is sector rotation. Traditionally, sector rotation involves moving portfolio allocations from certain sectors of the economy to others in an attempt to earn higher returns and limit volatility in difficult economic environments, such as recessions. However, sector rotation can also be applied within the bond market itself. Based on PIMCO’s research, credit sector rotation has the potential to provide higher returns not only in rocky markets but throughout the business cycle.

As shown in the chart below, we broke down the returns of six major fixed-income asset classes over the last 20 years and then averaged the returns for each asset class during different segments of the business cycle. Over the course of all business cycles since 1988, sector returns varied considerably. In general, investment grade corporate bonds and U.S. Treasury bonds outperformed lower quality bonds in the early stages of recession while lower quality bonds, such as high yield, outperformed in the later stages of recession. Performance during economic expansion, while positive overall, also varied from sector to sector during each phase, as shown in the chart.
 
Specifically, based on the annual returns of the respective Barclays, Merrill Lynch and JP Morgan indexes, we found that investors who successfully identified the onset of the recession beginning in 2008 would have saved nearly 20% in investment return by moving from high yield bonds to investment grade bonds and another 21% by shifting all the way to Treasuries. In addition, investors with the foresight to identify the end of the recession of the early 2000s would have found tremendous opportunities by moving down in quality. A move from Treasuries to investment grade bonds in 2003 would have added 6% to investment returns, while identifying the secular growth trend of emerging markets and shifting from investment grade corporates to emerging market bonds would have added 25% to returns.

Our research illustrates that significant opportunities exist in sector rotation, even within the confines of the bond market. Equally important, the ability to identify secular and cyclical trends and their implications for sector returns is the key to a successful sector rotation strategy.

Solutions for Investors
In light of the potential benefits of sector rotation, investors in dedicated credit sector strategies may want to consider moving to a strategy that can move nimbly among asset classes and takes a more flexible, less benchmark-oriented approach.

At PIMCO, we devote significant time and effort to identifying long- and short-term trends before they have unfolded, notably through our annual secular forum and our quarterly cyclical forums. While all of our investment strategies reflect these top-down views, four approaches, in particular, may fit investors’ needs in the current environment: Diversified Income, Global Advantage, Unconstrained Bond and Global Multi-Asset. All of these strategies have the flexibility to change allocations to sectors based on where we see the best risk-adjusted value opportunity.

PIMCO’s Diversified Income is a dynamic, multi-sector approach to investing in global credit markets. The strategy adjusts allocations among all three core credit sectors – global investment grade, global high yield, and emerging markets – and also has the ability to invest in non-core sectors, such as mortgage securities, when attractive opportunities arise. In a market and economic environment that we believe will be rapidly changing, this broad opportunity set and flexible approach should provide more potential for added return than a static and narrowly-focused credit benchmark.

Investors seeking broad exposure to the investment-grade fixed income market may want to consider Global Advantage, a globally diversified bond strategy. This core, all-in-one fixed-income solution was designed specifically to help investors seize the opportunities created by the dramatic secular shifts taking place in the global economy. Global Advantage offers a broad opportunity set across global fixed income markets and sectors, from developed to emerging, nominal to real and cash to derivative instruments. In addition, the strategy uses a GDP-weighted index created by PIMCO to offer a forward-looking investment approach. By moving away from market capitalization-weighted indices, Global Advantage seeks to avoid the adverse tendency of traditional approaches that allocate heavily to government debt and large issuers with excessive debt burdens and potentially deteriorating credit quality.

The Unconstrained Bond Strategy also offers a broad, diversified approach to high quality fixed income investing but differs in its absolute return orientation and its lack of traditional benchmark constraints. Broad investment guidelines allow greater flexibility in managing a core fixed income portfolio to take advantage of market opportunities. The Unconstrained Bond strategy is designed to provide enhanced return potential in all market environments and seeks to minimize negative performance by actively managing downside risk and taking defensive positions when market conditions warrant.

Finally, for investors looking for broad exposure beyond fixed income, PIMCO’s Global Multi Asset strategy offers a comprehensive portfolio solution. The strategy can invest in global equities, global bonds, commodities and real estate (through Real Estate Investment Trusts). Global Multi Asset takes a forward-looking approach to asset allocation by focusing on risk factors rather than on traditional asset class categorizations. The strategy also employs a “three-in-one” approach of combining beta, alpha and tail risk hedging strategies in an effort to create layers of performance potential and limit downside risks.


¹  As represented by Barclays Capital Global Aggregate Credit Index; actual rate of return was 14.28% for the 3/31/2009 – 9/30/2009 time period.
²  As represented by JPMorgan EMBI Global and BofA Merrill Lynch Global High Yield Master II Index; actual rates of return were 22.13% and 44.22% for the 3/31/2009 – 9/30/2009 time period, respectively.