Income Strategy Update: Higher Yields, Wider Spreads, Greater Opportunities
- We have fine-tuned the strategy to seek to take advantage of opportunities created by the market correction while keeping an eye toward resilience were the economy to fall into recession.
- The recent sell-off opened an opportunity to add back a bit of credit and interest rate exposure in parts of the yield curve that we believe will offset risk in an economic downturn.
- We are shifting risk away from more credit-sensitive sectors into high quality securitized credit that trades at similar valuations. Our non-agency MBS allocation remains concentrated in legacy positions that now have low loan-to-value ratios.
- Amid wider spreads, agency MBS presents an exciting opportunity to generate value, improve downside risk, and through active trading, seek to generate additional return.
- Within corporate credit we are defensive, but senior financials remain a core overweight. Many banks have historically high levels of capital and over the last several months spreads have widened more than we think fundamentals suggest they should.
The market sell-off presents attractive opportunities for active fixed income investors despite elevated volatility and recession risks. Here, Dan Ivascyn, who manages the PIMCO Income Strategy with Alfred Murata and Josh Anderson, talks with Esteban Burbano, fixed income strategist. Ivascyn discusses where he sees relative value for active managers in the current environment, and how the strategy is currently positioned.
Q: In the second quarter, the Bloomberg US Aggregate Bond Index slid 4.7% and the Bloomberg US High Yield Index dropped 9.8%. What drove the sell-off and has it changed your outlook?
Ivascyn: Volatility and uncertainty drove the second quarter sell-off. Early in the year and into the second quarter, investors focused on inflation and U.S. Federal Reserve policy. As the quarter progressed, though, their concerns migrated to the impact of policy tightening and geopolitics on economic growth and credit sector performance – concerns that persist today. The market’s dramatic repricing, however, in our view presents better long-term opportunities for active investors than we have seen in years. Yields have risen meaningfully, spreads have widened, and carry has increased, providing a potentially powerful source of return.
Q: Inflation risk is one of the key elements driving this repricing. How are you thinking about inflation risk today and for the cyclical horizon?
Ivascyn: Our base case view is that U.S inflation likely peaked in June but will remain elevated well into 2023, perhaps even 2024, before it trends down toward central bank targets. Although prices of some key commodities are declining and other price pressures have begun to dissipate, we believe inflation will remain a significant risk factor for investors, driven by uncertainty around the war in Ukraine, other geopolitical risks, and the evolution of COVID-19.
There is also an increasing trade-off between central bank tightening to contain inflation and resulting weakness in economic growth, employment, and credit fundamentals. This trade-off makes a minor-to-moderate recession increasingly likely and impacts our views on interest rate and credit exposure.
Across the income strategies, we run a defensive position in interest rate risk and own direct forms of inflation protection such as Treasury inflation-Protected Securities.
Q: What are our views on Fed policy rates?
Ivascyn: The markets are pricing in a federal funds rate close to 3.5% by the end of the year and peaking by the first quarter of next year. We think this is quite reasonable. In our view, the Fed will likely achieve its goals with a fed funds rate somewhere in the low- to mid-3% range, but the environment is very uncertain and we are not taking big risks on interest rate or Fed policy.
Q: Amid heightened uncertainty and increased volatility, how are we positioning the Income strategy?
Ivascyn: We have fine-tuned the strategy with an emphasis on resilience. We are targeting higher-quality assets with spreads that have widened in sympathy with more credit-sensitive assets. The recent sell-off opened an opportunity to add back credit risk in the front end of the yield curve, though we remain a bit defensive relative to our historical norm. We are also taking advantage of higher rates to gradually add a little interest rate exposure to the strategy.
We believe the result is a differentiated from other income-oriented strategies that tend to focus on more significant-sized exposure to the U.S. corporate credit market – a differentiation which we believe should lead to a better strategy.
Q: What is your interest rate positioning in the Income Strategy?
Ivascyn: We used the recent sell-off as an opportunity to add duration (interest-rate sensitive securities) in the intermediate part of the yield curve, although we remain a bit defensive relative to our neutral point. We think having a position tilted toward the front end of the yield curve will help offset some of the more credit-sensitive assets within our strategy: Should the Fed’s interest rate hikes pull the economy into a hard landing, then we would expect it to pivot and take rates down, boosting prices at the front end of the curve. As a firm we slightly prefer duration in the U.S. or Europe, and are underweight Japan, China, and even the U.K.
Q: Have you changed the Income Strategy’s positioning in agency mortgage-backed securities (MBS) as the market prices in the removal of Fed support?
Ivascyn: Agency MBS prices have done a round trip. As markets seized during the first quarter of 2020, agency MBS prices became very attractive and we added above average exposure. This position worked well in the remainder of 2020 when the Fed proceeded to aggressively buy a significant portion of the available supply of agency MBS, driving spreads to tight levels where we sold a lot of that exposure (at least indirectly) back to the Federal Reserve.
More recently, amid concerns about central banks selling mortgages back into the market, spreads have widened and we are steadily adding back this risk. We're also actively trading this book and seeking to generatee other forms of incremental return through selection of securities, coupons, and maturities. We think if inflation remains elevated, agency mortgage spreads can widen even further. This sector presents an exciting opportunity to generate value, improve the strategy’s downside risk profile and, through active trading, seek to generate additional return.
Q: What is PIMCO’s view of the securitized credit market?
Ivascyn: We are shifting risk away from more credit-sensitive sectors into high quality segments of the structured product opportunity set that trade at similar valuations. Our allocation remains concentrated in legacy non-agency mortgage positions that have benefited from meaningful equity build-up over many years of rising home prices, and now have low loan-to-value ratios that can help mitigate the risk of home prices falling. Our base case outlook calls for home prices on the national level to remain fairly stable, but even if prices were to fall, we believe our senior non-agency MBS positions should be resilient.
We also see relative value across other key areas of the structured product markets – commercial MBS, consumer asset-backed securities, student loans, and senior AAA collateralized loan obligations – where spreads have widened more than the underlying credit risk suggests they should. Our positions are concentrated in less volatile, senior risk with attractive liquidity profiles.
Q: Within corporate credit, how are you balancing wider spreads with rising recession risks?
Ivascyn: We are fairly defensive. Senior financials remain a core focus, banks in particular. Many banks have historically high levels of capital (required by post-global-financial-crisis regulation), and over the last several months spreads have widened more than we think fundamentals suggest they should. Within corporate credit, we also have exposures to liquid indices which help maintain flexibility. We view this as a defensive form of exposure that should outperform other areas of the corporate market in a more stressed environment.
We are also taking advantage of a significant improvement in the covenant protections and pricing that lenders can receive in the corporate market by making a few relatively small tactical allocations to special situations at yields that should positively impact overall returns.
Q: How are you positioning the strategy’s emerging markets allocation given increased geopolitical risk?
Ivascyn: Within the emerging markets asset class, we look for prudent sources of diversification or additional return, but we usually operate in the higher-quality, more liquid segments of the market: sovereign risk, quasi-sovereign risk, and currencies of higher-quality countries. We have little emerging market corporate credit exposure, and little local rates exposure, particularly in less liquid areas.
Over the last several months, we have reduced our exposure to emerging markets. Specifically, we pared back exposure to Asia, particularly to China, and to Latin America. We have had little exposure to Eastern Europe and we continue to avoid that part of the world because it is inconsistent with the liquidity and volatility profile of the strategy. Our allocation focuses on higher-quality areas, including Brazil and Mexico, with small positions in South Africa and Israel.
Q: What should investors expect from the Income Strategy over the secular horizon?
Ivascyn: The market’s repricing makes us very optimistic about the income-generating ability of this strategy over the next few years. Yet it may be a bumpy journey, with ongoing bouts of volatility and a potential economic downturn. Our positioning reflects this. We've continued to focus on cash flow seniority and add-in resilient sectors like agency mortgages, structured products, and higher-quality banks, as well as a variety of macro-oriented relative value strategies. Relative to many passive alternatives, we have less exposure to more economically sensitive areas of the market, like lower-rated corporate credit risk, where we think underwriting standards have weakened.
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Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Derivatives 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.
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