Income Strategy Update: Opportunities Ahead
- We’re beginning to see attractive opportunities in bonds amid higher interest rates, widening spreads, and spiking volatility – and have increased liquidity to take advantage of mispricings.
- We believe inflation will trend lower as we approach year-end, but still remain high. To counter inflation, we have maintained low interest rate exposure, a large allocation to inflation-linked instruments, and exposure to select commodity-exporting countries.
- The Income Strategy maintains its focus on securitized credit, including an allocation to seasoned U.S. residential non-agency mortgage-backed securities. These benefit from meaningful equity built up over years of rising home prices and have generally low loan-to-value ratios.
- Within corporate credit, we have shifted into more liquid bonds offering attractive yields, while targeting more defensive areas of the market. We favor financials – with a tilt toward the U.S. – and industries benefiting from the pandemic reopening.
Investors face tremendous uncertainty amid elevated inflation and recession risks and bouts of market volatility. Here, Dan Ivascyn, who manages PIMCO Income Strategy with Alfred Murata and Josh Anderson, talks with Esteban Burano, fixed income strategist. He discusses why he sees opportunities for active managers in the current environment, and how the strategy is currently positioned.
Q: How would you characterize the environment for bonds going forward?
Ivascyn: After many years of low yields and tight spreads, we see a more favorable environment emerging in which producing attractive returns for bond investors should be less challenging. Spreads are wider, yields are higher. We are beginning to see good long-term value and believe that although interest rates are rising, they will remain lower than they have in the past, certainly not returning to the levels of the late 1970s and early 1980s. In our view, the current market volatility presents attractive opportunities for active managers. We have built up a tremendous amount of strategy flexibility to take advantage of mispricing created by the volatility and uncertainty, and we are optimistic. Having a broad global opportunity set, unconstrained by any type of benchmark that drives asset allocation decisions, provides an advantage, in our view.
Q: How was the Income Strategy able to navigate the first quarter – a period in which the U.S. Aggregate Index saw its worst quarter since 1980, and risk assets sold off?
Ivascyn: The first quarter was a very challenging environment for most financial assets. Investors faced persistently high inflation, shifting monetary policy expectations, and geopolitical shock. Policymakers across both the developed and developing worlds are now reversing years of accommodation, and it’s led to a powerful sell-off for fixed income broadly. We’ve seen flattening in yield curves and some moderate weakening in credit.
In the Income Strategy, we’ve navigated these challenges by positioning defensively around interest rate risk and asset allocation. Going into this period, we anticipated central bank tightening would lead to higher volatility and, while credit was performing very well, we significantly increased overall flexibility by moving into more liquid credit and raising cash.
We believe this positioning will enable us to take advantage of ongoing volatility, which we think is here to stay for the foreseeable future, and will provide attractive opportunities throughout the year.
Q: How are you thinking about the global economy over the next 12 to 24 months?
Ivascyn: Investors need to get comfortable with significant uncertainty and volatility. The war in Ukraine is worsening supply-side pressures and pushing commodity prices higher. If the war in Europe escalates, we would expect even more volatility and potentially higher inflation.
Although not currently our base case, we think there is meaningful risk of a recession in the next couple years as central banks are forced to tighten aggressively to check inflation. Markets are pricing in Fed interest rate hikes up to 3% or greater. In the past when central banks have tightened policy to that degree, it has led to considerable downside risk in financial markets, which is one reason we have been cautious in adding back weaker forms of corporate credit risk.
In our view, this is a time to focus on capital preservation, flexibility and liquidity, while standing poised to take advantage of what we think will be attractive opportunities as we move forward this year. We don't think it’s time yet to expand our credit risk.
Q: What is our view on differing central bank policies around the world?
Ivascyn: Central banks are withdrawing support at uneven rates between regions, based on economic conditions, creating a lot of relative value opportunities across countries, between currencies and interest rates this year.
For example, we expect the U.S. Federal Reserve to move more aggressively than the European Central Bank, which is contending with a sharp economic slowdown amid a COVID outbreak and the war in Ukraine. Similarly, we think Japan’s central bank will be more patient, after multiple years of deflation. Policymakers in some areas of the developing world, such as Brazil and certain Latin American countries, have moved more quickly and aggressively, providing attractive opportunities.
Q: How are you weighing the risk of inflation pressures continuing to build?
Ivascyn: Our base case view is that inflation will begin to trend lower as we approach the end of the year, but will still remain frustratingly high and well above central bank comfort zones. To help counter inflation risk, we have maintained low interest rate exposure. We are running duration (interest rate risk) at roughly three years as opposed to the six-plus-year durations found in popular indices.
Within our defensive duration position, we have a large allocation to inflation-linked instruments, including U.S. Treasury Inflation-Protected Securities (TIPS). We are also targeting some of the commodity exporting countries that stand to benefit from this period of elevated prices.
Q: How is the Income Strategy positioned in credit?
Ivascyn: Spreads have widened across most sectors of the fixed income market, as is typical in times of interest rate volatility. We’ve been adding to sectors that have widened in sympathy with other segments of the market but don't represent meaningfully greater default or downgrade risk. We believe the strategy has a strong liquidity profile to navigate this period of uncertainty.
We’ve begun to gradually add back agency mortgage-backed securities (MBS), although we think patience is warranted ahead of the U.S. Federal Reserve reducing their MBS exposure. The sector benefits from a direct or strong indirect U.S. government guarantee and is very liquid compared to corporate credit, giving us the flexibility to generate returns by actively trading these positions based on relative value. We prefer higher coupons, which tend to be less susceptible to Fed sales.
Non-agency MBS remains one of our high-conviction themes. The sector offers attractive yields versus higher-yielding corporate debt and is less widely held, so we’re able to source sizeable pools of risk and in many cases structure that risk to minimize cost, give us more control, and increase its credit profile. Our allocation remains concentrated in legacy positions that have benefited from meaningful equity buildup 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.
Q: In addition to housing-related assets, what areas of the credit market does PIMCO find attractive?
Ivascyn: Within the corporate credit opportunity set, we think much of the recent spread widening is justified. We continue to emphasize liquidity in our credit positioning and have been moving into more liquid index credits that offered similar yields and far greater flexibility to shift exposure, while targeting more defensive areas of the market. We are focused on a few key areas of opportunity. Financials – with a tilt toward the U.S. – are a core overweight in the Income Strategy. Many banks have historically high capital levels and we think spreads have widened more than fundamentals suggest they should.
We are also focused on industries that are benefiting from the reopening process, including airlines, lodging, and leisure sectors that can continue to perform well over the next few months as the reopening process gains traction. They not only offer attractive yields and total return potential, but the dislocation in these sectors practically forced issuers to provide investors with attractive covenant protections or other forms of hard-asset collateral that offer downside support if the economy were to deteriorate.
Q: At a time when country selection across emerging markets (EM) is increasingly important, how are we thinking about positioning within this asset class?
Ivascyn: Our EM exposure continues to be in higher-quality, sovereign and quasi-sovereign exposure, and serves as an important strategy diversifier. We see prospects for attractive relative returns given starting valuations, although we have reduced our overall exposure by a few percentage points. The small positions we had in Russian sovereign debt have performed poorly and most of the risk of asset impairment is behind us. However, the Russian ruble has rebounded after collapsing last month and is fairly flat for the year. We are reducing this risk and will continue to look to do so over the next couple of months at attractive levels. We remain cautious on Eastern European markets, including direct Ukrainian and Russian risk.
We’ve reduced some of our exposure that has performed very well, including in Asia, where we’re concerned with risks of potential secondary sanctions if political frictions tied to the war in Ukraine escalate. We are also trimming exposure in commodity-producing areas that have been very strong.
Q: Can you share some of our high-level views on currencies, especially the dollar and the euro?
Ivascyn: We have a slightly negative bias toward the U.S. dollar with a focus on the currencies of some commodity exporters, both within the emerging and developed markets. Within developed markets, we prefer the Canadian dollar, some of the Nordic countries, and Australia. Our emerging markets exposure consists of a small, diversified basket, which includes currencies of certain countries in Latin America and Asia, including Indonesia, and South Africa.
Q: How is the Income Strategy uniquely positioned to take advantage of current market conditions?
Ivascyn: We’re beginning to see many attractive opportunities amid higher interest rates, widening spreads, and spiking volatility. For the first time in a while, these moves are creating opportunities in public markets that look quite attractive, even relative to private markets that have not adjusted similarly. The Income Strategy’s flexible, global mandate allows us to access opportunities that funds more narrowly confined to securities found in indices cannot, including many of the relative value opportunities across the yield curve in countries, currencies, and credits.
Past performance is not a guarantee or a reliable indicator of future results.
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. 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. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. Diversification does not ensure against loss. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.
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