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View From the Investment Committee

It Pays to be Defensive

In an excerpt from our recent Secular webcast, Group CIO Dan Ivascyn explains that as riskier sectors slowly adjust to tighter credit conditions, high-quality bonds can offer starting yields that are comparable to longer-term equity returns with potentially less volatility.

Text on screen: PIMCO

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Text on screen: Kimberley Stafford, Global Head of Product Strategy

Kimberley Stafford: As we talk about the aftershock economy, what are the implications for investors as they think about this over the next five years? And how can they build resilient portfolios and take advantage of the opportunities that present themselves?

Text on screen: Daniel J. Ivascyn, Group Chief Investment Officer

Daniel Ivascyn:  I think one of the aftershocks we're going to see in response to this massive tightening in policy rates, this very, very high inflation will be some challenges in those areas where people were reaching for yield.

Text on screen: We believe neutral long-run real policy rates will remain anchored in 0% to 1% range

Images on screen: The Federal Reserve building

But we still believe neutral rates are low, may not be as low as they were back with our new neutral research several years ago. But still relatively in a low range maybe a half a percent higher or so, but generally on the lower end of the range from a long term historical perspective.

Secondly, we've had a massive repricing. We haven't seen these nominal yields or real yields since back pre global financial crisis. And we think that global sustainable growth rates are lower today. So we think there's tremendous value there as well. Lots of near term uncertainty, lots of ongoing uncertainty around inflation, around risks of harder landing, but in the higher quality areas of the bond market, very, very solid return potential on a go forward basis.

Kimberley Stafford: So, moving to markets, over the past year, we've seen massive changes in central bank policy rates as we've been talking about. How does this impact various regions including both developed and emerging markets from your point of view?

Daniel Ivascyn: Yeah, so one of the key conclusions is that we're coming out of a period of relatively low variability in business cycles. A period of significant volatility suppression from global policy makers, an environment of more global interrelated markets to one where we expect cycles to be much less consistent with one another.

That could create some challenges, but it's great for active asset management, it's great for more flexible global mandates. It's great to be able to flex between public and private markets. So we do think one of the characteristics of the next few years will be certainly more geopolitical uncertainty, but also much less synchronized cycles, much less ability for policy makers to suppress volatility.         

Kimberley Stafford: So Dan, there's a lot of factors on the balance in the mix on corporate credit. What are our views on credit markets over the next five years?

Daniel Ivascyn: Today's investment grade and traditional high yield market

Text on screen: Credit markets are much higher in quality than they have been in the past

Images on screen: PIMCO trade floor

are much higher credit in terms of overall credit quality than they have been in the past, particularly the high yield corporate credit market where you have higher average rating, lower leverage with a lot of that excess lending over the last decade migrating into the senior secured loan space and into the private credit markets.

The IG and the high yield market are primarily fixed rate markets where companies were able to lock in record low rates during that 2020 and 2021 period. Household credit is rock solid because so many households were able to lock in record low mortgage rates over this period as well.

Text on screen: TITLE – High quality areas of the credit markets:, BULLETS – Investment grade, Consumer, Securitized, High yield

So we think given the uncertainty on the economic side near term, the high risk of recession, we think you should inherently stay up in quality. That means investment grade credit, consumer credit, securitized credit, when you can get additional protection in the form of subordination, hard collateral, better documentation, and we think the high yield market looks reasonable given the higher quality setup.

We are concerned more in the senior secured loan space. These prices have reset lower, but this is an entirely floating rate market. There's tremendous growth in this market back when investors saw very, very low front end rates and didn't expect them to go materially higher from where they were.

Kimberley Stafford: Let's maybe turn to the commercial real estate market. What is your outlook for that sector?

Daniel Ivascyn: The last few decades have seen a much tighter relationship between the capital markets and real estate valuations. We are going to see some significant upcoming maturities. There's certain sectors of the commercial real estate market that are facing longer term headwinds. Retail, which is then the case for now many, many years.

Images on screen: Office building exterior

The office space, which is one of these areas where there's a shorter term shock associated with COVID, which is becoming a secular challenge in terms of shifts in workplace preferences, worker preferences.

There are going to be continued challenges in those areas of the market, but when you step back and you look at residential real estate segments of the

Images on screen: Multi-family housing units, warehouse construction, data centers

commercial real estate markets, multi-family, new housing development, residential for rent type strategies, industrial strategies, data centers, which are nearly perfectly positioned for this new technological revolution that we're experiencing.

Here, you have a situation where these sectors need to adjust to the higher rate reality. They're going to be performing properties that just have a bad cap structure that need to be addressed, but these will be manageable and they're again, going to create tremendous, relatively low risk opportunities for new capital in that area of the market.

Kimberley Stafford: So if we zoom out public and private markets, PIMCO has a unique vantage point given our capabilities across this spectrum. Any other thoughts on various fixed income sectors that you want to add?

Daniel Ivascyn: So where we are today,

Text on screen: TITLE – Key investor takeaways:, BULLETS –Focus on areas of the market that have repriced as interest rates have risen, Be cautious in floating rate, economically sensitive areas of corporate credit markets, Prepare to pivot to private markets as they begin to better reflect fundamentals

we believe you should focus on areas of the market that have widened as interest rates have gone higher, but that do have inherent resiliency. Later on in our secular outlook, we think there'll be a time to pivot to some of the public opportunities in the more economically sensitive or lower rated areas of the corporate credit markets, and then pivot into the private markets as they finally begin to reflect true fundamentals.

We're more constructive on interest rates over the long run, but for investors that want more defensive characteristics in their portfolio in terms of interest rate risk, you can be resilient, you can be defensive, you can have shorter maturities and still generate returns in that high single digit range.

One area of the market we didn't talk about much today are agency mortgages,

Text on screen: Agency mortgage-backed securities (MBS) can provide high returns today

Images on screen: Residential neighborhoods

a sector that's been attractive during the peak COVID crisis back in the first quarter of 2020.

Now, of course, the central banks reducing balance sheet and banks are less active in the sector.

So that's probably the best example of a high quality asset, a bit more complex than a typical treasury bond or a typical corporate bond that's offering tremendous yield right now because of this fixed income volatility, which is elevated and very well maybe trending lower even as equity volatility increases over the course of the next few years.

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Please note that this video following contains the opinions of the manager as of the date recorded, and may not have been updated to reflect real time market developments. All opinions are subject to change without notice. The views and strategies described may not be appropriate for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, investment advice. Investors should consult their investment professional prior to making an investment decision.

All investments contain risk and may lose value. 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. 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. Investing in distressed companies (both debt and equity) is speculative and may be subject to greater levels of credit, issuer and liquidity risks, and the repayment of default obligations contains significant uncertainties; such companies may be engaged in restructurings or bankruptcy proceedings. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk.  Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. Diversification does not ensure against loss.

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In an excerpt from our recent Secular webcast, Group CIO Dan Ivascyn explains that as riskier sectors slowly adjust to tighter credit conditions, high-quality bonds can offer starting yields that are comparable to longer-term equity returns with potentially less volatility.

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