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Economic and Market Commentary

Credit Outlook: High Quality Bonds Offer Equity-Like Return Potential

Hear from PIMCO experts about how investors may benefit from capturing today’s compelling yields among high-quality bonds, including investment grade credit. Explore the potential for equity-like returns with lower volatility.

Text on screen: PIMCO

Text on screen: Mark R. Kiesel, CIO Global Credit

Kiesel: We think this is an excellent time to invest in high quality bonds. We're yielding now 6.5 to 7% on high quality fixed income investments and we see several catalysts for lower yields over the next several years.

FULL PAGE GRAPHIC: TITLE – Bonds are back: High quality credit may deliver equity-like returns based on current valuations, but with potentially lower volatility

Text on screen: TITLE - Bonds are back: High quality credit may deliver equity-like returns based on current valuations, but with potentially lower volatility

Overview: The chart visualizes the "Historical Distribution of 5-Year Forward Returns" with two distinct curves. One represents "Equities with a CAPE (Cyclically Adjusted Price-to-Earnings) Ratio greater than 30,” shown in blue, and the other denotes "Credit with a Yield Greater than 5%," depicted in green. The graph provides an illustration of high-quality credit investment outperformance of comparable equities, both in terms of a greater median return, a more limited downside, and a higher upside.

A caption at the bottom of the graph reads, "When looking at historical forward returns at current levels (CAPE > 30, investment grade credit yield > 5%), credit appears well positioned to outperform."; Detailed Description: The x-axis (horizontal) is labeled "Annualized Return" and spans from -20% on the left, incrementing by 10% intervals to +30% on the right. The y-axis (vertical) is labeled "Density" but has no specific numerical values. The equities curve begins at -10% annualized return on the left side of the graph, with a density level of zero. As the curve rises from the -10% annualized return starting point, it reaches a peak on the density axis at a value approximating 60% of the total height of the density axis. At the equities curve’s density peak, it resides at around -1%% on the annualized return axis. After the peak, the equities curve sharply descends as annualized returns increase, approaching 20% of its peak density around 8% annualized returns. As the curve continues along the annualized return axis to a value approximating 12%, the density level rises again, forming a second and much smaller peak, at around 25% of the density value of the first peak. Afterward, the curve descends once more, and trails off to a zero density level as the curve approaches a 20% annualized return. Meanwhile, the credit curve begins at a higher annualized return rate than the equity curve, with an approximate -2.5% return. The density level rises gradually until it stands at around 10% of the total chart height and an annualized return value of 2.5%. Afterword, as annualized returns rise, the credit curve continues to rise even more gradually along the density axis, at around half the rate of the initial rise. However, once the credit curve reaches an approximate value of 5% annualized return, the density level begins to soar. It rises very sharply, peaking at an approximate value of 8%-9% annualized return. The density peak is 30% to 40% than the peak of the equities curve, near the top of the density axis. As the annualized return continues to increase, the density value of the credit curve declines sharply. It trails off and declines to zero as the curve approaches a 25% annualized return.; As discussed above, the graphic shows that equities demonstrates has a lower median return, with its density peak occurring around a -1% annualized return, while the credit curve has a median return of around 2.5%. Equities also displays a greater downside with its beginning at a -10% return, while credit begins at -2.5%. Finally, the curve also suffers from a lower upside, with it reaching zero density at 20% while credit reaches zero density at 25%.; Compliance & Source Data Disclaimers: The data is "As of 31 August 2023. SOURCE: PIMCO, Bloomberg. For illustrative purposes only.”; Distribution is based on historical data back to January 1973. Equities refers to S&P 500, and CAPE refers to cyclically adjusted price-to-earnings ratio. Credit refers to the Bloomberg U.S. Aggregate Corporate Index, and yield refers to yield to worst. There can be no guarantee that the trends mentioned above will continue. Statements concerning financial market trends are based on current market conditions, which will fluctuate.

So these yields now provide potential equity-like returns with the third to half the volatility of equities and with growth slowing and inflation peaking and coming down, we think the central banks are near the end of the rate hiking cycle. So investors today can lock in these yields, which we haven't seen in 15 years.

Mittal: As Mark mentioned, it's a quite attractive time to be adding to high quality fixed income.

Text on screen: Mohit Mittal, CIO Core Strategies

We saw a glimpse of that during March of this year when equities declined post-SVB, but fixed income did quite well as yields came down.

Kiesel: We are finding opportunities across many sectors of high quality fixed income asset classes and I'll start with the credit corporate side. So just in the corporate side, we are seeing slower growth, but we still expect nominal growth of roughly 4 to 5% this should still generate positive earnings growth. In fact, many companies are actually using this excess cash flow now to delever their balance sheets.

FULL PAGE GRAPHIC: TITLE – PIMCO’s framework for uncovering credit opportunities

Text on screen: TITLE - PIMCO’s framework for uncovering credit opportunities

Overview: This visual provides a side-by-side comparison of three sectors that PIMCO is currently favorable towards and three sectors that it approaches with caution. The purpose of the visual; Detailed Description: The visual is of two columns, the favorable column (on the left) and the caution column (on the right), side-by-side. In the left column, under a green header labeled "What we like today", there are three sectors highlighted: 1. The Fun Trade, - Icon: A stylized airplane., - Description: This refers to sectors like airlines and hotels. 2. Financials, - Icon: A graph with three rising bars., - Description: This pertains to senior debt from what are referred to as "national champions." 3. Non-cyclicals with asset coverage, - Icon: A simple drawing of a house.,  - Description: Examples provided are telecommunication towers.; In the right column, under a purple header labeled "Where we are cautious", three other sectors are spotlighted: 1. Secularly challenged sectors,  - Icon: A price tag with a percentage sign.,  - Description: Retailers are provided as an example. 2. Asset light businesses: - Icon: A computer monitor with a chart on its screen.,   - Description: Technology is the example given. 3. Inorganic growth (M&A risks):   - Icon: A factory with smoke coming out of its chimney.,   - Description: The food & beverage industry is mentioned as an example.; Footnotes at the bottom provide additional context. The term "Fun trade" is defined as sectors best positioned to take advantage of pent-up consumer demand and a rebound in travel. "National champions" are described as banks with a strong asset quality which are also the main/biggest national banks of any given country.; Compliance disclaimer: Source data is as-of September 30th 2023. Source: PIMCO. The material is presented for illustrative purposes only.

So for example we continue to like companies like airlines, lodging, gaming companies, aerospace and also we've been moving into defensive sectors recently like hospitals, pharmaceutical companies as well as towers and telecom. These companies still generate very strong cash flow, even in a lower growth environment and most of these companies are still paying down debt. So what's really important about this is that while the government market technicals have turned negative lately with higher deficit spending, less foreign buying, we're seeing the opposite in the corporate bond market. These higher yields are actually attracting more demand from insurance and pension funds. At the same time, we think companies will issue less bonds at these significantly higher yields, which we haven't seen in 15 years. So that is also a further catalyst for investors to want to add to high quality corporate bonds.

Mittal: Yeah, as Mark mentioned, I think in addition to kind of the travel theme we have been steadily moving into more defensive areas of credit markets given where we are at this point in the cycle. I think one other area where we've been shifting to a defensive stand is through agency mortgages.

FULL PAGE GRAPHIC: TITLE – A decrease in demand from the Fed has cheapened valuations

Text on screen: TITLE - A decrease in demand from the Fed has cheapened valuations

Overview: The graph illustrates the "Agency MBS (mortgage-backed securities) Spreads" from 1995 to 2023. It shows that spreads were moderately consistent from 1995 to 2020, with the only significant variation occurring during the 2008 financial crisis. The 2020’s have been different— 2020 kicked off a period of immense spread volatility, with much higher variation in spread.; Detailed Description: The x-axis represents the timeline, starting from 1995 on the left and ending at 2023 on the right, with other years (1997, 1999, and so on) marked in between, in 2-year increments. The y-axis is labeled "bps" (basis points) and ranges from -60 at the bottom to 140 at the top, marked in intervals of 20. The graph shows a fluctuating line chart: - From 1995 to around 2008, the Agency MBS Spread line oscillates moderately between -20 and 20 bps. - There's a sharp spike upwards in 2008-2009, with MBS Spreads reaching 100 bps and then sharply dropping to -20 bps around 2009-2010. - From 2009 to 2019, the curve continued to oscillate moderately between -20 and 20 bps, with a brief exception when the curve nearly touched 40 bps in 2011. - In the next period, from 2020 to 2023, the curve displayed high levels of volatility. In 2020, bps jumped from around 0-20 bps to an approximate value of 70-75 bps, and then sank deeply in 2021, to an approximate value of -45 bps. In 2022 and 2023, as interest rates rose, bps rocketed upward, reaching a chart-peak in 2023 of 120 bps.; Data and compliance disclaimers: The chart is based on data sourced from PIMCO and Bloomberg as of 11 September 2023. A note explains that "Agency MBS spreads are PIMCO proprietary calculation; uses nominal spreads on current coupon MBS versus a composite of treasuries and incorporates the cost of hedging out rate volatility." Additionally, it is mentioned that there's no guarantee of future results and that a security's valuation may not ensure profit or protect against loss.

Agency mortgage backed securities underperformed, as the Fed started it’s quantitative tightening last year. They underperformed further post Silicon Valley Bank as FDIC reduced agency mortgages and then other banks have been on the sidelines. So when we look at the valuations there, they're the widest they have been in 15 years.

In addition to kind of the agency mortgages, we are also seeing opportunities outside of US. We are seeing growth divergence between US and other countries. We are seeing inflation divergence. So that is creating opportunities across regions, that is creating opportunities across sectors as well as individual companies. So for us, we think it's an attractive, very attractive time to be actively managing high quality fixed income, like high quality investment grade credit portfolios at this point. We are fortunate to have a team of large team of analysts as well as PMs to look for such opportunities and add value for our clients.

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Disclosure


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. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Investors should consult their investment professional prior to making an investment decision.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

This material contains the 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. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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