Uncertainty always exists in financial markets. But the COVID-19-driven disruption and recovery have been unprecedented, generating a high level of macroeconomic volatility that risks spreading to asset prices. At the same time, extraordinary policymaker support has led to generally rich valuations, meaning investors may not be getting paid appropriately for the risks they are taking.
We see four major concerns for fixed income investors in this environment – low interest rates, the potential for higher long-term inflation, tight credit spreads, and the risk that volatility could rise. In our view, such a difficult backdrop calls for a flexible approach to building resilient portfolios, including by diversifying sources of return and emphasizing relative-value opportunities when generic beta exposures don’t look compelling.
Four challenges for fixed income investors
1. Historically low interest rates: Central banks are trapped by the need to keep interest rates low at the front end of global yield curves – both to prevent the disinflationary shock of COVID-19 from turning into a debt-deflation spiral, and to allow governments to borrow at affordable rates to fund fiscal stimulus. Despite an uptick in early 2021, interest rates remain at low absolute levels, and are negative in many regions. In fact, at the end of June 2021, close to 20% of the global fixed income marketFootnote1 was composed of negative-yielding debt. For investors, starting yields have historically been a strong predictor of future five-year returns, as illustrated in Figure 1.
2. Potentially higher longer-term inflation: The outlook for economic recovery and continued government fiscal support has stoked concerns about rising inflation. While PIMCO’s base case is that many near-term inflation pressures will prove transitory, we remain humble in our forecasts and believe the upside risks to longer-term inflation are worth considering. Unfortunately, many investors remain vulnerable to higher inflation given they are handcuffed to high levels of duration (interest rate risk) through their benchmarks, and because rising inflation expectations put upward pressure on interest rates (and therefore downward pressure on bond prices).
3. Compressed spreads: Spreads across credit sectors have narrowed from their March 2020 highs, returning to their historically low pre-crisis levels, amid large-scale central bank purchases. The European Central Bank, for example, now owns nearly 12% of the European investment grade corporate bond market with the potential to increase its ownership to 30%.Footnote2 While spreads in specific sectors could still tighten, there is likely limited scope for generic spreads to compress further (see Figure 2).
4. Potential for elevated volatility: As global economies transition from policy-induced growth to organic growth, there is no guarantee the journey will be smooth. The unleashing of pent-up demand and lockdown-driven productivity gains could lead to growth surprises (and inflation). On the other hand, increased savings rates and a prolonged reallocation of workers and resources could lead growth to disappoint. And while we don’t see a repeat of the so-called “Taper Tantrum” of 2013, when U.S. Treasury yields surged after the U.S. Federal Reserve referenced potential plans to taper asset purchases, an eventual reduction of central bank support could cause volatility to pick up.
The potential benefits of flexible fixed income
For an active manager like PIMCO with a robust top-down investment process, these challenging dynamics and the resulting potential for wider dispersion of returns across assets can create opportunities. We believe PIMCO’s flexible income strategies are well-positioned to take advantage of these opportunities.
PIMCO offers two types of flexible fixed income strategies – those that seek to provide an attractive and consistent level of monthly income while mitigating downside risk; and dynamic strategies tailored to pursue an absolute return target over market cycles with a focus on capital preservation.
To try to meet those objectives in today’s low-rate environment, PIMCO’s flexible fixed income strategies can tap sources of higher yield and focus on what are believed to be the most attractive opportunities across global bond markets. This includes securities in potentially higher-yielding sectors like emerging markets (EM), as well as higher-quality interest rate markets like the U.S., where rates have more room to fall during a negative shock. Other potential sources of return include capital appreciation due to yield curve roll-down, especially now on the steep intermediate (3- to 7-year) portion of yield curves globally.
Meanwhile, the risk of longer-term inflation can potentially be countered by taking short positions at the longer end of the curve, where yields would likely increase most in an inflationary environment. Flexible strategies can also seek geographic diversification of interest rate exposure, which could include other higher-yielding developed markets (DM) and EM local rates.
To navigate compressed spreads, active managers can allocate capital to credits which have lagged during the initial stages of the recovery, but which have strong fundamentals and should benefit from an economic reopening. Sectors such as airlines, lodging, retail, and real estate are particularly compelling as continued policy support and vaccine rollouts will likely lead to a global rebound this year from the pandemic-induced economic slump. Other opportunities include assets where spreads have not been compressed by central bank activity. These include U.S. non-agency mortgage-backed securities (MBS), given the strength of housing in the U.S., as well as higher-quality EM credits, though we stress the importance of bottom-up research for these securities.
Finally, given the potential for elevated volatility, an active manager like PIMCO can tilt a portfolio toward what we categorize as higher-quality “bend but don’t break” positions, prioritizing seniority and security where possible. An emphasis on liquidity may also allow managers to take advantage of dislocations and attractive new issuances.
Fixed income investors face hurdles to building resilient portfolios that meet their objectives. Low overall interest rates and compressed yield spreads portend weak returns in coming years. At the same time, investors may be exposed to rising longer-term inflation and increased volatility as economies recover and central banks reduce support.
PIMCO’s flexible income strategies seek to mitigate these risks and add value in part by de-emphasizing generic beta exposure to interest rates and credit spreads when these don’t look compelling. They may also diversify across a range of return drivers in interest rate, credit, and currency markets, and seize opportunities in volatile periods.
Traditionally, the role of fixed income has been to generate additional return while providing diversification to other parts of the portfolio. With a flexible approach, fixed income can still play this role.