PIMCO’s Diversified Income Strategy is designed to provide investors with access to the full spectrum of global credit opportunities, following a risk-aware approach that balances return potential and yield against potential downside risk. In this Q&A, portfolio managers Dan Ivascyn, Alfred Murata and Eve Tournier discuss their investment approach as well as key opportunities and risks today.
Q: What is PIMCO’s Diversified Income Strategy, and what role can it serve in a portfolio?
Ivascyn: Diversified Income is PIMCO’s flagship multi-sector credit strategy. We seek to maximize risk-adjusted returns by allocating across the broad global landscape of credit opportunities and leveraging our resources on corporate, emerging market, securitized and municipal credit. We use a custom benchmark of one-third each high yield credit, investment grade credit and emerging market debt as a starting point for portfolio construction, but provide ourselves with ample flexibility to widen our horizons to include a broad set of global credit opportunities.
While we launched the strategy back in 2003, we believe it offers a timely solution for investors in the current environment. With over $13 trillion of outstanding global sovereign bonds offering negative yields, credit sectors will likely have to play a larger role in many asset allocation decisions as investors seek to balance assets and liabilities, prepare for retirement or receive ongoing income. We believe that a dynamic approach to credit investing can provide sufficient flexibility to navigate the evolving nature of credit markets and the significant changes in relative value that we continue to see across sectors.
Q: What are the key differences between the Diversified Income Strategy and PIMCO’s Income Strategy?
Murata: Despite the similar names, these strategies are actually two different approaches with different objectives.
The Income Strategy is a fixed income strategy with the primary goal of delivering consistent, steady income and a secondary objective of long-term capital appreciation. The strategy is less benchmark-driven and spans the entire spectrum of global interest rate, credit and currency markets.
Diversified Income is a multi-sector credit strategy, seeking to maximize risk-adjusted returns relative to broad credit benchmarks over a full market cycle.
Put simply, the Income Strategy will balance higher-yielding credit assets with higher-quality, interest-rate- sensitive assets, seeking to provide a balanced risk/reward profile, while the Diversified Income Strategy serves as a step out on the risk spectrum for investors seeking higher returns and willing to accept higher levels of volatility with a pure credit solution.
Q: How do you manage risk in a credit portfolio while still seeking to generate attractive yield?
Murata: The current portfolio management team has been managing multi-sector credit strategies for years in portfolios with varying objectives and structural features across various market cycles. Our approach focuses on two key themes: diversification and quality.
Diversification means ensuring that no single risk dominates the volatility of the portfolio in either direction. This is true both across different credit sectors (such as high yield, emerging markets, bank loans or non-agency mortgage- backed securities) as well as within sectors, where we maintain a diversified portfolio of credits with different risk characteristics and bottom-up credit fundamentals.
Turning to quality, we firmly believe that a focus on securities with a higher-quality bias and “bend but don’t break” risk profiles provides investors with superior risk-adjusted return potential over the long term, while also providing flexibility to capitalize on large dislocations in credit markets that occur periodically. It’s important to note this doesn’t mean owning only highly rated securities, but instead focusing on securities that we believe offer solid buffers to downside risk, whether due to structural seniority, robust asset coverage, attractive growth potential or strong barriers to entry.
Essentially, Diversified Income seeks to rely on a foundation of higher-quality assets, allowing us to spend our volatility and risk budget on high conviction recovery stories, opportunistic allocations or structural alpha themes.
I’ll add that we employ rigorous stress-testing of our multi-sector credit portfolios, analyzing portfolio- and asset-level performance across a variety of economic and financial market scenarios.
Q: What does structural alpha mean in a multi-sector credit strategy?
Murata: The term covers a wide array of opportunities in credit markets, but three key examples today would be non-agency mortgage-backed securities (MBS), large issuers and “rising stars.”
The non-agency MBS market is structurally inefficient: The majority of these securities were issued prior to the global financial crisis and have been downgraded to below investment grade, as most of them are likely to see some degree of losses and will not be paid back in full. Downgrades can also limit the demand base, as many investors are ratings-constrained and unable to hold or purchase bonds that have been downgraded below investment grade. As a result, while non-agency MBS are unlikely to receive full par back, they are priced at levels well below the value of the expected cash flows, resulting in attractive risk- adjusted return opportunities for investors. PIMCO remains constructive on the credit performance of housing-related investments such as non-agency MBS, as we believe rising home prices and labor market strength have put the U.S. consumer on firmer financial footing, while lack of new supply and strong household formations should provide continued strength in home prices over the coming years.
Tournier: Large issuers in the corporate bond market represent another example, as these deals often offer a premium for the size of the transaction and include greater investor protections to attract buyers as they seek to build a buyer base for the issue. This is another theme that we try to capitalize on in new-issue markets.
Rising stars are high yield companies that have attractive potential to deleverage their balance sheets and earn an investment grade credit rating. Rising star opportunities have been a key investment theme at PIMCO for multiple decades, and our team of more than 50 credit analysts spends a significant amount of time seeking out and evaluating them.
Q: How do you balance the importance of sector rotation across credit markets versus security selection within credit sectors?
Murata: Both approaches to alpha generation are critical, as we seek to employ broad risk factor diversification across credit sectors while relying on a granular approach to security selection to maximize risk-adjusted returns from within each credit sector. Here is a recent real-world example: Earlier in 2016, many areas of the global credit market were extremely volatile, and certain sectors that were sensitive to technical factors were hit especially hard. That is precisely the time when sector rotation can play an important role in a multi- sector credit strategy, and that is the approach we took.
Today credit markets are in a very different place: Most have performed extremely well since the Brexit vote in June, and valuations across most sectors are much more fair. As a result, much of our effort has been focused on finding bottom-up stories within credit sectors to enhance risk-adjusted returns in the portfolio.
Q: How do you manage liquidity in a credit-focused strategy such as Diversified Income?
Tournier: Managing liquidity is of paramount concern in today’s bond markets, particularly given the unexpected swings that can occur in investor sentiment. At PIMCO we employ a disciplined approach to maintaining sufficient liquidity in our credit portfolios. A multi-sector credit approach such as Diversified Income enjoys a meaningful advantage over single-sector approaches, particularly in higher- yielding segments of the credit universe, because it has the flexibility to diversify risk across a variety of sectors, security types and quality cohorts, leaving the portfolio less exposed to risks that can emanate from specific parts of the credit universe. We seek to build portfolios composed of both high quality, liquid credit instruments – which can act as a cushion in times of stress – and higher-yielding instruments, where we can sacrifice some liquidity for higher return potential.
Where appropriate, we also make tactical use of standardized derivative instruments that offer extremely high levels of liquidity. In some circumstances, the derivative approach may be preferable to trading cash bonds, as the latter requires paying transaction costs and navigating potentially illiquid markets.
Q: How are Diversified Income portfolios positioned today? Where are you finding opportunities, and what areas are you avoiding?
Tournier: Overall, we have brought down risk in the portfolio over the past few months. The rally in credit markets has provided attractive opportunities to reduce exposure to higher-beta credits that have exhibited some of the strongest performance year-to- date, specifically within energy markets.
In general, we have a slight bias toward high yield and investment grade corporates relative to emerging markets, and we continue to maintain tactical allocations to sectors such as bank capital and also non-agency and commercial MBS, where structural seniority and market inefficiencies continue to create opportunities.
Within high yield, we have targeted shorter-dated assets and credits tied to the U.S. consumer or U.S. housing, two areas that we feel are well-insulated from many of the key risks hovering over risk assets more broadly.
Emerging market debt has performed quite well over the past 12 months, and we are becoming more constructive on emerging market fundamentals, with two key tail risks – commodity price volatility and U.S. dollar strength – not as concerning as they were heading into 2016.