With the global economy in the midst of a profound transformation in the wake of Europe’s debt crisis, investors are finding both challenges and opportunities across the credit markets. In the following interview, portfolio manager Eve Tournier discusses PIMCO’s Diversified Income Strategy, a comprehensive global credit strategy. By combining investment grade, high yield and emerging market debt, Diversified Income is designed to uncover the most attractive opportunities across global credit markets.
Q: Some experts believe that in the fixed income universe, a paradigm shift has occurred and government bonds issued by the developed countries are not perceived as “safe havens” anymore. Do you agree?
Tournier: Historically, government bonds issued by developed countries were viewed primarily as instruments with interest rate risk and very little credit risk relative to emerging market or corporate bonds. In recent years, however, we have witnessed a paradigm shift in which some developed market sovereign debt has begun to include credit risk as well as interest rate risk.
Over the longer term, PIMCO expects that developed economies will suffer from weaker growth due to the burdens of high debt levels and aging populations. Slower growth will likely make it challenging for these sovereign issuers to reduce their leverage. Additionally, central banks in much of the developed world are more focused on providing support to financial markets through extraordinary measures in an effort to boost the real economy, while judging inflation risks to be contained. In our view, in the short term, inflation expectations should be well-anchored, but over the longer term, there is a material risk of inflation expectations rising and getting away from central banks.
While we expect that higher-quality developed markets will continue to function as perceived “safe havens” in the short term – particularly in periods of flight to quality – over the longer term, we expect the debt burdens in these economies to be unsustainable on the current path especially when off-balance-sheet liabilities are taken into account. Clearly, this does not bode well for investors when coupled with the pernicious effects of inflation. The current extremely low interest rate environment means that investors are being paid very little for this long-term risk.
We think the Diversified Income Strategy is especially well-suited to this environment because it focuses on maximizing the return potential per unit of risk by investing across a large universe of global credit, as well as sovereign and quasi-sovereign debt linked to higher-quality emerging market countries, which tend to have better initial financial conditions and higher growth potential than many developed economies.
Q: In the current environment, some investors have transitioned from government bonds to corporate bonds. Do you agree that companies are generally looking stronger than governments?
Tournier: From a balance sheet perspective, many companies currently have record levels of cash and low leverage. At the same time, credit spreads are pricing in higher default expectations than historical averages. So we have seen greater investor interest in global credit strategies, such as Diversified Income, as spread levels appear to be compensating investors for the actual default risk they are taking. However, it is important to remember that sovereigns have the flexibility to increase taxes and, in extreme cases, to confiscate assets. For this reason, corporate risk cannot be completely decoupled from sovereign risk, even when corporates are demonstrating solid growth and have healthier balance sheets than sovereigns.
Q: If corporations in general are strong, do credit spreads have the potential to narrow? Is credit attractively valued?
Tournier: Despite overall spread tightening in the past year, we believe that many global credit sectors – particularly emerging markets and investment grade – offer attractive levels of return potential per unit of risk for investors with a long-term investment horizon. However, in the short term, many credit sectors have benefited from a significant rally, and risk assets generally appear to be priced for a more favorable outcome than what we see signaled by the economic data. While establishing causation is tricky, it is reasonable to suppose that a significant part of the rally in risk assets has occurred on account of the extraordinary measures taken by central banks and monetary authorities in an effort to keep interest rates low.
Q: Where do you currently see the most compelling relative value opportunities within the global credit space?
Tournier: Given our expectation of continued weakness in the eurozone and slow global economic growth, we have tended to focus more on investment grade debt as we believe it currently exhibits a better risk-adjusted return profile than high yield. Regionally, we have seen evidence of improving fundamentals in the U.S. economy, particularly in the housing sector. We also see fairly strong growth prospects in a number of emerging markets with solid long-term growth drivers, such as Brazil, Russia and Mexico. With a globally diversified credit portfolio, we are able to look for opportunities not just across the quality spectrum but across regions and markets as well. In addition, we think currently there is significant value in the short duration sovereign debt of Italy and Spain, and are taking advantage of opportunities we see resulting from the unprecedented measures by the European Central Bank through the OMT [Outright Monetary Transactions] program.
Q: The strategy has historically included a meaningful allocation to emerging market debt. What is your view on this sector?
Tournier: We believe that globally diversified credit portfolios today need to include an allocation to emerging markets. Long-term trends – the high debt loads, aging workforces and increasing healthcare and retirement costs in developed markets and the better financial conditions and higher growth potential in emerging markets – have helped create a new investing environment, or a New Normal. As a result, we are placing less emphasis on developed markets and more on emerging markets. In high quality emerging markets, such as Brazil, Mexico and Russia, we see opportunity in large quasi-sovereign and strategically important corporations in the utility, infrastructure and natural resources sectors, which can offer additional yield potential relative to the underlying sovereigns.
Q: Can you elaborate on the recent improvement in the U.S. and how that might affect the Diversified Income Strategy?
Tournier: The U.S. economy is experiencing positive tailwinds that have improved its growth outlook relative to other developed markets, including Europe and Japan. One of the most interesting developments we’ve witnessed is the positive impact of falling labor costs in the U.S. Historically, labor cost arbitrage, especially in EM countries such as China, was a force pushing U.S. producers to locate operations offshore. However, as EM economies have continued to exhibit relatively stronger growth, labor wages in many of these countries have also risen. For example, labor costs in China have soared sharply since 2000, and by some estimates are expected to rise by an average of 15% every year for the next few years. Meanwhile, labor costs in the U.S. have trended downward over a 10-year period.
At the same time, inventory and supply chain management costs have taken on greater importance for many international firms. And as oil prices have increased, transportation costs have begun to consume a growing share of total production costs. As a result of all this, some U.S.-based companies, such as GM and Caterpillar, have shifted production from abroad to places like Texas. Over this past year, more than 50 companies have announced plans to move parts of their manufacturing back to the U.S. Lower U.S. natural gas prices have also translated into lower production prices, further incentivizing companies to relocate operations to the U.S.
The country’s competitive advantage in energy costs, alongside the increasing attractiveness of U.S. labor from a cost standpoint, should provide support for the improving economic picture in the U.S. For the Diversified Income Strategy, this means our view on U.S. credits, especially investment grade companies, has also improved.
Q: What is your view on the current situation in Europe?
Tournier: In Europe, the OMT program, as well as Mario Draghi’s vow to defend the euro “at any cost,” has been effective at reducing negative event risk. The OMT program has significantly reduced the pressure on sovereign yields, in the near term.
However, the fundamental structural problems in the eurozone related to monetary union and fiscal disunion remain. In addition, the region will likely continue to face the headwinds of weak growth and austerity due to significant debt burdens. As a result, we are very cautious on European corporate credits.
Q: How is the Diversified Income Strategy positioned with respect to duration?
Tournier: The U.S. Federal Reserve and the Bank of Japan have indicated higher inflation targets while central banks in the U.K., Brazil and the eurozone have indicated greater tolerance for short-term or transitory inflation, which, over the long term, should weigh on duration risk. This is particularly so given the current environment of low interest rates kept artificially tight due to various quantitative easing and “twist” operations. We do not expect a sharp move up in rates in the immediate future, but more likely a prolonged stay at the zero bound before rates eventually begin to rise.
We are cautious on long-term interest rate levels and favor a yield curve position with the front end strongly anchored. We view the five- to 10-year part of the curve as being the most attractive for potential carry and roll-down, which is the price appreciation that can result as a bond approaches maturity and “rolls down” the yield curve. In addition, we have found attractive opportunities to position our portfolios in countries with high real rates, such as Brazil and Australia. It is important to note, however, that Diversified Income is primarily a credit-driven strategy, and duration-driven alpha potential can be relatively low under normal conditions.
PIMCO also offers a duration hedged version of the Diversified Income Strategy for investors concerned about interest rate risk. The hedged strategy provides investors with the same global credit exposure but seeks lower levels of duration risk.
Q: How do you select portfolio positions? Is it a bottom-up process or do you place more focus on the macro environment?
Tournier: PIMCO is uniquely suited to managing global credit portfolios because of our global investment platform as well as our investment process. Over the long term, we look to generate attractive return potential with relatively low levels of risk by combining PIMCO’s top-down macro views and strategic allocation process with a rigorous bottom-up approach to selecting credits. In global credit portfolios, it is important to have a platform and a process that do both. It is also important to have a robust approach to managing risk: We aim not only to provide return upside and current income, but also to hedge against market volatility.
As the global economy changes and interest rates remain low, we think a diversified global credit strategy such as Diversified Income offers a compelling value proposition for investors. It aims to provide income by investing in higher yielding instruments, as well as upside return potential by finding opportunities in high quality emerging markets. At the same time, we are extremely focused on seeking to deliver this higher upside potential and attractive ongoing yield without exposing investors to unacceptable levels of downside risk.