Both higher-yielding and higher-quality bonds rallied in the second quarter, mainly driven by signs of easier monetary policy, particularly in the U.S. Portfolio managers for PIMCO’s Income Fund, Dan Ivascyn, Alfred Murata, and Josh Anderson discuss the market, their outlook, and how they are positioning the fund.
Q: WHAT IS HAPPENING IN THE GLOBAL ECONOMY, AND WHAT ARE THE IMPLICATIONS FOR THE INCOME FUND?
Ivascyn: We have seen weakening global growth over the last several months, especially in the manufacturing sector, and considerable uncertainty on the political front, including escalating trade tensions between the U.S. and China and increasing uncertainty around Brexit. Global central banks have become quite dovish quite quickly, and the result has been a rally in the bond market that has driven yields much lower. Today, nearly $15 trillion in bonds actually have negative yields.*
Our longer-term outlook for the global economy and the markets calls for greater uncertainty over the next few years; we see the potential for disruptions to the global economy from several ongoing developments, including China’s growth and increasing friction with the U.S., the spread of populism, and advances in technology.
Given that view and our focus on capital preservation in the Income Fund, we are not being overly aggressive. Instead, we’re building a portfolio consistent with our long-standing principles, seeking responsible sources of income with the aim of being resilient even during a far greater economic downturn than PIMCO anticipates. That means canvassing the global markets, targeting segments and sectors where we see less aggressive underwriting and less market excess.
Ironically, these sectors tend to be the areas that have become heavily regulated since the financial crisis: housing and financials.
Q: CAN YOU DISCUSS THE INCOME FUND’S CURRENT INTEREST RATE EXPOSURE, OR DURATION?
Ivascyn: We think that the markets have gotten a little ahead of themselves regarding assumptions on central bank rate cuts. After the Federal Reserve’s interest rate cut last month, and perhaps even after a series of cuts, we think the Fed will get back to focusing on economic data, and some recent data have been better than anticipated – the June U.S. employment report, for example. That said, some of the key disruptors that we highlighted in our longer- term outlook are already impacting the markets in the short term, namely China, and these concerns are also likely to impact central bank policy.
Still, for an investor, being right on policy rates could potentially provide a small positive return, but the cost of being wrong could be far greater, given that yields are so low and, in some cases, negative. So we are trying to be defensive on interest rate exposure as well.
Murata: In general, there are two main reasons to have duration in a portfolio. The first is because you think that interest rates will drop over the long term, and the second is to hedge the portfolio against a possible sell-off in higher-risk assets like equities.
As we expect long-term interest rates to rise modestly, instead of dropping, the first reason to hold duration is not applicable at the moment, so we have reduced portfolio duration so far this year. The Fed has been very accommodative in its guidance, which has already caused interest rates to fall this year, and as Dan noted, we think the market has been very aggressive in its expectations for rate cuts.
On the second point, however, we want to be in a position to help protect the portfolio in the event of a sell-off in risk assets, so we still want to have some duration in the portfolio.
With respect to positioning on the yield curve, we find the intermediate portion of the U.S. yield curve to be the most attractive. Interest rates are higher in the U.S. than in most other developed markets, and by taking intermediate-term positioning, the fund is less exposed to the front end of the yield curve, which could be exposed in the event that central banks do not cut as much as the market is anticipating, and the fund is also less exposed to the long end of the yield curve, which we expect to rise over time as government deficits increase.
Q: WHAT DROVE PERFORMANCE OVERALL FOR THE INCOME FUND DURING THE SECOND QUARTER?
Murata: As we have said in the past, the Income Fund is divided into two primary components: One is invested in higher-yielding assets, which tend to perform well in a strong growth environment, and the other in higher-quality assets, such as U.S. Treasuries, which tend to perform well in a weaker growth environment. In the first half of this year, because spreads on higher-yielding credit tightened and interest rates dropped, both portions of the Income portfolio benefited.
Typically, we expect one portion of the portfolio to do better than the other at a given time, and over the years this diversification has helped the fund.
Q: HAVE YOU MADE ANY CHANGES TO THE FUND’S INVESTMENTS OVER THE PAST QUARTER?
Anderson: We made some modest shifts based on relative value, focusing on higher-quality securities and those we think could benefit from continued central bank stimulus.
Specifically, we added agency mortgage-backed securities (MBS), which we viewed as 20 to 30 basis points cheap relative to other assets, in part because the Fed has been selling agency MBS and in part due to summer seasonal effects. We also added some investment grade credit. As offsets, we reduced our holdings of government-related securities and allowed some of our emerging market bonds to mature and essentially “roll off.”
We would also highlight two themes in the portfolio that have not changed: our preference for non-agency MBS relative to other higher-yielding assets and our emphasis on liquidity.
Q: HOW DOES PIMCO MAINTAIN ITS POSITION IN NON-AGENCY MBS WHEN SUPPLY IN THAT SECTOR IS DECLINING?
Ivascyn: First, we are very active in the secondary markets — we are probably one of the most active firms in this space.
Second, we now source reperforming mortgages and collaborate with banks to securitize the loans to help with liquidity and flexibility. Several financial institutions have been selling their positions recently, in part as these positions have generally performed quite well in the last few years; they tend to have low loan-to-value ratios and multiple years of timely payments.
We often source these exposures through auctions, but we also actively look to acquire them and are in the markets every trading day.
Q: WHY DO YOU CONTINUE TO FIND HOUSING-RELATED ASSETS MORE ATTRACTIVE THAN CORPORATE CREDIT?
Ivascyn: We favor housing-related investments because we find the fundamentals to be far stronger than those in corporate credit investments.
Legacy mortgage borrowers in the U.S. have now had a decade of job growth and rising home equity, so leverage has gone down significantly. This is also a sector with very generic structures, generally predictable cash flows, and minimal issuance, and it therefore should be less subject to negative technical factors if market sentiment shifts. Yields are attractive, offering us spreads closer to triple-B minus or even double-B levels for risks that we think are closer to those of triple-A or double-A credits today. And finally, when you compare U.S. home prices to rents and incomes, we believe they still look quite reasonable.
Combine all of this with a strict lending environment, and you have a healthy market that we think will be resilient in a much more challenging economy.
By contrast, we think that the sector most prone to disappoint investors over the next several years is nonfinancial corporate credit. We have seen steady deterioration in underwriting standards, an uptick in leverage, and alarming levels of issuance relative to historical patterns. In corporate bonds, we try to zero in on segments we believe are attractive and very resilient, and we may trade tactically from time to time, but in securities with attractive liquidity profiles.
One bright spot for us in corporate credit is the financial sector. Banks came under heavy regulation after the financial crisis, and the results today are increased capital standards and less risky business models. As a result, volatility has decreased in the banking system.
Q: HOW ARE YOU MANAGING LIQUIDITY FOR THE INCOME FUND?
Ivascyn: Throughout our history, including through the financial crisis, liquidity has been a priority. In fact, many times we have sought to generate value for our investors by providing liquidity to others in the marketplace.
In the Income Fund specifically, a focus on liquidity is embedded in our approach. From day one, we never wanted income to be our sole objective because that can lead to focusing only on lower-quality assets, which may have higher yields but also generally exhibit much more volatility and correlation with equities. Strategies investing in lower-quality bonds tend to do well during an extended economic expansion when stocks perform well. But in our view, they cannot provide the diversification that a high-quality bond strategy can, and they may not have the same amount of liquidity and flexibility.
With large banks now less inclined to provide liquidity to the markets, we think liquidity within the Income Fund has become even more important. Unless we are paid to take on extra risk – during market dislocations, for example – we tend to focus on defensive and therefore more liquid segments of the marketplace.
Now that economic growth is slowing a bit, we want resiliency to provide potential downside protection for investors. When we get bouts of volatility, we can be more aggressive and target higher-yielding, more interesting total return opportunities. Until then, we think playing defense – steady and diversified – is the way to go.