The uncertain economic recovery amid a continuing pandemic creates risks for investors, but opportunities as well. Here, lead portfolio managers for PIMCO’s Income Fund, Dan Ivascyn, Alfred Murata, and Josh Anderson, discuss PIMCO’s economic and market views along with current portfolio positioning.
Q: What is PIMCO’s broad economic outlook?
Ivascyn: Our base case outlook is cautiously optimistic, with continued albeit varied improvement in how the coronavirus is treated and managed globally, including a vaccine perhaps early next year. We are beginning to see a bounce in economic growth up from dramatically low levels, largely driven by massive support from both monetary and fiscal policy. We expect a fairly sharp recovery, at least initially, before momentum tapers. The recovery will likely be uneven, both over time and across different regions of the world. In the U.S., we don’t anticipate returning to late 2019 growth levels until 2022.
Tremendous uncertainty remains around the outlook. Other factors outside the pandemic, such as geopolitics, could have an impact. And even with all the policy support, some areas of the economy will be permanently damaged. These risks of capital impairment make this an environment to tread carefully and keep a defensive mindset.
Q: What does this outlook mean for global bond markets?
Ivascyn: Many fixed income sectors have retraced a significant amount of the spread widening we saw in March, especially sectors where central banks are providing support. But that sector-level tightening can mask pockets of weakness. This combination – tighter overall spreads, but also areas that haven’t recovered (and may never recover) – complicates the process for investors targeting attractive yield along with resiliency within a portfolio.
In the corporate sector, central bank intervention has allowed a lot of high quality companies that were quite stretched to go to market and reissue debt, providing a bridge to the future, where we expect improving economic growth. However, the corporate sector in general was already highly leveraged going into this period. As debt levels increase further, we may see instabilities build in some parts of corporate markets over the longer term.
Amid an overall convergence in fixed income spreads, we’re seeing a number of attractive opportunities poised to deliver income and long-term price appreciation, but active management remains critical.
Q: What are the high-level investment themes in the Income Fund today?
Ivascyn: In light of the fund’s focus on generating an attractive dividend stream across market environments, even within a lower-yielding marketplace, and with long-term capital appreciation as an important secondary objective, we continue to have a high-conviction view on the mortgage-related sector. We believe these securities have potential to deliver not only yield but attractive total return, along with the ability to withstand a more severe downside scenario. It’s true that housing-related sectors have generally lagged a bit in the recent recovery, but after the significant spread convergence, we are seeing the high quality segment of the market as resilient risk assets pricing at very attractive levels.
In other areas of the market, we see attractive tactical opportunities in corporate credit. There’s been a lot of issuance in that space, and we have been able to obtain what we believe to be attractive terms within the new issue market and via reverse inquiries. But after the significant rally and spread retracement that we’ve witnessed, we’re now becoming a bit more cautious on that sector again.
We maintain minimal exposure to the more esoteric risks in structured products or in riskier segments of the emerging markets, for example, instead seeking more liquid, senior opportunities in these segments.
We also have a few investments that could benefit from U.S. dollar weakness. We don’t expect the dollar to collapse, but we do expect ongoing weakness due to COVID challenges and more aggressive policy support in the U.S. relative to the rest of the world.
Q: Let’s look more closely at housing-related sectors. What is happening in the U.S. agency mortgage-backed securities (MBS) market, and why do we still find it attractive?
Anderson: We view the agency MBS sector as a high quality market that currently provides attractive yield and price appreciation potential, particularly relative to U.S. Treasuries and other more liquid assets in the portfolio.
Agency MBS spreads reached dramatic highs during the liquidity-driven volatility in March – even wider than levels reached during the global financial crisis. Spreads have retraced since the Federal Reserve stepped in, but we still believe valuations remain attractive given the potential for further spread tightening amid continuing Fed support.
We believe active management is crucial to identify relative value within this sector. Currently, we’re focusing on lower coupon issues, which have lower expected paydowns over the next year or so.
Q: What is PIMCO’s outlook for non-agency mortgages, a sector in which we’ve had strong conviction for many years?
Murata: In our base case, we estimate U.S. housing prices will be flat over the next two years. Over the longer term, we think that house prices will gradually increase as interest rates remain at very low levels. But even in a much more negative scenario – if for example housing prices drop by 30% over the next two years – we believe that loss-adjusted yields on non-agency MBS would still likely be positive and continue to offer a stable cash flow. The yield profile in our base case outlook remains attractive, with further potential on the upside.
Non-agency MBS are a clear example of the “bend-but-don’t-break” investments we favor in the Income Fund. Such investments tend to be resilient amid negative economic challenges. We favor non-agency MBS assets offering several features that should help them withstand a downside scenario. One feature is the underlying loans: We’ve focused on securities backed by a diversified pool of legacy first-lien mortgages that borrowers took out before the global financial crisis. Since then, these homeowners have built up substantial amounts of equity, making these positions much more resilient to potential weakness in the economic environment, in our view.
As with any investment, rigorous analysis is key to evaluating opportunities and risks. Our proprietary tools, such as our GeoScore mapping analysis, help us make highly granular assessments of housing markets and price trends around the world in order to identify properties and locations with attractive upside potential.
Q: What are PIMCO’s views on global corporate credit and how are they reflected in the Income portfolio?
Ivascyn: We think that the corporate credit opportunity set is quite interesting versus where it was a year ago. It’s become more of a lender’s market than a borrower’s market in the sense that lenders have more ability to influence terms. That said, investors have to be much more selective in corporate credit today than back in March. The spread convergence since then, driven by central bank and overseas purchases, is likely to be less impactful from here. And as I mentioned earlier, all of this new issuance means the sector is taking on even more leverage in an uncertain economic environment.
Overall, we remain cautious, but within the Income Fund we have added some high quality corporate credit in the last couple of months. One area of focus continues to be the financial sector. We still think, despite earnings challenges across European banks in particular, and a more uneven picture in the U.S., that financials offer attractive starting capital positions. There is relatively little risk-taking in a historical context. Overall we still believe the financial sector, one of the more liquid areas of the corporate credit market, represents good relative value.
Q: How is the Income Fund positioned in emerging markets?
Ivascyn: We haven’t made major shifts. This segment of the portfolio is still modest in size and serves as a diversifier. We find emerging markets (EM) to have more attractive valuations than many other spread sectors, at least from a longer-term historical perspective. This makes sense given the near-term uncertainty around COVID, policy, and politics – EM investments will likely be closely tied to local growth dynamics, with both notable upside potential and downside risks.
In the Income portfolio we’ve remained mostly in more defensive high quality EM sovereign bonds or quasi-sovereign bonds, and we are just fine-tuning our positions here. We are reluctant to move into less liquid segments of the market such as EM corporates.
Q: What are your views on duration in this environment?
Ivascyn: Interest rates are historically low, with many parts of the world offering near-zero or negative sovereign yields, and central banks seemingly focused on keeping them there. Over the short to intermediate term, we believe rates will remain relatively range-bound.
As always, we remain focused on delivering attractive income, and duration plays an important role within the portfolio even at record-low absolute yield levels. It serves as a hedge against the riskier segments of the portfolio, though it may not be as effective in the current environment. So, we have taken our interest rate exposure up a bit, mostly adding unhedged longer-maturity positions. We still prefer U.S. duration over other high quality interest rate markets because there is some room for nominal yields to compress if there are additional shocks to growth.
Q: To sum up, what is your overall approach in the Income Fund today?
Ivascyn: We think this is a time to be a bit more cautious, given the rally in both fixed income and equity markets despite an ongoing pandemic and economic uncertainty. Monetary and fiscal policy support has helped the economy and markets, but we don’t want to count on it. We would like to have a few other layers of resiliency, and we’re taking a fairly defensive approach to income generation.
The Income Fund seeks to deliver an attractive and stable level of income; this objective guides our investment process and decision-making. But as stewards of our clients’ capital, we will not stretch for yield by adding more risk than we feel comfortable with given the fund’s diversified and balanced approach. We are not alone among our peers in experiencing some pressure on dividend levels given the sharp fall in global bond yields since the beginning of the year. We embed a long-term philosophy and seek to deliver attractive risk-adjusted long-term total returns, driven by an attractive income level.
Looking across the global opportunity set, we see many ways to take advantage of the inherent flexibility in the Income Fund. We’re pleased with its trajectory the past few months, and we will continue to leverage PIMCO’s investment process, focusing on bottom-up analysis and seeking attractive ideas around the world.