PIMCO recently introduced the Low Duration Global Investment Grade Credit Strategy, a global bottom-up approach to credit investing with a focus on short-dated investment grade corporate bonds.
In the following interview, Deputy CIO Mark Kiesel and product manager Anna Dragesic discuss the benefits of investing in short-dated corporate bonds, the differences between this approach and a duration-hedging approach and applications of this strategy within an investor’s asset allocation.
Q: What is the PIMCO Low Duration Global Investment Grade Credit Strategy?
Kiesel: This new strategy offers investors a long-term, strategic allocation to the short-dated segment of the global credit market. The strategy invests primarily in global corporate bonds rated BBB− or greater by at least one of the nationally recognised credit rating agencies and having less than five years to maturity.
Q: How does it differ from the PIMCO Global Investment Grade Credit Strategy?
Dragesic: This strategy is essentially a clone of PIMCO’s longstanding Global Investment Grade Credit Strategy but uses a structurally lower maturity benchmark of 1–5 years and an absolute duration band of 0–4 years.
The same team and investment process that was awarded the Morningstar 2012 Fixed Income Fund Manager of the Year (USA) award is responsible for managing and delivering alpha in this strategy. PIMCO’s macroeconomic outlook, which forecasts forces likely to affect fixed income markets over the short and long term, helps drive duration and regional positioning, while PIMCO’s deep and experienced 50+ member credit research and portfolio management teams drive the bottom-up credit and instrument selection.
Q: What are the benefits of the investment approach of this strategy?
Dragesic: As some investors are worried about the impact of potentially rising rates, they are seeking solutions that will likely lower their overall exposure to interest rates (duration). The strategy’s focus on short-dated corporate bonds provides investors with the ability to capture PIMCO’s consistent global credit expertise but with less sensitivity to interest rate risk than a traditional global credit strategy.
Investments in short-dated corporate bonds can also provide enhanced yield potential relative to government bonds. The higher average coupons that global corporate bonds provide may act as a cushion to help weather potential future rate hikes; with rate volatility expected to remain high, credit may be the preferred risk. Compared with sovereign bonds, global credit provides additional diversification benefits because of its exposure to a broader set of risk factors and also capitalises on the improved balance sheets of companies relative to some governments that continue to suffer from outsized debt burdens. Investing in sectors and companies, particularly those that are outpacing sovereign growth rates, may allow investors to gain greater exposure to a cyclical economic rebound in developed markets.
Q: How does the 1–5 year universe of credit bonds compare with the full maturity spectrum?
Kiesel: The 1–5 year universe of credit bonds is roughly half the size of the full maturity spectrum at around $5 trillion (source: Barclays Global Aggregate Credit 1–5 Year Index). The short-dated market provides us with a rich opportunity set to invest tactically in different regions, industries and issuers amid changing economic environments. The sector weights are broadly aligned, with the key differences being a modestly higher weight in the short-dated universe to banks and a lower weight to utilities. However, PIMCO’s credit philosophy is to focus on companies that we believe have good prospects for price appreciation due to improving credit fundamentals, and our guidelines provide us with ample flexibility to overweight and underweight sectors irrespective of benchmark weights.
Q: Why did you choose to lower duration through short-dated bonds instead of duration hedging?
Dragesic: There are two main ways to lower portfolio duration: 1) choose short-dated bonds, or 2) use duration-hedging techniques such as pay-fixed swaps or selling futures. PIMCO believes that a focus on short-dated bonds may be preferable due to its better risk-return profile.
Currently, the yield of a duration-hedged credit index slightly undershoots the yield of a short-dated credit index. However, more striking are the risk profiles. As Figure 1 highlights, the duration-hedged strategy is much more volatile as it has a wider distribution of returns.
In the current environment, PIMCO also believes the interest rate curve will remain steep as major central banks stay ‘on hold’, making it more expensive to hedge duration. When you invest in a duration-hedged product, you are explicitly making three bets: 1) spreads will tighten and 2) rates will rise and 3) the government curve will flatten. These are a lot of bets to get right, and in the meantime, the cost in lost yield for holding a duration-hedged portfolio will likely be quite high unless you get a quick spike in interest rates; with range-bound rates or falling rates, we expect portfolios to underperform with a duration-hedged approach. The short-dated approach benefits from being able to roll down the steepest part of the curve. While there may be appropriate times to employ duration-hedging techniques, we believe a low duration approach is a better structural, long-term solution.
Q: How will the strategy navigate a rising rate environment?
Kiesel: The strategy structurally has a lower duration than a traditional corporate bond portfolio helping defend it naturally against rising rates. Also we have greater flexibility with this strategy to adjust duration lower to between 0–4 years depending on PIMCO’s forecast for interest rates; this allows us to limit the downside potential of interest rate changes even further when we anticipate higher rates. Moreover, the strategy’s focus on credit instruments means it will empirically behave as if it has less interest rate risk than might be initially estimated.
Q: How does PIMCO’s investment process inform this strategy?
Kiesel: PIMCO’s investment process involves three essential steps: We evaluate top-down considerations, bottom-up fundamentals and valuations. The process is anchored by PIMCO’s secular and cyclical forums, which provide the framework for the regional and industry allocations. In addition, our global investment team of over 50 credit analysts and over 50 credit portfolio managers gives us the ability to perform independent, bottom-up credit research and source the most attractive investments globally for our clients.
Q: Which sectors are attractive currently?
Kiesel: Our investment strategy today is to ‘go for growth’ and seek out companies with growth profiles higher than their respective economies’ overall growth rates. We are also focused on pricing power, which is a great gauge of how well companies are doing; if companies can increase prices, that is a sign that demand is picking up. Cable television, autos, airlines, healthcare and housing-related sectors are all examples of areas where companies have the ability to raise prices given positive supply-demand factors. Basically, we are seeing more demand than supply due to industry consolidation and cyclical recoveries.
For example, the cable sector has had a wave of M&A activity, which has made valuations more compelling. The growth in demand for broadband has allowed companies in Europe, the UK and the US to raise prices, improving cash flow generation and margins. The auto and airline industries have also each consolidated in recent years, resulting in significantly less outstanding capacity and the reduction of operational inefficiencies. The net result is an improvement in pricing power. In addition, the US healthcare sector, specifically hospital operators, should benefit from the Affordable Care Act. More coverage across the US means people visiting hospitals will actually be covered, leading to greater volume and a decrease in bad debt expense. Finally, US housing starts are growing from very cyclically depressed levels. Consequently, we see opportunities in sectors that stand to benefit directly or indirectly from this growth in residential spending; these include homebuilders, building materials, appliance manufacturers and US banks.
On the other hand, fundamentals remain weak in certain sectors around the globe due to industry-specific dynamics such as pricing and competitive pressures and risks of product obsolescence. As a result, we remain cautious on many companies in the wireline, technology, food and beverage and retail sectors.
Q: How might the Low Duration Global Investment Grade Credit Strategy feature within an investor’s asset allocation?
Dragesic: The Low Duration Global Investment Grade Credit Strategy may offer multiple applications within an investor’s portfolio. Firstly, the strategy can serve as a complement to higher-quality cash holdings for investors who do not need liquidity immediately but are seeking a solution with a modest volatility profile and the potential to enhance returns in an environment of suppressed short-term interest rates. Alternatively, this strategy might be used as part of a credit allocation for investors who desire a high quality credit alternative that may benefit from improving global economic conditions but who want less price volatility than would structurally come from the higher duration of a traditional corporate bond portfolio.