Text on screen: PIMCO
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Text on screen: PIMCO EDUCATION –Title – Bond are Back: Making the Most of Today’s Market with John Nersesian and Tony Cresenczi (8 minutes)
Text on screen: TITLE – Learning objectives:, BULLETS – Yield peaks and future performance: the repricing of yields has created attractive opportunities, Active investing in fixed income: considering the benefits, Key consideration for investors: volatility, liquidity, and market timing, Key consideration for investors: behavioral science and its impact on investment decisions
Text on screen: John Nersesian, Head of Advisor Education
John Nersesian: Hi, everybody. I'm John Nersesian and I'm so pleased to be joined by my friend and my colleague, Tony Crescenzi. Tony is a member of the PIMCO investment committee. And Tony is the author of The Strategic Bond Investor.
So we all know of course that 2022 was a tough year
FULL PAGE GRAPHIC – TITLE -- 2022 Fed Hiking Cycle; Subheader: “2 year Treasury Yield and Federal Funds rate have rapidly surpassed their highs from the prior hiking cycle.” This chart shows the rise of the 2-year Treasury Yield, Federal Funds Rate, and the Crane Money Fund Average 30-day yield, over the period spanning from December 2021 to December 2022. It displays the 2-year treasury yield and the federal funds rate rising from approximately 0.9% and 0.3%, respectively, in December 2021, to both sharing a similar rate of around 4.5% in December 2022, with the Federal Funds Rate slightly higher than the 2-year treasury. The chart also shows the Crane Money Fund Average rising from 0% to 3.5% over the same period.
Notably, the federal funds rate, after remaining below the 2-year treasury yield from December 2021 to September 2022, recently surpassed the 2-year treasury for the first time in the period shown, around November/December 2022.
for the bond market. Lots of volatility. Saw a significant spike in rates.
You've made the case recently though that this is an appropriate opportunity to think about allocation to fixed income. You want to expand on that a little bit?
Text on screen: Tony Crescenzi, Portfolio Manager, Market Strategist
Tony Crescenzi: Well it's fairly simple in a sense. Despite the anxiety from last year, the repricing of yields has created attractive opportunities for investors. Because yields today look very attractive on three fronts.
Text on screen: TITLE – Today’s yields look attractive on three fronts:, BULLETS – Versus inflation, Relative to volatility, Diversifying in times of stress
Number one versus future inflation. Markets are priced for the inflation rate to drop somewhere into the low twos. This is based on inflation protected securities and other gauges.
So low twos, but yields today, according to the Bloomberg Aggregate, which is sort of like the S&P 500 of bonds, that's in the low fours. And we think yields returns could be achieved around 5 percent plus when you mix that Bloomberg Aggregate with investment grade securities that we like. So yields above 5 percent relative to that 2 percent expected inflation is very attractive.
Secondly, yields look very attractive relative to volatility. Of course I'm not talking about 2022-like volatility, but historical volatility.
Bonds tends to move perhaps around 5 percent per year. So thinking about a 5 percent-ish yield versus a 5 percent long term volatility is a very good so-called sharp ratio. It's pretty good. And certainly very good relative to more volatile assets such as equities, which tend to have volatility in the mid-teens and certainly a lot higher. And so on those fronts it looks very good.
And finally, when we think about yields, and we have to put them in the context of the diversifying characteristics of bonds, they tend to be a diversifier in times of stress. And that time of stress, who knows, could be around the corner if there's ever a recession. So we have to be thinking about that aspect, not just the yield in itself.
John Nersesian: I love those references.
FULL PAGE GRAPHIC: TITLE – Today’s yields are at a much stronger starting point. The bar chart shows yield to worst (YTW) for various fixed income asset classes. YTM is the estimated lowest potential yield that can be received on a bond without the issuer defaulting. The solid-colored bars show YTW as of December 31, 2022 at much higher starting points compared to December 31, 2021 across fixed income asset classes, namely core bonds, investment grade credit, high yield credit, emerging market bonds, municipal bonds, and high yield municipal bonds. The yields for most fixed income asset classes more than doubled in 2022 from 2021 levels.
So starting yields are a lot higher today, right? And of course starting yields are a very key determinant in the total return that we might receive when we allocate money to fixed income. Let's talk a little bit more specifically about this active and passive decision that investors face. I know that in the equity markets, passive investing has really taken on a life of its own. What about in the fixed income market? What are the opportunities for active managers specifically to add value in the fixed income markets?
Tony Crescenzi: John, one of the first things that's coming to mind is something I read in a famous book from Frank Fabozzi, The Handbook of Fixed Income. There's a chapter in there written by our own Chris Dialynas, a member of the investment committee, on the importance of index consciousness. What does that mean?
Well you have to be thinking about the index that the investments you have is judged against and what's in it. So for example,
Text on screen: TITLE – Convexity:, BULLETS – Definition: Convexity is the price measure of how much a bond's price/yield curve deviates from a straight line (measure of the degree of curve of the price/yield relationship). Implication: This number, used with modified duration, shows how the duration of a bond changes as the interest rate changes.
convexity. In the Bloomberg Aggregate, it includes lots of mortgage securities. And that matters because there's more convexity in that than there is in a corporate bond index. Meaning if yields decline, we know that homeowners would decide to perhaps sell their homes and buy other ones. Or perhaps refinance their mortgages.
The point is that the mortgages that are in the pool of the securities that investors hold will go away. And suddenly the duration, in other words declines, and that's not what you want when yields are falling. So you got to be thinking about the convexity. You have to have some degree of index consciousness.
One other point to make on index consciousness in this day and age, Uncle Sam has been issuing lots of bonds, and making up an increasing part of this market weighted — these market weighted indices. And that — does an investor want to be investing more and more into US Treasuries which have lower yields and can be offered on other high quality bonds where the chances of default we think are rather low in certain ones that we buy of course.
No. And so an investor should be thinking about what's in these indices when they're making decisions. And lots of decisions to be made today with these yields.
John Nersesian:I love that point. I know that when I buy the index on the equity market, the S&P 500, I kind of know what I'm investing in and what kinds of attributes I'm going to receive. When it comes to the fixed income market however, the ag, I'm curious how many investors actually understand what is in the ag and what they ultimately own from a decision to allocate to that. Investors —
Tony Crescenzi: And John, it's constantly changing too.
John Nersesian: Absolutely. Constantly evolving. Look at all the new issuance in the fixed income market, which you don't necessarily have in the equity market. Which makes that index replication, the replication of the return in the index, that high tracking error that we see in the fixed income market very different than what an investor might receive when they index to the equity market.
Tony Crescenzi: Absolutely right. And so it's not only a matter of looking at the yield on these things, but thinking about what's in the mutual funds perhaps that investor's in. And more importantly speaking, John, investor's today with the repricing of yields face an important decision point. And some of the decisions they have to make are personal and really up to the individual investor and advisors.
Text on screen: TITLE – Key considerations for investors in the fixed income market:, BULLETS – How much volatility to expect?, How much liquidity is needed, Market timing
There are three major parts of this decision point. Number one, how much volatility does the investor expect. PIMCO would suggest that volatility this year, 2023, will be a lot lower than last year. Secondly, an investor has to just these yields against the amount of dry powder that they want. PIMCO itself is looking to have more dry powder. That could be in the form of cash of simply flexibility within a portfolio to maneuver from one asset to another. So in other words, be thinking about liquidity.
Finally in this decision point for investors after the repricing of yields, investor has to think how long do I want to continue to market time this diversification benefit that bonds tend to have.
Because many investors are deciding well interest rates might rise more, so perhaps I'll take a break from bonds and simply buy them later. It's an idea we would suggest avoiding generally when seeking to diversify, especially if there's a recession around the corner. Because bonds tend to have higher — high excess returns as they're called. They tend to fare well relative to equities and risky assets in those times of stress.
John Nersesian: Yeah. I love that. And I love your reference to the individual investor and the challenges that they're facing. Tony, I have a suspicion that the decision making process of the individual investor today is governed by the experiences that they had last year. It's recency bias.
Text on screen: TITLE – Recency bias:, BULLETS – Definition: When an investor looks at recent market returns when making important financial decisions. Implications: Clients may choose an investment based on recent returns or some news that was recently heard rather than perform a thorough analysis. May cause clients to chase performance – buying high and selling low
Wait a minute, I had a negative experience last year, is that likely to replicate itself again this year.
Text on screen: TITLE – Loss aversion:, BULLETS – Investors typically feel the pain of loss more profoundly than the joy of an equivalent gain. Implications: May prevent clients from unloading unprofitable investments. Causes investors to take on additional risk to avoid pain from losses
Loss aversion. I hate losing money. I saw a loss in my fixed income portfolio last year. Maybe that's something I'll avoid this year.
These are the kinds of issues that many investors are facing, in addition to anchoring. I'm accustomed to a particular return or a particular data point. I kind of hold on to that and I make future decisions based on that.
These are the kinds of challenges that the individual investor faces, which is why they're so often seeking the benefit of an active manager who can help them navigate the complexity of the fixed income market, and the personal attention and guidance that they receive from a financial advisor.
Tony, I want to thank you for the time today. And I want to encourage all of our viewers who have enjoyed this conversation to continue it, to continue to access the expertise that PIMCO can bring to the fixed income market by contacting your local PIMCO account manager. Thanks so much for your time today.
Text on screen: Visit pimco.com to discover how PIMCO fixed income can lead to better outcomes
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