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Inflation in Context: Managing Portfolio Risk

David Braun, portfolio manager, recently joined The Exchange with Douglas Yones, Head of Exchange Traded Products at NYSE, and Robert Trumbull of J.P. Morgan. They discussed inflation uncertainty, the growth environment and why active management is critical for managing inflation risk in your portfolio.

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Image: NYSE logo, The ETF Exchange with Douglas Yones, HomeofETFs.com

Text on screen: Douglas Yones, Head of Exchange Traded Products, NYSE

Yones: Welcome to the second edition of The Exchange, brought to you by PIMCO and J.P. Morgan Wealth Management. I'm Douglas Yones, your host. As a reminder, today's interview is for informational purposes only. The NYSE does not recommend investments or investment strategies.

I want to move right into it with David. For a broad core bond mandate how do you account for this inflationary moment and how do you go about predicting possible future trends?

Text on screen: David Braun, US Financial Institutions Portfolio Management and ETF Portfolio Manager, PIMCO

Braun: So as core bond manager I'll say three things. One, everything I talked about before in our outlook is our base case, but I acknowledged that there's a lot of uncertainty around the base case. So an active manager should really be humble in this environment and realize a good chance that things come in better than their base case or come in worse than their base case. So a portfolio needs to be resilient in those deviations.

The second thing I'd say is investors out there, everyone seems to be worried about inflation, as Rob said, and they shouldn't be relying solely on their bond manager. There's a lot of other things they can do whether it's dedicated long-term mandates to inflation-protected securities, real assets and other real return strategies.

That certainly makes sense as a core allocation for someone's portfolio. Because if you look at the bond manager, they're largely beholden to doing like TIPS, Treasury Inflation-Protected Securities, and right now we view them as neither rich nor cheap. So not a screaming buy or not a screaming sell, pretty much priced in line with our longer-term inflation estimates.

The third thing I'd say is what can an active manager do to position for this stronger growth and potentially higher-inflation environment? There we think it pays to go outside of the kneejerk reaction of, well, I'll buy some TIPS or overweight generic credit.

If you think the economy is going to grow strongly and we're going to reflate, there's a lot of other reflation trades you can do that might offer a better risk/reward proposition than TIPS or generic credit. So I'll give you a couple of things to think about.

If you think the economy is going to reflate, even though we think rates are going to be largely range-bound, nominal rates, on average, should go up and curves should continue to steepen, and we've certainly seen that over the past six months.

So most of our generalist portfolios are positioned slightly underweight in duration terms and positioned for a curve steepener, which both should pay off if inflation does come in higher. Second, when we look at credit risk we want to be overweight credit risk.

With this growth backdrop and this reflationary backdrop you want to be investing in credit assets, however, generic credit is priced pretty much to perfection. So we're going outside of generic credit securities and getting invested in things that are more attractive, first banks. We like banks.

They got attractive debt metrics and leverage metrics. We're willing to go down on the capital structure on things like preferreds and subordinated debts. They're much more lower-levered than their non-financial colleagues. Second, we really like the U.S. housing story.

You look at how strong the housing price inflation has been coming in. We think that's set to continue, and we look at household balance sheets. Those who own homes, very little leverage on their balance sheet. So we want to lend, and most of our accounts are heavily invested in non-agency mortgages.

And then third thing we can do to participate in this reflationary, strong growth, reopening trade is a direct COVID investment. Invest in the sectors that were most hit by COVID and thus have the most convexity on the way back as we recover, so things like aircraft, gaming, hospitality, etc.

So when you combine these all together, we think a core bond portfolio can be positioned for the reflation trade, but not necessarily just doing it via inflation-protected securities.

Yones: So, Rob, I want to come back to you from a client's perspective. I'm curious, when you're in conversations, how they think about active management during times like this for bond portfolios. And of course in general, as you're expressing your broader asset allocation views, are you using active management? Are you using actively managed ETFs?

Text on screen: Robert C. Trumbell, Vice President, Wealth Advisor, J.P. Morgan Wealth Management

Trumbull: Doug, our approach is, as you know, I spent 15 years in the ETF industry. So I know the ETF market inside and out. Our approach is to manage ETF portfolios for clients that leverage the macro asset allocation insights of some of the leading asset managers in the marketplace.

At the end of the day, from a value proposition perspective for our clients, those firms have tremendous resources behind the asset allocation decisions, and we want to make sure that we're leveraging that for our clients.

On the fixed income side of the portfolio within the ETF portfolios we have decided to go active, and we've decided to go active because we really believe that, whether it's duration, credit quality, all of the individual bonds themselves, we really want a skilled manager at the helm to help make those decisions in real time.

Look, this is a very dynamic environment that we are in. You look at the last 18 months. There's not a lot of market environments that we've seen this level of swing in the marketplace. So at the end of the day we feel really good about having active in the fixed income part of the portfolio.

If you look at the data it's pretty overwhelmingly clear that from a risk budget perspective you have a higher probability of outperforming in fixed income on the active side than in the equity side of the portfolio. So the place that we really lean into active is on the fixed income side of the portfolio.

Yones: Now David, I want to come back to you. Now I know, of course, both you and PIMCO have very strong views here, but how would you summarize the benefits of active management in a core bond context, and how does PIMCO really position itself, I guess, and take initiatives in adjusting exposures?

Braun: First, I'd agree with Rob. If you look at the historical data—and we've published our data on this on our website under the tagline of 'bonds are different'—

Image: TITLE – Why active for bonds? SUBTITLE – Active bond managers have a solid track record vs. their passive peers. TEXT -- A bar graph shows the percentage of active funds within each category that outperformed the passive median fund (10-year).

historically the data shows that active fixed income managers have had success beating their passive peers, even though active equity managers may not have had the same success.

The second thing I'd say is when you look at the bond market and the indices that represent the bond market, we think there's significant flaw in them. A bond index is not optimized for you, the investors. They're optimized for the borrower, the person issuing debt.

So if someone wants to issue more 30-year bonds they're going to go on the index, and you, the passive investor, are going to buy more 30-year bonds. That's why the duration of the Barclays overall U.S. Aggregate is now six years versus before the great financial crisis it was under four years, because people have issued more long-term debt in this low-rate environment.

Second, the more credit gets in the index it's dominated by lower-rated companies that issue more and more debt. You look at the Barclays Corporate Index. Before the great financial crisis it was a little over 30% BBBs. It's now over 50% BBBs.

So you've got an extension in duration because borrowers want to borrow longer out the curve, and you've got a degradation in credit quality because companies are issuing more and more debt and their ratings are dropping. So those are index construction flaws that a passive investor is just kind of beholden to go buy.

And then the third thing I'd say is, again considering what Rob said, we're in a pretty unique environment where there's a lot of uncertainty out there. We expect volatility to stay elevated, and we think that's a ripe opportunity for an active manager. In that environment we all know how low rates are and how low yields are.

So the alpha or excess return that an active manager is going after is a bigger part of the expected total return going forward than in kind of prior cycles. So when you glue that all together, we believe that an active manager, especially in this environment where generic betas—like I mentioned before how rich generic credit is—there's a halo effect.

Once you're index-eligible—that's generic credit—you have a financing advantage because of the captive audience, where passive investors and lower-active-share investors buy your bonds because they're in the index. The spreads there are pretty much tighter than or lower than where they were pre-coronavirus, yet we're in an inherently more uncertain world.

A large active manager like PIMCO, with depth of resources, can venture outside of those generic credit securities and find credit securities, like I mentioned earlier, that we believe offer the same yield or even higher yield for the same or even lower risk. So you get a much more resilient portfolio from a risk/reward perspective.

And at the end of the day, with our growth outlook and the reflationary outlook, we want to be out-yielding generic benchmarks, and we're doing that [trafficking] outside of generic assets.

Yones: As a reminder, you can find this episode alongside a lot of other episodes of educational content on our website home of etfs.com. David, Rob, thank you very much for joining us. That's a wrap on the latest episode of The Exchange, brought to you by the New York Stock Exchange, the home of ETFs.

Image: NYSE logo

Disclosure


IMPORTANT NOTICE

Please note that the following contains the opinions of the manager as of the date noted, and may not have been updated to reflect real time market developments. All opinions are subject to change without notice.

All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha. Beta is a measure of price sensitivity to market movements. Market beta is 1.

The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

It is not possible to invest in an unmanaged index.

PIMCO is not affiliated with the NYSE or JPMorgan Wealth Management.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only.  Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2021, PIMCO

Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626.

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