While PIMCO expects bond yields to remain range-bound for several more years, they’re also likely to be volatile, as the recent sell-off demonstrated. Dan Ivascyn and Alfred Murata, portfolio managers for PIMCO Income Strategy, discuss the current and longer-term environment for bonds and how the strategy’s investment team pursues consistent income even in turbulent conditions.
Q: Can you explain what is happening in the markets currently?
Ivascyn: Following recent Federal Reserve communications, we saw a deleveraging across stocks, bonds and other asset classes. While the markets fixated on those aspects of the Fed’s statements related to potential tapering of its quantitative easing (QE) program, they discounted the bank’s reaffirmation of its commitment to accommodation by maintaining its policy rate – the federal funds rate – at zero until unemployment targets are hit. PIMCO believes that it is important for investors to view the communications in aggregate.
Another aspect of central bank action is that any reductions in asset purchases are predicated on the Fed’s relatively optimistic view on the trajectory of economic developments, including real GDP growth in the 3% to 3.5% range in 2014. This has significant implications for investment portfolios. While PIMCO doesn’t expect this level of acceleration, strong growth would be positive for some economically sensitive assets such as U.S. non-agency mortgage-backed securities and senior secured bank loans. On the other hand, if the economy does not achieve escape velocity, we do not expect the Fed to materially scale back its quantitative easing program, which would be positive for higher-quality interest rate duration exposures.
Q: How does PIMCO’s view differ from the reaction by the markets?
Murata: PIMCO is more cautious on the trajectory of global growth. In addition to the structural challenges in Europe, we are also concerned about economic developments in China and in Japan, while the U.S. faces its own long-term problems, including the demographic challenges associated with Medicare and Social Security. Furthermore, we think that it is important to not overlook potential geopolitical risks, which are most pronounced in Egypt, Syria and in North Korea, which could have a material impact on financial markets globally.
Q: What kind of impact might this have on interest rates?
Ivascyn: In PIMCO’s view, the sell-off has likely been overdone. It’s important to recognize the difference between tapering and tightening. The latter is critical to bond prices, yet the unemployment rate remains well above the Fed’s 6.5% threshold, and inflation is at a 50-year low. So while we may see some tapering, possibly later this year, the central bank is likely to remain accommodative for several years. Rates will certainly fluctuate over the short term – for example, we’ve seen considerable volatility in 10-year Treasuries – but we believe U.S. growth will underperform Fed expectations. Should that happen, and GDP data disappoint, yields would be expected to decline.
Q: How are you structuring the strategy as a result?
Murata: Given the objectives of generating consistent income and preserving principal, we are looking for the best income ideas in the global fixed income markets. In pursuing these goals, we have divided the strategy into two components: a higher-yielding segment, which we would expect to benefit from stronger economic growth, accompanied by higher interest rates; and a higher-quality segment that should benefit from weaker economic growth and lower interest rates. Asset classes more likely to do well in a stronger growth environment include U.S. non-agency mortgage-backed securities and senior secured bank loans; on the other hand, we would expect Australian interest rate exposure to fare better in a weaker growth environment.
Q: How did PIMCO Income Strategy fare in this environment?
Ivascyn: As active investment managers, it’s PIMCO’s job to ably navigate changing market conditions on behalf of our clients – something we as a firm have been doing for more than four decades. In the Income Strategy, our goal is to generate a high income stream that can be sustained over time. That means we won’t compromise capital by reaching for yield, even in today’s low yield environment. Rather, we have been reducing credit risk in the strategy for some time by being generally defensive – for example, underweighting duration and emphasizing securities more senior in the capital structure. Yet we are selectively opportunistic by investing in higher risk sectors to meet our objective of generating an attractive income level.
Q: What role can the Income Strategy play in a broader fixed income allocation?
Ivascyn: Many investors are seeking income to help meet expenses – a population that will obviously be increasing as baby boomers retire. At the same time, generating a high, sustainable income stream has become much more difficult as yields have fallen and risks have gone up. So, dedicating a portion of your fixed income allocation to an income strategy that actively targets both a consistent distribution and risk management can make a lot of sense. Finally, because the Income Strategy’s investment universe and strategy differ somewhat from that of most core bond funds, it can also serve as a diversifier within an overall fixed income portfolio. Although it’s important to note that diversification can’t guarantee against loss.
Q: What steps are you taking to navigate this uncertainty?
Murata: This is a major focus for PIMCO and our team. Currently, we are very concerned about the negative impact of weak economic conditions and potential downside risks. In addition, we are concerned about the potential volatility that may result from unprecedented monetary policy. Both may have a strong impact on interest rates, and we have a number of tools at our disposal to help us position for and navigate changes caused by this uncertain environment. Among them is the ability to actively manage duration; the strategy has a duration range of zero to eight years, giving us broad latitude to decrease or increase overall interest rate sensitivity based on our economic forecast.
It is also important to recognize that many bonds have the potential to perform well if rates increase. For example, floating rate securities, which are well represented in the portfolio, have coupons that reset to prevailing interest rates and so may actually benefit. And as I mentioned, higher interest rates are typically correlated with robust economic growth and higher home prices, which would be a positive for the portion of the portfolio invested in higher-yielding assets. In addition, under these conditions, higher yields would eventually boost reinvestment rates, potentially resulting in an increased distribution for the strategy over time.
Q: Where are you finding opportunities in the current market environment?
Murata: The Income Strategy’s flexibility and robust credit research infrastructure allow us to invest wherever we identify attractive risk-adjusted opportunities. Given our outlook for continued sluggishness in the global economy, we are targeting securities that have the potential to deliver attractive current income even if weakness persists.
One area that we’re examining closely is U.S. agency mortgage-backed securities, which benefit from backing by an agency such as Fannie Mae. The sector was hit particularly hard during the sell-off in May and June, in large part due to selling by REITs that employ substantial amounts of leverage. As a result, we’re seeing some value there.