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Unconstrained Bond Investing in The New Neutral

A lower neutral real policy rate has several implications for unconstrained bond investing.

At our recently concluded Secular Forum, PIMCO investment professionals from around the globe gathered in Newport Beach to discuss and debate the secular outlook for major world economies. With insight from guest speakers and new MBA/PhD hires, PIMCO coined the phrase The New Neutral to define its secular three- to five-year outlook for the world economies. In his most recent Investment Outlook, Bill Gross further elaborated on The New Neutral.

What are the key aspects of the New Neutral framework? We believe high financial leverage (aggregate government, household and corporate sector debt relative to GDP) and weakening demographics (the declining working age population relative to the aggregate population) in the U.S. and many other developed economies will result in a New Neutral real policy rate of around 0 basis points (bps) in most developed economies, instead of the 200–300 bps that most forecasts assume. A lower neutral real policy rate should benefit most asset valuations relative to traditionally assumed “fair value,” in our view – and this has several implications for unconstrained bond investing.

The benefits of active management in The New Neutral
As Carmen Reinhart highlighted in March 2011 (see ”The Liquidation of Government Debt,” by Carmen M. Reinhart and M. Belen Sbrancia, National Bureau of Economic Research), historically high debt/GDP ratios have been reduced by (a) austerity, (b) economic growth, (c) defaults, (d) inflation or (e) financial repression. Globally, there remains little appetite for austerity. Demographics in the developed world prevent an “old-normal”-like economic growth spurt. That leaves (c) defaults, (d) inflation and (e) financial repression as feasible means to reduce high debt burdens. We think a combination of these factors will characterize The New Neutral and lead to negative real returns on cash. While traditional beta returns will likely outperform cash, passive portfolios may suffer from a low Sharpe ratio driven by low real absolute returns. An active global unconstrained bond approach is designed to provide higher returns than traditional beta while maintaining lower volatility through a focus on higher real absolute return opportunities globally.

PIMCO’s approach to unconstrained bond investing since we began managing Unconstrained Bond Strategies in 2007 has focused on an absolute return orientation, a high Sharpe ratio and, most importantly, a dynamic allocation of risk across global markets where PIMCO has its highest convictions. The New Neutral period with the prospect for low real returns and a low risk premium in traditional markets offers attractive opportunities for PIMCO to add value to client portfolios through active management of risk.

Duration opportunities in developed and emerging markets
In the developed markets (DM), we expect neutral real policy rates to remain around 0 bps, driven by high debt and weakening demographics. The Federal Open Market Committee forecasts a roughly 2% real neutral fed funds rate. Many other developed market real rates are expected to rise to about 2% in the secular horizon. Given this difference in our outlook and central bank forecasts, we believe maintaining modest long developed market duration is an attractive way to enhance risk-adjusted returns in unconstrained portfolios.

In emerging markets (EM), implied forward real yields are higher relative to those in developed economies. Low expected real growth in developed markets combined with strong and improving balance sheets in these select emerging economies makes duration in these emerging economies attractive to hold in unconstrained portfolios.

We see several secular implications for credit
It is a common perception that as the U.S. economy recovers over the next three to five years, credit spreads should compress and low quality (high yield) should outperform high quality (investment grade). We disagree – The New Neutral is also characterized by low growth versus expectations. We expect real growth to hover around 2% over the secular horizon instead of around the “old normal” 3%. While we recognize that in The New Neutral central bank policies will likely succeed in clipping the left tail and preventing a large recession and massive defaults, we believe defaults in the low quality space will be higher than expectations given low real growth. Hence, our preference would be in high quality U.S. credit over low quality. In cases where we go into low quality, we plan to focus on shorter maturities to stay ahead of the anticipated pickup in defaults.

It remains important to focus on deleveraging in the credit space in The New Neutral, though low volatility, tight spreads and improved financial conditions are also conducive for increasing corporate sector leverage. Additionally, we believe areas tied to the housing recovery, like non-agency mortgages, offer better value than corporate high yield in The New Neutral.

In contrast to the U.S., the European Central Bank, through its announcements of Targeted Longer-Term Refinancing Operations (TLTRO) and non-sterilization of the Securities Markets Programme (SMP), in addition to cutting the deposit rate to negative, is finally acting on its long-ago stated words of “whatever it takes” to keep the eurozone united. Under a supportive central bank, peripheral European credit remains one of the few areas in the developed credit markets where spread compression remains a possibility. Within peripheral credit, our preference would be for sovereign, followed by financial and finally nonfinancial credit.

Many developed economies, suffering from high debt and weakening demographics, would lag many emerging economies, which have improving demographics and many of which have also successfully been deleveraging. Given these dynamics, emerging market credit offers attractive opportunities relative to many developed markets. Within emerging market credit, our preference is for sovereign followed by high quality quasi-sovereign financial and nonfinancial institutions while avoiding low-quality corporates that have been able to take advantage of the easy global financial conditions to increase leverage even as their default risk remains elevated.

EM currencies likely to benefit in The New Neutral
DM currencies, through low real yields, will remain the funding currencies for global investments. Japan should see more investments as policymakers try to engineer inflation while keeping real yields suppressed through quantitative easing programs. In Europe, while short-term inflows into peripheral credit to take advantage of ECB policies theoretically should support the currency, low long-term real yields should be negative for the currency. Mexico, Brazil, Korea, Poland and India’s currencies stand to benefit given high real yields, particularly if central bank policies there can manage to put a lid on inflation.

Unconstrained strategies can capitalize on bouts of market volatility
We expect low economic volatility in The New Neutral given the likelihood that debt and demographics prevent high “old-normal”-like growth while central bank policies may mitigate the left tail risks. The financial sector, however, can still exhibit periods of high volatility as central bank policies adjust and financial asset liquidity remains low given increased regulation limiting use of dealer balance sheets. In additional to focusing on duration, credit and currency, PIMCO’s approach to unconstrained investing also involves taking advantage of bouts of market volatility amid low expected real growth volatility in The New Neutral.

Summary

  • PIMCO’s The New Neutral is characterized by a convergence to modest trend growth rates, low volatility, low real rates, multi-speed global growth and low returns on financial assets.
  • PIMCO’s unconstrained approach to global fixed income investing is designed to help investors achieve returns that exceed traditional benchmark returns while maintaining lower volatility.
  • Our approach also utilizes all areas of global fixed income markets involving duration, credit, currency and volatility risks.
  • Currently, given the New Neutral outlook for the world economy, we like modest DM and EM duration, select DM high quality credit, European peripheral credit and EM sovereign and quasi-sovereign credit, select EM currencies and volatility exposure in an attempt to construct a global diversified unconstrained bond portfolio.

Disclosures

Past performance is not a guarantee or a reliable indicator of future results. Absolute return portfolios may not fully participate in strong positive market rallies. 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 the current low interest rate environment increases this risk. Current 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. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss. 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 suitable 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.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.

This material contains the opinions of the authors but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. 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 or registered trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. THE NEW NEUTRAL and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Pacific Investment Management Company LLC in the United States and throughout the world. ©2014, PIMCO.