Investors are finding it challenging to identify sufficient income-generating opportunities in an extraordinarily complex investment landscape, hampered by an environment of low yields and anemic growth. In the following interview, senior Portfolio Manager Dan Ivascyn discusses markets and how the PIMCO Income Strategy pursues attractive sources of income while also seeking the protection of capital and long-term growth potential.
Q: Amid concerns that global growth may remain subdued for years to come, do you anticipate low bond yields to become the norm for the foreseeable future?
Ivascyn: Bond yields have been declining on a secular basis and have now reached levels unimaginable to an earlier generation of investors. The decline has been driven by economic fundamentals, including more disciplined central banking and innovations in financial intermediation. More recently, the global financial crisis and its recessionary aftermath drove desired savings higher and triggered an aggressive monetary policy response by central banks, both of which have put further downward pressure on bond yields. Although we expect this combination of fundamentals and technicals to keep rates low for an extended period, we are also cognizant of the potential of brewing inflationary pressures over the longer term horizon.
Q: What does such a low bond yield environment mean for investors who seek income for retirement and other goals?
Ivascyn: In the current low yield world, investing solely in lowest-risk government bonds may not provide adequate sources of income to meet investors’ goals. At the same time, searching for yield by taking on increasing amounts of risk could expose investors to principal loss, the base upon which income is generated. As such, capital preservation must be a priority.
Q: Shifting gears to focus more on the PIMCO Income Strategy, which sectors and strategies do you find attractive in the present environment?
Ivascyn: While we remain concerned about systemic risks, we find pockets of value across the globe, and across the credit quality spectrum – both above- and below-investment grade. We are generally focusing on three high-level strategies in an effort to generate income. First, we are utilizing a global opportunity set to diversify the portfolio and to help identify the best sources of value in this uncertain economic environment. This provides us with the ability to identify interesting opportunities due to global deleveraging. Second, we are selectively targeting the most senior part of the capital structure, which can provide support in periods of prolonged market stress. In other words, in the event of a default or other credit event, other subordinated instruments would likely absorb losses before our holdings would be impaired. This is intended to provide investors with an additional layer of protection. Third, we focus on entities and regions of the world that have strong fundamentals. By that I mean that many corporations have deleveraged and cleaned up their balance sheets since the start of the credit crisis, enhancing their ability to repay debt; some developing countries have navigated the crisis and the period since effectively, further lowering their debt-to-GDP ratios from already low levels. PIMCO’s time-tested investment process and global infrastructure help us to identify income-generating opportunities, both from a macro perspective and through fundamental bottom-up credit selection. Of course, risk management plays an essential role throughout.
Using income-efficient portfolio management strategies, the Income Strategy has the ability to invest across the globe in all sectors of the fixed-income universe, including agency and non-agency mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), government bonds, inflation-linked issues, asset-backed securities (ABS), covered bonds, corporate bonds, bank loans and emerging market bonds. We believe this flexibility may allow for the generation of attractive income with less risk relative to a single-sector, single-country strategy where concentration risk could threaten capital in a tail-risk event. Given PIMCO’s guarded macroeconomic outlook, the Income Strategy has invested in more defensive risk assets. When allocating to investment grade corporates we emphasize sectors that tend to be recession-resistant, such as industrials and utilities. Select investments in high yield corporate bonds offer strong income-generation potential; however, we remain selective and focused on candidates for upgrade.
The strategy currently has a large allocation to senior non-agency MBS as well as agency MBS pass-throughs, which have generally offered attractive yields well above developed market sovereign bonds, but with similar credit quality. Agency pass-through securities are backed by residential mortgages and the Agencies reduce the risk of default to the holder by guaranteeing payments. Likewise, select senior non-agency MBS holdings continue to be attractively priced, delivering higher levels of income potential, buoyed by signs of a bottom in U.S. housing.
The Income Strategy continues to feature modest exposure to high quality developed and emerging market countries such as Australia, Brazil and Mexico that exhibit relatively little near-term debt maturities and a high level of reserves.
Q: How does the strategy navigate risk in this uncertain environment?
Ivascyn: Unlike many other income-oriented strategies, the strategy has a flexible approach, enabling it to tactically shift exposure from one country or sector to the next depending on where we believe the best income-generating opportunities are to be found. This flexibility allows the strategy to tap into a much broader opportunity set, allowing it to seek the best income-generating opportunities while actively managing portfolio risk.
Q: How do strategies get implemented within the Income Strategy?
Ivascyn: As a first step, the Income Strategy is governed by PIMCO’s investment process that starts from the top-down with our time-tested forum process. We hold our annual Secular Forum every May where the critical themes of the next three to five years are discussed. This is complemented by the quarterly Cyclical Forum, where the contours of the global business cycle are debated over the coming six to 12 months.
Building on this fundamental process, PIMCO’s 330+ strong portfolio management team, including 48 credit analysts and over 100 structured product resources, is charged with scouring the investment universe for mispriced issues, seeking to add value from the bottom-up. Finally, an independent risk team highlights the underlying sources of volatility across portfolios. It is the portfolio manager’s responsibility to construct a portfolio that is consistent with PIMCO’s top-down outlook and implements the credit analysts’ best bottom-up ideas.
Q: How do you evaluate sectors and securities from an income perspective?
Ivascyn: As an overlay to the standard PIMCO investment process, we apply an income-generating filter. This exemplifies the distinction of the Income Strategy compared to the way in which many other PIMCO strategies are managed: While the sole objective of most other PIMCO strategies is to maximize total return subject to benchmark-like risk, the Income Strategy’s primary objective is to maximize current income. While we strive to pay a consistent distribution, the Income Strategy’s secondary objective aims to achieve capital preservation and to maximize total return through capital gains, providing investors with long-term capital appreciation potential.
To this end, we utilize a proprietary system that projects the Income Strategy’s monthly income returns over the course of the year. This information helps us target a stable and consistent income flow which is intended to be used to fully pay monthly distributions, with the goal of leaving capital protected as a source of distributions. In other words, we view our clients in the strategy as generally income focused, but that does not mean they are willing to sacrifice capital to arrive at their respective income goal. We work diligently to preserve principal as we pursue income.