PIMCO recently introduced the Global Low Duration Real Return Strategy, a global approach to real return investing with a focus on lower-maturity
inflation-linked sovereign bonds.
In the following interview, portfolio manager Jeremie Banet and product manager Berdibek Ahmedov discuss the potential benefits of a shorter-dated global
real return strategy, the differences between this approach and more traditional inflation hedging and applications of this strategy within an investor’s
Q: Why have you created the PIMCO Global Low Duration Real Return Strategy? How does the new strategy differ from your flagship Global Real Return
We launched this new strategy to enable investors to obtain a strategic exposure to global inflation-linked bonds (ILBs) as an asset class but with a
structurally lower real interest rate risk profile than traditional approaches. The strategy is unique because it is based on a global ILB index comprising
developed sovereign bonds with maturities between one and five years. By anchoring the portfolio duration on this benchmark, the strategy maintains a
structurally lower real duration vis-à-vis traditional ILB strategies that use benchmarks spanning the entirety of ILB curves. In that sense, this is a low
duration version of our flagship Global Real Return Strategy that we have been managing for more than 10 years.
The choice of benchmark for this new strategy enables investors to substantially shorten the duration of their global ILB allocations (see Figure 1), which
results in a lower risk profile overall. However, similar to our Global Real Return Strategy, investors potentially benefit from a global investment
opportunity set, consistent real returns, inflation protection and portfolio diversification characteristics of global inflation-linked bonds. Importantly,
this is also an actively managed strategy, and we will use our proven expertise in navigating the intricacies of the global inflation-linked markets in
order to target consistent excess returns relative to the benchmark.
Q: Which types of investors would find this strategy suitable?
Primarily, we created the Global Low Duration Real Return Strategy for investors who want inflation-linked bond allocations but desire a lower real
duration profile than traditional ILB strategies. For investors with existing allocations, the strategy can help mitigate potential return headwinds from
rising real rates. Furthermore, through a combination of our flagship Global Real Return Strategy and this low duration version, investors are able to
tailor their allocations to a desired real duration target.
Investors who traditionally favour low duration fixed income strategies could find this an attractive proposition to improve portfolio diversification and
also help enhance after-inflation returns by explicitly hedging inflation risks. Traditional low duration strategies may not benefit from or hedge against
certain inflationary environments (the first half of 2008 and early 2011 are recent examples), and a low duration ILB strategy could help plug that gap in
Moreover, in today’s financially repressed and low-yielding environment where cash and cash-equivalent portfolio allocations are returning close to zero,
this strategy can help investors preserve real purchasing power by moving out modestly on the term structure without introducing undue volatility.
Property and casualty (P&C) insurance companies may also look to the Global Low Duration Real Return Strategy to diversify their traditional, low
duration nominal and corporate bond holdings. P&C insurers tend to have relatively low duration liabilities with some implicit or explicit inflation
linkage and could find this a suitable solution to hedge the inherent inflation risks as well as to boost the inflation sensitivity of their portfolios.
Q: Inflation has been trending lower recently. What is PIMCO’s outlook for inflation over the cyclical and secular horizons?
In 2014 we expect inflation in the developed countries to remain subdued, but we think in most regions inflation has bottomed. Beyond 2014, however, we see
inflation risks as being generally skewed to the upside.
In the US, this year we forecast that the consumer price index (CPI) will move above 2%, led by higher shelter costs. Still, we expect core PCE, the Fed’s
preferred inflation gauge, will remain short of their 2% inflation target, ticking up from 1.1% to 1.6%. In the UK, we expect CPI to be steady at about the
2% target. In Europe too, we expect inflation to tick up from a 0.7% low to 1% or slightly above. In Japan, the sharp depreciation in the yen has already
passed through to inflation. With both the fiscal and monetary authorities committed to the Abenomics programme, inflation is an important risk factor and
likely to rise further.
Overall, this gives all the large developed central banks room and reason to maintain a dovish stance. This posture, however, could well yield higher
inflation pressures over the secular term.
In emerging markets, the shift toward stimulating domestic demand as the more important driver of growth implies the end of the multi-year trend of
emerging markets exporting disinflation.
Q: How have you positioned the strategy to reflect the inflation outlook? What investment themes are embedded?
In the US as well as in Europe, we believe inflation implied by linkers is below our forecast for the next few years. For example, we have an overweight to
German inflation-linked bonds because the market has priced in extremely low inflation, well below our expectations. Similarly, in the US, TIPS (Treasury
Inflation-Protected Securities) imply core CPI will stay at 1.6% when we expect it to move to 2% later this year. Thus we favour maintaining a long
exposure to breakeven inflation rates. We find intermediate maturity US inflation breakevens highly attractive today.
We expect central banks to keep rates lower for longer and normalise rates gradually. That means positioning on the attractive parts of real yield curves,
which are historically steep. The primary example here is the US TIPS curve, where we favour holding TIPS on the intermediate part of the curve in an
effort to benefit from attractive roll-down. This part of the curve is particularly attractive as it underperformed the wings in the sell-off last year.
From a broader asset allocation point of view, although ILB markets on the whole fully price in the subdued inflation outlook over the next few months,
longer-term inflation risks are not reflected. Therefore, we believe it may be a good time to start building allocations to inflation bonds. The secular
journey from currently low inflation toward higher inflation – and even the cyclical journey from well-below-target to at- or about-target inflation – is
likely to be beneficial for holders of inflation bonds.
Q: Which countries do you favour in the strategy?
Right now our favourite market is US TIPS. After the sell-off last year, TIPS are offering comparably higher yields than their European counterparts.
We also like the real yield pickup on New Zealand and Australian ILBs versus other markets. They offer positive real yields backed by strong sovereign
balance sheets and a more favourable macro backdrop for inflation. Within Europe, we have an overweight to German inflation-linked bonds and Italian ILBs,
which we prefer to French linkers. We believe French bonds don’t have a sufficient credit premium over Germany. What’s more, valuation of the French
CPI-linked part of the market remains distorted by domestic technical factors.
Q: How is the Global Low Duration Real Return Strategy able to navigate a rising rate environment?
Active management will be key for managing duration risk in times of rising rates. In addition to the buffer from structurally low duration, the new
strategy benefits from guideline flexibility and from PIMCO’s expertise in managing interest rate risk. If we anticipate rates will rise, we can
underweight duration by as much as two years, compared with the benchmark duration, which is currently about 2.8 years.
Also, because rising rates are usually preceded by rising inflation, we think an increase in inflation rates would largely offset potential headwinds from
Q: How does PIMCO’s investment process inform this strategy?
PIMCO’s investment process is integral to the management of this strategy, as it has been for our Global Real Return Strategy. Our positioning will reflect
both our top-down and bottom-up views. And we’ll fully tap into the insights we get from our regular forums and investment committee deliberations.
Another unique strength is PIMCO’s real return team, which brings together expertise in both global inflation-linked and commodity markets. These insights
are crucial to our views on the likely path of inflation rates: Inflation expectations and therefore relative valuations of shorter-dated inflation-linked
bonds tend to be closely correlated with changes in commodity prices (see Figure 2).
Q: How might the PIMCO Global Low Duration Real Return Strategy feature within an investor’s asset allocation?
The strategy would fit well in a portfolio’s inflation-hedging bucket. Investors who are concerned about rising rates can also use the strategy on a
tactical basis. And some investors may prefer to hold a low duration linker strategy instead of a full duration linker strategy. Bottom line: For real
return investors, the strategy can be a lower duration alternative; for short-end fixed income investors, it’s an inflation hedging opportunity.