Strategy Spotlight

Global Low Duration Real Return Strategy Targets Structurally Lower Real Duration​​

The strategy can be a lower-duration alternative for real return investors, or an inflation-hedging opportunity for short-end fixed income investors.

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 asset allocation.

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 Strategy?
Banet: 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?
Ahmedov: 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 their portfolios.

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?
Banet: 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?
Banet: 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?
Ahmedov: 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 rising rates.

Q: How does PIMCO’s investment process inform this strategy?
Banet: 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?
​Ahmedov: 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.

The Author

Berdibek Ahmedov

Product Manager, Unconstrained and Real Return

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results. 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. 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. 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. 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. 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. The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

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 long-term, especially during periods of downturn in the market. Strategy availability may be limited to certain investment vehicles; not all investment vehicles may be available to all investors. Investors should consult their investment professional prior to making an investment decision.

The Barclays World Government Inflation-Linked Bond (ILB) 1-5yr Index is a subset of the Barclays World Government Inflation-Linked All Maturities Bond Index. The Barclays World Government Inflation-Linked All Maturities Bond Index measures the performance of the major government inflation-linked bond markets. The index is designed to include only those markets in which a global government linker fund is likely to invest. This makes investability a key criterion for inclusion in the index. Markets currently included in the index (in the order of age) are, the UK (1981), Australia (1985), Canada (1991), Sweden (1994), U.S. (1997), France (1998) and Italy (2003). The S&P Goldman Sachs Commodity Index (S&P GSCI) is a composite index of commodity sector returns, representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. Inception Date: 12/31/69. It is not possible to invest directly in an unmanaged index.

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