PIMCO recently announced a new leadership structure with the appointment of a Group CIO and a team of five CIOs. Many of our liability-driven investment (LDI) clients are wondering how these senior leadership changes might affect our LDI business. In the following Q&A, we asked lead LDI portfolio managers Steve Rodosky, Mark Kiesel and Mohit Mittal and LDI product head Jim Moore to address this question and provide insight on how they will be managing pension strategies going forward.
Q: Which portfolio managers are involved in managing liability-driven investment (LDI) portfolios at PIMCO? Has this changed since Bill Gross’ departure?
Steve Rodosky: I oversee PIMCO’s long duration and LDI portfolio management, and during the seven years that I have led that effort, there has been little turnover among the portfolio managers who support me. In fact, our numbers have grown. As credit gradually became a more important component of LDI portfolios over the past several years, we have increased an already strong collaboration with the credit portfolio management team. Specifically, Mark Kiesel and Mohit Mittal have taken on lead portfolio responsibilities on the more credit-heavy LDI accounts. My team’s expertise and understanding of all the subtleties associated with managing at the long end of the curve, combined with Mark’s team’s unparalleled credit capabilities and resources, have enabled us to provide significant value to our clients over the years. This partnership remains intact. Furthermore, our implementation of LDI portfolios leverages a large cross-section of PIMCO’s more than 240 portfolio managers across several sectors of the bond market.
I would also like to emphasize that our LDI business is very much driven by our pension solutions experts in product management. These specialists work with our clients to identify and isolate the risks associated with their liability stream and develop customized investment strategies that address their unique objectives. As the three lead portfolio managers, Mark, Mohit and I, as well as Ed Devlin for our Canadian clients, come in at that point to discuss the client’s goals for alpha generation vis-à-vis tracking error tolerance relative to the plan liabilities. Given the collaboration across multiple teams required to manage LDI mandates at PIMCO, this is about as far from “key man” risk as you can get: This business line should be seen as very stable through transitions. In fact, only a small number of our LDI portfolios saw a change in lead portfolio manager as a result of Bill Gross’ departure.
Mark Kiesel: I completely agree with Steve. Our investment philosophy across LDI mandates is unchanged and is driven by our time-tested investment process. This process is firmwide and combines top-down themes, formulated at our cyclical and secular forums, with bottom-up security selection, implemented by our generalists and specialists, who draw on PIMCO’s best trade ideas from around the world. However, as Steve alluded to earlier, the degrees of freedom that we take relative to the LDI benchmark will be constrained by the client’s tolerance for tracking error versus their unique liabilities.
Mohit Mittal: Relative to a long duration benchmark, our strategy continues to involve positioning the portfolio for outperformance across a number of key risk factors, while still keeping the end client’s liabilities in mind. Among the most important of these factors are duration positioning, curve positioning, credit positioning, in-benchmark sector over- and underweights, out-of-benchmark exposures, exposure to volatility and individual security selection. Consistent with the broad goal of these portfolios, we do not overemphasize any single exposure, but seek to maintain a view across all these factors over time and use all of them to generate alpha for clients while closely tracking their liabilities.
Q: How are the liability-driven investment portfolios allocated between the three lead portfolio managers?
Jim Moore: Steve is the lead and dedicated portfolio manager for PIMCO’s LDI business, and he is the firm’s de facto expert on the long end of the yield curve (bond maturities longer than 10 years). In his role, Steve is responsible for managing a large share of U.S. LDI portfolios at the firm. Given that credit is an important part of many liability-driven investment benchmarks, Steve works very closely with Mark, Mohit and the investment grade credit team to make sure PIMCO’s best bottom-up ideas are incorporated into these portfolios and that the work of our very deep team of credit analysts is leveraged for the benefit of LDI investors.
For LDI mandates with a heavier credit focus, the roles are often flipped so that Mohit or Mark will take on lead portfolio management responsibility, working closely with Steve. Together, they will also consider inputs from other sector specialists as they construct LDI portfolios in order to incorporate best-in-class ideas and trade execution. We believe that achieving the right balance between the contributions of our dedicated LDI team members and those of our sector specialists ultimately leads to optimal portfolio construction.
Q: Mark, will your appointment as CIO Global Credit affect your day-to-day involvement in long credit portfolios?
Kiesel: No, there should not be a material impact. My portfolio management responsibilities have not changed, and I remain strongly committed to delivering the same value and successful performance that our long credit and investment grade clients have come to expect. It is critically important to remember that management of these portfolios has always been a team effort – one that relies on a deep bench of close to 100 bottom-up credit professionals. This enables me to focus my time and effort on evaluating investment ideas and portfolio construction. Let me be clear, I still make the final decisions on how to structure all the long credit portfolios on which I am lead portfolio manager, but the team plays an integral role in the generation of alpha and management of risk.
Q: How do you all work together to develop a portfolio’s investment strategy?
Rodosky: As Jim mentioned earlier, LDI portfolios benefit from the input of many portfolio managers beyond the three of us. I am responsible for adapting PIMCO’s top-down views to the unique realities of the long duration market and implementing those views in LDI portfolios, subject to a client’s guidelines, objectives and risk tolerance. At that point, Mark and Mohit’s expertise in bottom-up portfolio construction becomes crucial to achieve the optimal balance between macro risk exposures and security selection.
Mittal: It is also important to recognize that we work very much as a team managing LDI portfolios. While Steve focuses more on macro positioning and implementation at the long end, Mark and I are responsible for bottom-up positioning. Yet those decisions are not made in isolation. We collaborate to integrate top-down and bottom-up views in a cohesive fashion.
Kiesel: I would add that over time, the relative weight of top-down versus bottom-up strategies in portfolios may fluctuate depending on where we see most value in a given environment. This provides our clients with a very appealing investment approach that combines diversification across several alpha generation strategies with flexibility to adjust portfolio positioning to a specific market environment.
I want to emphasize Mohit’s point on credit selection. Long maturity credits are not as liquid as five-to-ten-year securities and have higher bid-ask costs. This is where our deep team of over 50 credit analysts comes in. With lots of boots on the ground and relationships with company management, we feel we can select and trade credits as well as or better than anyone.
Q: What is your outlook for liquidity in these strategies?
Rodosky: A lot has been written about liquidity challenges in long duration markets, especially as dealer balance sheets have become more constrained due to increasing regulations and scrutiny. When markets behave in an orderly fashion, liquidity in both the Treasury and credit markets is fair, but one has to be cautious when markets are gapping. With fewer dealers willing to warehouse risk, large trades will tend to leave a larger footprint in the market over the short term. Given that we pay very close attention to the liquidity of our portfolios, we will look to capitalize on opportunities that this may create.
Mittal: Adding to what Steve said, I think it is important to be cognizant of issues surrounding liquidity when markets are selling off. Overall market liquidity has improved significantly since 2009. For example, the bid-ask spread, or cost associated with both buying and selling the average investment grade corporate bond, is roughly one-fifth of what it was five years ago. Trading volumes and new issuance of long corporate bonds are also markedly higher. Having said that, the turnover in long credit markets has fallen and primary dealer activity in the secondary market has declined relative to, say, 2006–2007 (as measured using percentage of outstanding bonds). Regulation has likely had some impact, but as long as there is relative balance between buyers and sellers, liquidity conditions should continue to support regular market functioning and should not have a meaningful impact on security prices beyond their fundamental value. Finally, this decline in liquidity relative to 2006–2007 is also the reason why it is important to focus on detailed credit analysis while investing in long maturity corporate bonds. PIMCO’s credit team with approximately 100 analysts and portfolio managers is uniquely positioned on that front to add value to client portfolios.
Q: What is your near- and long-term outlook for the long end of the yield curve?
Rodosky: In the near term, we expect long-end yields to rise moderately. The economy is showing some broad-based strength, which should put upward pressure on rates. In addition, with the end of quantitative easing the Fed is ceasing their buyback program in which they purchased 41% and 86% of gross supply of U.S. Treasuries with maturities greater than 20 years in 2014 and 2013, respectively. Now the marginal price-setter for the increasing supply in the long end will become private investors, who will demand a concession to invest in a long duration product at such low yields. Finally, there is still a risk that we see an uptick in inflation, which would put upward pressure on long-end yields.
However, in the long term we see the Treasury market finding support at levels not too far from current rates. Slower global growth will anchor U.S. rates to some extent, we expect demand from liability-driven investors (pensions and insurance) to pick up as rates rise, and, keeping with our New Neutral thesis, we expect interest rates to remain historically low.
Kiesel: Overall, we remain constructive on long credit as both supply and demand of longer-maturity issues continue to grow. Demand is largely being driven by investors searching for yield given low U.S. Treasury rates and from large institutional players, specifically pensions and insurance companies, due to the need for asset-liability matching. On the supply side, we are seeing roughly $125 billion of issuance per year of long corporate bonds, coming from the need to finance things like capital expenditures and M&A activity, and we remain constructive on both in the U.S.
In short, we think the demand for credit will outweigh the supply. Valuations and fundamentals remain supportive for credit, but active management and credit selection will continue to play a meaningful role. We see opportunity in credits supported by a few common characteristics: companies that are likely to grow faster than the economy over the next few years, have attractive underlying assets and benefit from barriers to entry, which improve a company’s pricing power and financial flexibility.
Q: What other LDI resources are available for clients beyond portfolio management?
Moore: Over the last few years, many plan sponsors have taken a more dynamic and tailored approach to managing their plan investments. This has resulted in a desire for more customized and flexible approaches when structuring LDI mandates. In fact, we think the corporate DB world is really moving beyond LDI. LDI is a core element, but it is one piece of a pension risk management story. Accordingly, we have a deep and dedicated pension solutions team with diverse backgrounds and a breadth of expertise including actuarial science, risk management, derivatives, corporate finance, asset allocation and pension plan regulation. We have found that these capabilities become very useful in helping clients design optimal LDI strategies.
LDI is seldom a “set it and forget it” strategy and requires ongoing monitoring and guidance as plan liabilities change and plan sponsor needs evolve. Our pension solutions experts are frequently called on by clients and consultants to offer support on a wide range of matters such as liability-focused benchmark construction, glide path design, liability immunization, overlay implementation, asset allocation, evaluating annuitization or debt issuance to fund a plan, and overseeing completion management assignments.