t’s a challenging time for fixed income investors. “Risk-free” bonds globally are yielding close to zero – or in some cases below zero. Yet global bond markets offer many other sources of potential return beyond long-only interest rate exposure. In the following interview, Marc Seidner, CIO Non-traditional Strategies, who recently assumed the role of lead portfolio manager for PIMCO’s Unconstrained Bond Strategy, explains how PIMCO’s unique approach creates the potential for harvesting attractive absolute returns in a manner that both diversifies interest rate risk and retains some of the key characteristics of core bonds that investors rely on in their total portfolio.
Q: Why should investors consider benchmark-agnostic fixed income approaches such as PIMCO’s Unconstrained Bond Strategy?
Seidner: Investors in traditional bond approaches face a problem. Central bank intervention has pushed yields on government bonds and other high-quality sectors to historically low levels and, in an increasing number of markets and countries, nominal yields are actually negative. And these conditions are likely to persist. The latest entrant is the ECB, which just initiated a €1 trillion bond buying program, which is expected to extend through September 2016.
Low yields mean low return prospects for traditional bond strategies that are tethered to traditional benchmarks. That’s why many investors are diversifying their existing bond allocations with non-traditional fixed income strategies that employ other drivers of return.
Fortunately, there are numerous fixed income risk premia beyond interest rate exposure that we can harness in an unconstrained strategy. The unconstrained approach enables us to be more diversified and opportunistic across the spectrum of global fixed income risk premia, including interest rates, credit, volatility and currency, plus the ability to go long or short, in seeking attractive absolute returns that are untethered from traditional bond benchmarks.
Q: What differentiates PIMCO’s approach to unconstrained bond investing?
Seidner: The beauty of this product is its flexibility. But flexibility can be a double-edged sword. When we look within the non-traditional bond category, we see a very heterodox universe. One popular style replaces interest rate with credit risk. While this approach may increase yields and deliver attractive returns during certain stages of the cycle, it also tends to be highly correlated with equities and prone to large drawdowns. Investors should be wary of this trade-off, especially since an important strategic role of bonds is to help diversify equity risk in the context of the total portfolio.
By contrast, I would characterize our style as balanced. PIMCO’s investment process has for decades assessed the range of global fixed income risk factors – including interest rates, credit, volatility and currency. We also assess liquidity risk. As a result, the composition of our portfolios tends to be more diversified in general, or as I said, more balanced. Not only do we diversify across fixed income risk factors, but we also diversify across global regions and look to balance top-down macro strategies with bottom-up idiosyncratic or relative value positions. In doing so, we fully leverage the expertise of the unconstrained bond team and the deep bench of regional and sector specialists that comprise PIMCO’s global portfolio management team.
While we tend to be more diversified, on average, to be clear we’ll also take large positions, either long or short, whenever we have conviction. Importantly, though, our style doesn’t structurally rely on simply exchanging one risk concentration for another.
The result is an unconstrained bond approach that we believe has greater potential to deliver absolute returns across different stages of the cycle and to do so in a very high risk-adjusted manner and in a way that typically results in low-to-negative correlations to equities, which is an important characteristic for a bond investment to retain.
Q: Tell us about the unconstrained bond team at PIMCO and what in your view makes them uniquely qualified to manage a strategy like this?
Seidner: First, much of the credit for refining the strategy’s investment process should go to my four co-portfolio managers who were on the team before I joined. But, to answer your question, perhaps what is unique and most important is the team’s experience as portfolio managers. Make no mistake – ina highly discretionary product like this, experience matters.
The team I lead is among the most seasoned of any strategy managed by PIMCO. My co-PMs are Mohsen Fahmi, Dan Ivascyn, Sudi Mariappa and Mohit Mittal. All of us are managing directors, three of us are members of PIMCO’s Investment Committee, and two of us are among PIMCO’s seven CIOs: I am the CIO of Non-traditional Strategies and Dan is Group CIO of the firm. Each of us has a very accomplished background, and collectively we have more than 115 years of investment experience.
I believe this wealth of experience, individually and collectively, gives us three key advantages. First, it makes for a powerful combination of global, sector and bottom-up expertise. Second, it helps with sizing and scaling. This is critical. Even if you get most of your views right, you still have to size your positions appropriately so the impact of the inevitable losers doesn’t outweigh that of the winners. Having been through many market cycles and macro regimes, the group is particularly attuned to this important aspect. Lastly, our maturity makes us a relatively low-ego team. We’re not here to prove ourselves as individuals. Rather we operate in a collaborative manner, open to fresh ideas, and always with a focus on delivering results to our clients.
It really is a strong and seasoned team, and I’m proud to lead it.
Q: After leaving PIMCO in early 2014, why did you return, and how does being based in PIMCO’s New York office affect the way you work as a team with your Newport Beach-based colleagues?
Seidner: Personal reasons were a major factor in my decision to leave PIMCO for a position in Boston. However, I soon learned that you don’t really miss what you have until it’s gone. So when given the opportunity to return to PIMCO in the large and growing New York office, I jumped at it. In my view, PIMCO’s investment process, combined with the depth of talent here, creates an incredibly powerful approach that is unparalleled in the industry.
Working with the team from New York is easy. For one, I have personal relationships with my Unconstrained Bond Strategy colleagues and many others throughout the firm, having worked in Newport Beach for many years prior. As I noted, our team is quite mature and collaborative. Dan, Mohsen and I are on PIMCO’s Investment Committee, which means we’re at the center of the firm’s thinking, discussing and debating investment topics four days a week, two hours a day. The unconstrained bond team has a daily morning call and a weekly meeting, in addition to all of our ad hoc communication. And I’m back in Newport Beach at least once a month. So bottom line, we are extremely connected. Plus, I think working in different offices allows for diverse perspectives that can be valuable, especially in a flexible strategy like this.
Q: What are your current investment views, and how is the strategy positioned for the potential of rising interest rates in the U.S.?
Seidner: In short, our current positioning is designed to serve as an “antidote” for the key challenges facing traditional bond strategies. Most notably, we are short interest rates in the U.S. given today’s realities of low yields and high valuations. The U.S. is on the verge of Fed tightening, so we want our portfolio to benefit as yields move higher. In addition we are emphasizing a diverse set of other strategies that relate to the two dominant themes we see today: divergence and reflation.
By divergence we mean the sharp differences in growth and monetary policy trajectories across the developed world. The U.S. is clearly outperforming in terms of growth, in large part from having taken early and aggressive policy action in the aftermath of the financial crisis, whereas Europe embraced austerity. So today we see the U.S. removing monetary accommodation, whereas the parallel programs in Europe and Japan are on the upswing. The upshot is twofold. First, we believe the dollar will continue to outperform the euro and the yen, so that’s a key position. Second, as I mentioned, we are modestly short U.S. duration, both because of the monetary policy reversal and because of our second theme, reflation. However, we have long duration positions in eurozone peripherals, notably Italy and Spain, which we think will be supported by the ECB’s new QE program.
Reflation is a goal of all the major central banks, not only in response to the deflationary shock of the global financial crisis but also on the heels of the recent collapse in oil prices. Fortunately, we’ve been avoiding exposure to energy and have generally been short the currencies of commodity-producing countries. But as energy bottoms out, it may be time to pick up some of the pieces, including currencies of some emerging economies and exposure to the high yield market, where we have observed spreads widening for high-quality companies with little or no energy exposure, in sympathy with the energy-related issuers. We also think breakeven inflation rates on Treasury Inflation-Protected Securities (TIPS) have overshot following the massive oil decline, so we are adding positions there as well.
Q: How might investors think about incorporating PIMCO Unconstrained Bond Strategy into their existing asset allocation?
Seidner: Every investor has different objectives and constraints so the overall size and placement of PIMCO Unconstrained Bond Strategy in a portfolio will vary. In general, the strategy is designed to seek the traditional benefits of core bonds – modest volatility, equity diversification and capital preservation – but with its greater investment flexibility, it is designed to offer more absolute return potential over a cycle, with reduced interest rate risk. As such, it can serve as a diversifying complement to traditional core bond strategies. Today that benefit is more important than ever, and we believe using PIMCO Unconstrained Bond Strategy to help mitigate and diversify the high concentration of interest rate risk in traditional bond benchmarks makes sense. The low level of interest rates in the U.S., combined with sooner-rather-than-later Fed rate hikes, brings this issue to the fore.
While the most common use today is as a diversifying complement to traditional bond strategies, other investors may use the Unconstrained Bond Strategy as a liquid alternative, since we explicitly target absolute returns with lower average correlations to mainstream markets. Both uses are justifiable given the characteristics of the strategy.