In the following interview, Eve Tournier, portfolio manager and head of pan-European credit portfolio management, and Loren Sageser, product manager, discuss how PIMCO’s Diversified Income Strategy has evolved over the past 12 months, and where it is finding attractive global credit opportunities within The New Neutral paradigm.
Q: How was PIMCO’s Diversified Income Strategy positioned for 2013?
Sageser: Across global credit sectors, high yield bonds were the top performers in 2013, generating returns of 6% (according to research by BofA Merrill Lynch as of 31 May 2014). While the strategy benefited from its high yield exposure, investment grade credit and emerging market bonds did not perform as well on an absolute basis last year, returning 0% and -6%, respectively (based on data from J.P. Morgan and Barclays as of 31 May 2014). Both credit sectors were negatively impacted by the rise in U.S. rates during May and June, while emerging markets also suffered disproportionately from investor outflows.
Because the strategy takes a diversified approach to global credit and manages to a benchmark consisting of one-third high yield, one-third investment grade and one-third emerging markets, the weak performance in investment grade and emerging markets translated into weak absolute returns for the strategy overall.
However, the strategy has benefited from its flexibility and ability to tactically allocate to non-traditional credit sectors. For example, in 2013, we transitioned out of emerging market local debt and currency exposures and in turn increased allocations to bank capital, European peripheral debt and non-agency mortgages. These allocations largely made up for the underperformance the strategy experienced in its tactical emerging markets exposure.
Longer term, we think investors will be rewarded for maintaining a diversified allocation to credit because it has historically led to a more predictable and less volatile return profile. Indeed, we have already seen the relative value pendulum swing back towards emerging market bonds, which have handily outperformed high yield bonds year-to-date (according to research by J.P. Morgan, Bank of America Merrill Lynch as of 30 May 2014).
Q: How have your investment strategies evolved in 2014?
Tournier: For PIMCO’s Diversified Income Strategy, 2014 is off to a great start. Through the end of May, the strategy has generated absolute returns which have exceeded high yield indexes. More importantly, the strategy’s yield remains comparable to high yield levels, but with a more diversified higher credit quality portfolio.
The main contribution to the strategy’s performance this year has been our tactical allocation to emerging markets. By year-end 2013, we thought that – after 18 months of continuous declines – emerging market debt was priced at attractive levels. The timing was fortuitous as investor sentiment towards emerging markets became more positive in the first quarter of 2014, causing spreads to tighten and emerging market bonds to rally. And despite the nice upswing in emerging market performance this year, we still think that there will be good upside opportunities in this sector. For example, we believe that Russia in particular presents a compelling relative value as negative investor sentiment seems to have overshot on the downside. While the increase in geopolitical risk has led Russian debt to underperform year-to-date, we see many quasi-sovereign Russian corporates with robust credit fundamentals offering attractive yields.
Although the strategy was negatively impacted by holding Russian debt prior to the start of the crisis in Ukraine, we believe that our focus on fundamentals will be rewarded as investor sentiment continues to improve.
Overall, 2014 has thus far demonstrated the importance of staying diversified in our approach to global credit investing. We continue to see good opportunities for investors who have the tactical flexibility to take advantage of relative value dislocations in global credit markets.
Q: So, what are our current investment themes in the strategy?
Tournier: As previously noted, we believe that emerging market debt continues to represent an important source of yield and potential growth. Many emerging market debt issuers with strong underlying fundamentals and high growth prospects offer higher yields than their developed market counterparts, suggesting that there are still compelling relative value opportunities in this space. However, we are taking care to avoid emerging market countries that, despite recent outperformance, suffer from weak fundamentals and are susceptible to external capital shocks. We continue to work closely with PIMCO’s global team of country specialists and credit analysts to ensure that the credits we select for the strategy demonstrate an optimal balance of risk and return.
Looking at housing markets, we think that there is still upside from betting on the recovery of the U.S. housing sector, and continue to see attractive yields in the non-agency residential mortgage space. We also continue to favour financial issuers, because we think large multi-national banks will continue to deleverage their balance sheets due to regulatory pressure in both the U.S. and Europe (see Figure 1).
As they deleverage, we expect subordinate bonds – debt issued lower in the capital structure – to outperform more senior-level bonds of these financial issuers. These subordinate bonds also offer a nice boost in yield, which is a precious commodity in today’s low yield environment.
Recently, there has been a lot of new issuance of corporate hybrids. These are debt instruments typically issued by high quality corporations which include equity-like features, such as a junior position in the capital structure or greater optionality. For issuers with lower default risk, we think corporate hybrids are another useful way to enhance the strategy’s yield profile without taking on too much downside risk.
Within the high yield corporate space, we currently favour short-dated bonds which mature within the next two to three years, since we believe that near-term default risk is low. Indeed, many high yield borrowers have taken advantage of the low rate environment and have refinanced their debt maturities well into the future (see Figure 2).
This focus on short-term bonds has also allowed us to lower the overall duration (or sensitivity to interest rate movements) of the strategy, leading to less downside risk in the event of a rise in interest rates.
Q: Many fixed income investors have been focused on a potential rise in interest rates in the U.S. and the UK, and the impact this could have on their bond portfolios. How have you addressed this risk in the strategy?
Sageser: Global credit issuers, such as corporations and emerging market governments, generally represent less rising rate risk than developed market government bonds, since they pay an additional credit spread which is not directly linked to changes in interest rates. We also have the added flexibility of being able to lower the strategy’s overall interest rate sensitivity based on PIMCO’s forward-looking view on interest rates.
For those investors who are interested in completely removing interest rate risk from their bond allocation, we also offer a version of the strategy which targets a duration of less than one year.
Q: Given PIMCO’s expectation for The New Neutral of low nominal growth coupled with high debt levels, what is your outlook going forward?
Tournier: The investment implications of PIMCO’s New Neutral outlook are characterised by a multi-speed world of global economies converging to lower – yet more stable – growth rates and contained inflation. Corporations have benefited from lower yields, and PIMCO expects them to be big beneficiaries of The New Neutral environment. The ability to borrow at such low rates will exert a strong tailwind for credit issuers, assuming profits remain stable.
However, the ability for investors to generate outperformance by picking winners and avoiding losers will be even more critical in this low rate world. It will also be increasingly important to be highly flexible, tapping into a global opportunity set and taking advantage of relative value opportunities across credit sectors by being tactical in your investment approach.
With that in mind, we plan to capitalise on the built-in flexibility of the strategy – as well as on PIMCO’s broad, global platform – to identify these current and developing opportunities, and to put them to work in PIMCO’s Diversified Income Strategy.