Strategy Spotlight

PIMCO's Real Return Limited Duration Strategy: Preparing for Inflation as Rates Rise

Higher short-term real yields make investing in low-duration TIPS more attractive now than during most of the past five years.

As the Federal Reserve is expected to embark on the journey to normalize interest rates, five-year U.S. Treasury real yields have finally moved back into positive territory. After many years of financial repression ‒ interest rates on savings below the rate of inflation ‒ investors can now take advantage of this opportunity in an actively managed portfolio. To that end, PIMCO offers the Real Return Limited Duration Strategy, the lower-duration sister to PIMCO’s flagship Real Return Strategy.

Higher short-term real yields make investing in a short-duration portfolio of Treasury Inflation-Protected Securities (TIPS) more attractive now than during most of the past five years. In addition to more attractive real yields, inflation expectations, which are expressed in the “breakeven rate”– the difference between the yield on TIPS and the yield on a comparable nominal U.S. Treasury bond – are near record lows; all else being equal, the lower the inflation expectations, the greater the chance that inflation will come in higher and the total returns on TIPS can exceed expectations (Figure 2).

Today, short-term TIPS can offer inexpensive hedging against various sources of potential future inflation, like a global increase in monetary easing or a rebound in commodity prices. Falling commodity prices have been the main reason why headline inflation has remained so low recently. But at today’s depressed levels, commodity prices actually pose a concern for future inflation. Within a little over a year, commodities have lost about 35% in value, reaching levels we haven’t seen for over a decade (Figure 3). Even though we believe a repeat of the commodity super-cycle of the mid-2000s is unlikely, we also believe that current depressed commodity prices are unsustainable and will incur a supply response through a reduction in capital expenditure – ultimately leading back to a more balanced market and higher prices.

The potential benefits of investing in lower-duration TIPS
Because of their lower duration, shorter-term TIPS naturally have lower interest rate sensitivity and lower volatility than longer-term TIPS. Shorter-duration TIPS have another important potential benefit for investors: Their returns tend to have a higher correlation to both absolute levels of inflation and changes in inflation compared to their longer-duration counterparts (Figure 4). While principal on all TIPS adjusts one-for-one with realized inflation (based on the Consumer Price Index, or CPI), total returns on TIPS are also influenced by changes in real yields. This effect can temporarily “dilute” the direct linkage between CPI and TIPS returns and is more pronounced with longer-duration TIPS. Because lower-duration TIPS are less affected, they tend to have a higher correlation to realized CPI.

Of course, there are trade-offs between short- and full-duration TIPS. The longer-duration TIPS index offers both higher real yields, as investors can earn a higher term premium, and more protection from changes in inflation expectations (rather than realized inflation). For example, when inflation expectations increase (breakeven rates widen or rise), the greater the potential benefit for portfolios with more breakeven (TIPS) duration.

Why index selection matters in low-duration TIPS accounts
For the Real Return Limited Duration Strategy, we have chosen the Barclays 1-5 year TIPS index as our benchmark rather than a 0-5 year index because we believe TIPS with slightly higher maturities offer investors better inflation hedging. For TIPS with maturities of less than a year, and especially less than three months, inflation hedging is significantly reduced due to the two-to-three-month time lag between the CPI printing and its accrual to TIPS; in the final two to three months before maturity, TIPS therefore tend to trade much like nominal Treasury bonds without any linkage to CPI. By focusing on the one-to-five-year segment and avoiding these ultra-short TIPS, every single TIPS in the index can benefit from increases in CPI.

Adding value in managing low-duration TIPS
The PIMCO Real Return Limited Duration Strategy is designed to fully benefit from the same active TIPS management we employ in the PIMCO Real Return Strategy: It is managed by the same portfolio management team and leverages PIMCO’s time-tested investment process and global resources in an effort to successfully navigate the world of inflation-linked bonds (see Figure 5).

Because low-duration TIPS tend to have a higher correlation to headline CPI, accurately anticipating headline CPI is a crucial piece in managing short TIPS to generate value for investors. PIMCO’s unique integrated real return desk, which intrinsically combines inflation-linked bond management with commodities management, has allowed us to build more robust bottom-up inflation models, recognizing that commodity price changes are responsible for most of the changes in headline CPI.

Figure 6 illustrates the importance food and energy prices play in any changes to CPI. Even though food and energy costs represent only about a quarter of the overall consumption basket, the two categories have been responsible for over 80% of the volatility in CPI.

Why now?
As investors prepare for rising rates and a potential rise in inflation in the U.S, PIMCO’s Real Return Limited Duration Strategy seeks to provide lower structural interest rate sensitivity while maintaining a full inflation hedge. By focusing on TIPS in the one- to five-year segment, the strategy offers a high correlation to realized CPI, and aims to take advantage of today’s positive real yields combined with attractively priced inflation expectations. PIMCO’s Real Return Limited Duration Strategy is also designed to benefit from the same time-tested investment process and portfolio management team as PIMCO’s flagship Real Return Strategy.

Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting Please read them carefully before you invest or send money.

The Author

Jeremie Banet

Portfolio Manager, Real Return

Klaus Thuerbach

Product Manager, Real Return


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. 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. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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.

Duration is the measure of a bond's price sensitivity to interest rates and is expressed in years. 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.

Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays U.S. TIPS Index is an unmanaged market index comprised of all U.S. Treasury Inflation Protected Securities rated investment grade (Baa3 or better), have at least one year to final maturity, and at least $250 million par amount outstanding. Performance data for this index prior to 10/97 represents returns of the Barclays Inflation Notes Index. The Consumer Price Index (CPI) is an unmanaged index representing the rate of inflation of the U.S. consumer prices as determined by the U.S. Department of Labor Statistics. There can be no guarantee that the CPI or other indexes will reflect the exact level of inflation at any given time. It is not possible to invest directly in an unmanaged index.

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