Global central banks have been aggressive in their efforts to push investors out along the risk spectrum, attempting to reflate global markets by driving real returns on “risk-free” assets down to negative levels. However, memories of Lehman Brothers’ bankruptcy and the ensuing market seizure are still fresh in the minds of many investors, and there is an understandable reluctance to transition portfolios into more volatile asset classes. And so the search is on for “safe spread” – sectors that we believe are most likely to provide attractive yields while withstanding the fluctuations of a wide range of possible economic scenarios.
PIMCO’s Diversified Income Strategy – a diversified blend of corporate and emerging market sovereign securities from across the quality spectrum – seeks to offer a path to higher yields without taking on excessive additional risk. Many corporates and emerging market sovereigns offer attractive real yields and potentially lower levels of downside risk due to their historically strong balance sheets and relatively healthy growth prospects. By focusing on a diversified set of risk factors, attractive current yield and total return opportunities, the Diversified Income Strategy seeks to provide access to equity-like returns with lower levels of volatility.
The current market environment is particularly challenging, because greater investor demand for income-producing assets has helped drive bond yields lower for many asset classes. How can we position portfolios for potentially attractive returns and simultaneously look to preserve capital? PIMCO’s Diversified Income Strategy is designed to help investors confront this challenge.
Active management within a broad opportunity set
Within global credit sectors, risk and return generally reflect the ebb and flow of investor risk appetite, along with fundamental factors such as balance sheet strength and corporate profitability. For calendar year 2008, for example, high quality corporate bonds, as measured by the Barclays Global Aggregate Credit Index, dropped roughly 3% in value, while high yield bond investors experienced a stomach-churning drop of 24%, based on the Bank of America Merrill Lynch Global High Yield BB/B Rated 2% Constrained Index. The following year, the tables were turned as the high yield index advanced 50% for the calendar year versus a more modest 14% gain by the Barclays Global Aggregate.
The multisector credit portfolio of the Diversified Income Strategy can be proactively allocated to lower risk sectors in anticipation of an uptick in market volatility and to higher risk sectors as volatility declines. The strategy also has the flexibility to avoid sectors that have become expensive and to favor sectors that PIMCO believes may offer better relative value.
In addition to active sector rotation, the strategy takes a broad-based, global approach to credit investing. Why constrain a credit portfolio to developed market corporates, when similarly rated emerging market bonds may offer higher yields and better growth potential? Similarly, why focus solely on corporate bonds, when other sectors such as municipals, bank loans and non-agency mortgages may offer a similar (or better) return profile while providing an opportunity for greater risk diversification? By expanding the opportunity set, PIMCO’s Diversified Income Strategy may benefit from opportunities overlooked by more constrained approaches to credit investing. In addition, the strategy’s broad-based investment approach allows PIMCO greater scope to identify and invest in companies with attractive bottom-up credit fundamentals.
Potential opportunities: Falling interest rates in Brazil
PIMCO expects New Normal slow growth characteristics in much of the developed world, reinforced by the headwinds of eurozone austerity and periodic spikes in volatility. This has led to policy activism by many central banks, as they have focused on reflating financial assets in an effort to stimulate growth. In the developed world, policy rates are effectively at the zero bound and can go no lower, necessitating quantitative easing. By contrast, many emerging market countries have higher benchmark rates and hence greater degrees of freedom to lower rates. For example, Brazil’s benchmark rate exceeded 12% in 2011. As the global economy slowed during late 2011 and into 2012, interest rates fell steadily to 7.25% as of 31 December, as shown in Figure 1, which presented an opportunity for improved total return for investors in shorter duration Brazilian sovereign debt. As short-term rates fell, investors with economic exposure to short duration Brazilian debt saw the value of these positions rise – even amid deteriorating global economic conditions.
The housing sector
We have observed increasing demand for high yield bonds in 2012 as investors have been pushed out along the risk spectrum in search of positive real yields. While this has affected a wide variety of income-producing asset classes, not all global credit sectors have received the same level of investor attention. The Diversified Income Strategy aims to add value by investing in some of these overlooked sectors.
For example, many non-agency U.S. residential mortgage-backed securities (i.e., those not underwritten by government agencies such as Fannie Mae and Ginnie Mae) currently offer yield profiles similar to high yield bonds partly due to their structural complexity as well as their relative opacity and low liquidity. However, senior securities in these vehicles are typically structured to withstand severe losses in the underlying mortgages before experiencing significant losses themselves. In addition, with few new issues since the onset of the financial crisis, the supply of non-agency residential mortgage securitizations has become smaller each year as the principal on the securities amortizes.
As the U.S. housing market has shown nascent signs of recovery, shown in Figure 2, these bonds in general may offer opportunities for improved total return. In fact, even when assuming house price appreciation of close to zero over the next few years, PIMCO still finds that in many cases the risk-return trade-off for non-agency mortgages is more attractive than that for comparable high yield corporate bonds. That said, it is important to note that this is a highly idiosyncratic asset class that requires in-depth analysis of each underlying mortgage. With our expertise in the asset class and our analytical resources, PIMCO can rigorously assess the risks embedded in each of these securities.
Investment grade risk with attractive yield potential
At the higher end of the quality spectrum are U.S. municipal bonds, and PIMCO’s Diversified Income portfolios have the flexibility to include tactical allocations to this sector.
From a credit-picking perspective, the analysis required to understand, say, a Build America Bond for a toll road is similar to the process for assessing the risk of a natural gas pipeline operator. Because of differing supply-demand dynamics in the taxable municipal bond market relative to the investment grade corporate bond market, however, municipals often offer higher yields relative to similarly rated corporate bonds. In addition, tactically including municipal bonds within Diversified Income portfolios may allow for a greater level of overall diversification, a critical component of building portfolios for a variety of market environments.
Stable yet higher-yielding emerging markets
Emerging market countries with strong balance sheets, such as Brazil, Mexico and Russia, can be potentially attractive investments, combining the robust growth dynamics of the EM world often with lower volatility than many developed markets, due to better fundamentals and growth prospects. However, 2012’s broad-based credit rally has led to lower yields for many EM sovereigns.
Quasi-sovereign issuers – defined as emerging market corporates with greater than 50% state ownership – have also seen an impressive rally but in many cases still offer yields exceeding those of their parent countries by 0.5% to 1%. In a world dominated by anemic interest rates, an additional 1% can go a long way towards building a higher yielding portfolio.
Navigating between the troughs and the peaks
These examples highlight ways that PIMCO’s Diversified Income Strategy can potentially add yield to global credit portfolios while managing risk in different market environments. Today’s “safe harbor” can still be hit by tomorrow’s “perfect storm,” and as investors are all too aware, storms have appeared with some frequency in the New Normal. PIMCO believes that the Diversified Income Strategy’s highly flexible approach to global credit investing can help investors seek attractive returns and income without taking on elevated levels of risk.
In constructing our Diversified Income portfolios, we combine our robust, risk-focused process for top-down macroeconomic analysis with our rigorous bottom-up approach to credit. And with our broad, global investment platform, we can pursue a truly global approach to credit investing designed to provide both upside potential and diversification of risks.