Investors Need to Pivot
March 20, 2013
by William Benz
- Fixed income investors need to think differently in the current environment.
- Investors may want to consider pivoting to strategies that are less focused on traditional benchmarks and more oriented to generating income and providing greater flexibility to hedge against rising rates, widening credit spreads or higher inflation.
- With interest rates near historical lows, and return expectations broadly diminished, investors seeking to meet yield or return targets may want to include strategies that specifically target income and flexible, relatively liquid absolute inflation-adjusted returns in their investment portfolios.
What hasn’t changed much are the underlying reasons investors look to fixed income. Yes, there’s been some evolution over time, and yes, investors are increasingly differentiating among types of fixed income based on their own unique situations and needs. Yet, in general, investors have continued to own if not increase their allocations to bonds for one or more of the following reasons:
- Total return/absolute return
- Inflation/deflation hedge
- Liability management
At PIMCO we talk about the need to “pivot” in terms of changing the way we think about markets and investment strategies as well as the way we serve our clients. For example, while some investors may be tempted to move away from their traditional core fixed income allocations into equities and higher risk alternatives, they may be better served by first rethinking or redefining their definition of “core.” For most investors, core fixed income means a benchmark-driven allocation to intermediate-duration, multi-sector, multi-country and/or multi-currency bonds – an approach that has basically served them very well over the past 10, 20, or even more years. But is this the best way forward? For some, perhaps, especially those who are willing to expand their opportunity set and consider more forward-looking (e.g., GDP- rather than market value-weighted) indexes. But, for many, probably not.
Figure 1 attempts to capture the concept of pivoting, albeit in a simplistic manner. It starts with the 20-year to 30-year super-secular decline in longer-term government bond yields; the 10-year U.S. Treasury yield, for example, fell from a yield of 10.8% at the beginning of 1980 to less than 2% today supporting many asset classes. For the most part, this was a great time to be in a wide variety of securities – including a variety of bonds, first governments, then credit, emerging markets, mortgage-backed and asset-backed securities, as well as equities all of which had broad outperformance and provided robust real returns during this period. But now, with interest rates near historical lows, and return expectations broadly diminished, investors seeking to meet yield or return targets may want to include strategies that specifically target income and flexible, relatively liquid absolute inflation-adjusted returns in their investment portfolios. And at some point in the next few years, they will likely want to pivot further and add more sectors traditionally viewed as inflation hedges as the impact of accommodative central bank monetary policies worldwide takes root. Indeed, we’re already seeing some investors moving in this direction.
But now we’re entering a new era when bonds will likely struggle to fulfill at least parts of their primary mission. This isn't to say that bonds won't continue to play an important role in portfolios. They most certainly will. But in anticipation of secular shifts in the years ahead, including eventual rises in interest rates and inflation, we believe investors can benefit from pivoting and rethinking their approach to the fixed income sector – particularly as they look to achieve their income and absolute return objectives.
For investors who are concerned with low yields and an inability to meet their income needs, pivoting toward an income- or yield-based approach may make sense. This doesn't imply a wholesale shift toward high yield and riskier sectors, but it does suggest potentially moving away from a portfolio built using the standard intermediate duration benchmark toward a portfolio that is less tied to a benchmark in an effort to more effectively meet specific income targets with the goal of delivering income rather than simply matching the bond market’s total return over time.
For those with intermediate benchmarks who worry about the risk of rising interest rates, a more flexible duration approach may make sense – one that is still multi-sector, multi-country and multi-currency, but one that also has the ability to go to a short or even negative duration to hedge against, if not benefit from, rising rates. This would be more of an absolute return investment style targeting a specific return goal over Libor, depending on an investor's objectives, along with ample liquidity such that it remains a key component of the core bond allocation.
Investors with intermediate credit-based benchmarks may also want to hedge against rising rates, or widening spreads, and similarly shift to a more flexible, benchmark-agnostic style that allows for shorter durations, short credit positions and/or the ability to move across different spread sectors, such as investment grade versus high yield. Again, this would be an absolute return strategy with ready liquidity and relatively modest single-digit return targets, rather than the double-digit targets generally found in the hedge fund or alternatives space.
Those worried most about inflation might look to shift their core nominal bond positions toward real return-oriented strategies by moving directly from nominal instruments into inflation-linked securities. Alternatively, investors might consider an allocation to emerging market currencies which may respond positively to inflationary pressures in the developed world. If inflation stems from a decline in reserve currencies like the U.S. dollar, euro, and Japanese yen, EM currencies—particularly in countries with healthy fundamentals—are likely to appreciate in response, providing a hedge.
Investors may also simply allow portfolio managers more investing flexibility in their portfolios. This always sounds counterintuitive. Yet, if yields have indeed troughed and are destined to embark on a secular journey higher, adding additional tools is probably the best, if not the only, way to provide necessary income, meet required return objectives and hedge against downside risk.
In summary, fixed income investors need to think differently in this environment, potentially pivoting to strategies that are less focused on traditional benchmarks and more oriented to generating income and providing greater flexibility to hedge against rising rates, widening credit spreads or higher inflation. The same can be said for equity investors – and even more so for multi-asset investors – in terms of expanding the opportunity set and moving away from traditional benchmark investing. It's a new era … and it may be time to pivot.
Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Investing in the bond market is subject to certain risks, including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. Commodities contain heightened risk including market, political, regulatory and natural conditions, and may not be suitable for all investors. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. 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. 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. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. © 2013, PIMCO.