With global growth slipping and significant uncertainty around trade and politics, PIMCO’s Income Fund is taking the long view and positioning defensively. Here, lead portfolio managers Dan Ivascyn, Alfred Murata, and Josh Anderson discuss their outlook and recent performance.
SUMMARY
- The risk remains that a deterioration of the economic landscape could be more significant than markets expect, and we see a high degree of fragility in the markets, especially in equity and credit.
- Yields on a significant portion of the fixed income universe are negative, putting pressure on many investors to take more risk than they may be comfortable with; this search for yield could support further excesses in certain market segments.
- In the Income Fund, we have the flexibility to construct a portfolio that may be meaningfully different from traditional bond indices, which is an advantage given the unattractive risk profiles of many indices today.
- We are focusing on the long term in the Income Fund, constructing a portfolio that aims to generate a consistent but responsible dividend stream, maintain flexibility, and provide investors with resiliency.
Q: Where does PIMCO see the global economy heading?
Ivascyn: We are cautious on economic growth over the next year. Our base case forecast is for lower global growth on the order of 2%−2.5%, and we would not be surprised to see U.S. GDP growth down around 1% during the first half of next year.
That will likely lead to more focus on whether the U.S. economy or even the global economy will slip into recession. We think we’ll avoid recession, but we do see the probability increasing. Currently, we put it somewhere around 30% for the next 12 months. That is a warning sign for investors to be careful in areas of the markets that are sensitive to growth.
Another key theme in our outlook is uncertainty. We discussed our expectation for long-term market disruptors at our Secular Forum in May, and the news flow over the last several weeks suggests we’re already in an environment of significant macro uncertainty, particularly in trade and politics.
When markets are priced attractively, investors can overlook some uncertainty, but when valuations look at best fair, and in many cases quite expensive, as they do now, a lack of clarity will likely lead to higher volatility and weaker performance in credit-sensitive assets.
Q: Returns have been broadly positive this year for credit and equity markets, despite slowing growth. Why do you think that is?
Ivascyn: One main reason is that the central banks are back, and they plan to be highly accommodative if they need to be. The Federal Reserve has announced three cuts in as many meetings, and we expect them to be data-dependent from here, responding aggressively to any material weakening in growth. Other central banks — including the European Central Bank, the People’s Bank of China, and even central banks in several emerging markets – have also shifted to far more accommodative policy.
We think that the increased liquidity and the driving down of yields in higher-quality bonds has led to some complacency that policymakers can engineer a soft landing. But the risk remains that a deterioration of the economic landscape could be more significant than markets expect, so there is a high degree of fragility in the markets, especially in equity and credit.
Q: Do you have concerns about the low yields in the bond market?
Ivascyn: The most important point I can make now is that the yield compensation for taking interest rate exposure has never been lower. For example, the yield on the Bloomberg Barclays Global Aggregate Index1 is below 1.5%, while its duration, or interest rate sensitivity, has extended all the way out to about seven years. Similarly, the Bloomberg Barclays U.S. Aggregate Index2 now yields only a little more than 2¼% with a duration above five and a half years.
Yields today are so low that investors are exposed to the risk of significant price underperformance if yields rise. So within the Income Fund, we want to hedge against not only credit or default risk as growth slows, but also the risk of rising yields in the event of a more positive economic scenario or scenarios that could drive intermediate- or long-term interest rates higher.
Because the Income Fund’s primary objective is to provide income − total return is a secondary objective − and it is benchmark-agnostic,3 we can structure a portfolio that may be meaningfully different from the traditional indices when we think that is in the best interest of our investors over the long term. That flexibility is an advantage for us given the unattractive risk profiles of many traditional bond indices today.
Q: How do you think about liquidity in the Income Fund?
Ivascyn: Liquidity is a key tenet of our portfolio management process. We break down liquidity into two buckets: defensive liquidity, which aims to meet the needs of our end investors every day, and active liquidity management, which aims to put the fund in a position of providing liquidity when others desperately need it.
In this environment of increased volatility, with markets prone to overshooting on the downside, as they did late last year and in early 2016, we think this is the key to long-term success. We are patient and defensive, maintaining portfolio flexibility with almost every decision we make so we can go on offense on behalf of investors when we see attractive opportunities.
Q: How have you positioned the Income Fund so far this year, and what changes have you made this past quarter?
Murata: Fixed income returns are typically driven by two main risk factors: interest rate exposure, or duration, and credit risk. The duration of the Income Fund today is relatively low because, as Dan mentioned, overall interest rate exposure is not particularly compelling. However, we still want to have some duration in the portfolio as a hedge against a possible sell-off in risk assets. So we have interest rate exposure mainly in the U.S., where yields are relatively high.
We have been reducing generic credit exposure for some time. We think corporate credit is the riskiest part of the fixed income markets right now: Issuance has been high, investors are chasing yield, and underwriting standards have deteriorated. So this year, we have been focused instead on mortgage credit in the Income portfolio.
Q: Why do you prefer mortgage credit?
Anderson: Given valuations and where we are in the economic cycle, we strongly believe it makes sense to be overweight in mortgage-related credit relative to corporate credit.
First, mortgage credit is secured debt, while corporate bonds are typically unsecured. Second, mortgages are deleveraging as borrowers pay them down and home prices rise, while companies are generally releveraging. Finally, mortgage-backed securities (MBS) are based on thousands of loans across the country, while companies have more idiosyncratic risk and can be prone to large price drops for that reason.
The amount of transparency in mortgage pools relative to corporates is underappreciated, in our view. Mortgage pools are generally static; we know where the homes are, the level of mortgage payments, and the borrowers’ underlying credit quality. By contrast, companies are not static: At any time, a company can become riskier for many reasons, even because of management’s actions.
We think when the next economic downturn comes, the corporate bond market will be in the fulcrum, while we believe our mortgage-related holdings have the potential to be resilient and provide attractive yield.
Q: Can you discuss why the fund has increased its holdings of U.S. agency MBS in particular?
Anderson: Agency MBS have fallen to their cheapest valuations in 10 years.* Low interest rates have led to more issuance, and the Fed has been selling about $20 billion in agency MBS every month from its balance sheet.
As we move into the winter months, agency MBS should be more supported, as U.S. mortgage supply typically slips due to lower home sales. We also expect to see refinancing activity fall if we stay at these rate levels for a while. And finally, during past market dislocations, spreads on agency mortgage pass-throughs have tended to tighten while those on investment grade corporates have tended to widen.
Murata: We also continue to like non-agency MBS. Regulation following the financial crisis made it much more difficult to originate loans that have significant default risk, and so issuance is low. Additionally, we think housing prices will continue rising by about 3% annually over the next two years, and in that scenario, the yield on non-agency MBS should be around 4%, by our estimate. Even in more negative home-price scenarios, we expect to see attractive loss-adjusted yield levels.
Non-agency MBS is an example of what we call a “bend but don’t break” asset – one that can fluctuate in price at times but can be very resilient across a variety of scenarios.
Q: Are there any sectors of the corporate credit market that you find attractive?
Anderson: We like the bank sector. Banks have come under heavy regulation since the financial crisis and now their capital levels are at multi-decade highs, the loans on their balance sheets are much cleaner, and in general, they just don’t have the credit risk they had before the crisis. In our view, this combination makes the debt part of the bank capital structure much safer.
Q: Are there other sectors of the fixed income market that you like for the Income portfolio?
Ivascyn: We have diversified the portfolio with select emerging market bonds that have attractive credit fundamentals and with small exposures to higher-yielding emerging market currencies, all based on the recommendations of our emerging markets team.
Recently we have also focused on inflation-protected securities. We don’t have major inflation concerns in the short term, but with extreme political uncertainty, rising deficits, and policy proposals around the globe for more aggressive fiscal spending, we’re not ready to declare that inflation is dead. This is a unique position for an income-oriented portfolio, but one that we think could have positive returns in a reflationary environment and is materially more liquid than corporate instruments.
Q: The Income Fund has delivered income and capital appreciation so far this year but has trailed some popular fixed income benchmarks. How do you think about the Income Fund’s performance?
Ivascyn: When a significant portion of the fixed income universe has negative yields, investors who rely on steady income can feel pressured to take more risk than they may be comfortable with. We see that dynamic at work now around the world, and it is a key risk because the search for yield could support further excesses in certain market segments.
As a result, we are focusing even more on the long term, constructing a portfolio that generates a consistent but responsible dividend stream and maintains flexibility. We are willing to give up a little total return in the near term while seeking to provide investors with the long-term resiliency they expect from this strategy. It’s a patient approach − we think good defense will lead to the ability to go on offense. That’s the mindset of the Income team.
* Based on PIMCO’s analysis as of 30 September 2019
DISCLOSURES
1 Bloomberg Barclays Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities.
2 Bloomberg 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. It is not possible to invest directly in an unmanaged index.
3 The Income Fund’s performance benchmark is the Bloomberg Barclays U.S. Aggregate Index, as above.
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All investments contain risk and may lose value. 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 low interest rate environments increase this risk. 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. 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.
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This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only 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. PIMCO Investments LLC, distributor, 1633 Broadway, New York, NY 10019, is a company of PIMCO.
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