Income Fund Update: Compelling Yields Today, Potential Price Appreciation Tomorrow

by Daniel Ivascyn, Esteban Burbano of PIMCO, 2/23/24

Many investors remain in cash, but we think it’s time to shift exposure to bonds.

Today’s bond market offers the potential for equity-like returns with less risk thanks to the highest yields in recent history. Here, Dan Ivascyn, who manages the PIMCO Income Fund with Alfred Murata and Josh Anderson, talks with Esteban Burbano, fixed income strategist. They discuss how the portfolio is positioned not only for higher yields currently, but for potential resilience and price appreciation across a range of future economic scenarios.

Q: What contributed to the Income Fund’s strong performance in 2023?

Ivascyn: It was a challenging but exciting year for fixed income. Yields ended the year about where they started, but with tremendous volatility in between. This volatility provided opportunities to tactically adjust duration (interest rate sensitivity), add exposure around the globe in areas with attractive relative value, and diversify our sources of return. Rallies can happen quickly. For investors reluctant to shift out of cash, I think 2023 offered a good example of how being patient and able to withstand a little volatility in bond markets can lead to additional return above what is already an attractive yield.

Q: Interest rate markets expect many developed market central banks to start cutting rates, which suggests a slowdown. On the other hand, credit spreads remain tight, indicating perhaps a more optimistic macro outlook. What is PIMCO’s outlook for U.S. Federal Reserve policy and the U.S. economy?

Ivascyn: Our base-case forecasts anticipate inflation will continue moderating, though sticky wages may prevent it from quite reaching central bank targets. The progress on inflation means that many developed market central banks, the Fed included, will likely cut rates this year in an effort to support growth. Still, we think the markets – both equity and fixed income – appear too optimistic about how quickly central banks will cut rates.

We think the market is rightly suggesting that a soft landing in the U.S. is possible. However, credit spreads and equity valuations factor in a very low probability to the risk of either a recession or of inflation reigniting. Monetary policy takes time to filter through the economy, and we see supply and demand growth across developed markets stagnating. In our view, this suggests a higher risk of recession in many developed market economies than markets are currently pricing.

Q: What is your outlook for bond returns versus equities or cash?

Ivascyn: We think the next few years look quite bright for actively managed income-oriented bond funds like the Income Fund. Fixed income markets tend to be more predictable and less volatile than other segments of the financial markets, and starting yields historically are a great forecaster of returns over the next three to five years. In this environment, we think bonds can generate equity-like returns with less risk. When the Fed begins to cut rates, we believe price appreciation could lift returns above even the high levels achieved last year. Cash yields may have peaked and those returns are fleeting. When interest rates decline, we could have a situation where the return on cash comes down as the return on bonds goes higher.

Q: How does your economic outlook inform portfolio positioning?

Ivascyn: Fixed income markets have the potential to weather multiple macroeconomic outcomes. Yields are still close to 15-year highs. Valuations actually appear more expensive in the higher-risk segments of the market, so we don’t have to give up much yield to shift exposure into better-quality, more resilient, more liquid areas.

To help mitigate the risk of an economic hard landing, over the last few quarters we have significantly shifted out of lower-rated and more economically sensitive corporate credit – which has limited covenants to support investors – into higher-quality, liquid securitized markets. Being more liquid gives us the agility to target what very well could be some interesting opportunities this year and beyond.

We think our global positioning in more resilient areas of the market differentiates the Income Fund from other multi-sector or strategic income bond funds.

Q: The Income team is very active in duration positioning. What specific points of the yield curve and which markets around the world offer the best value?

Ivascyn: We reduced the fund’s interest rate exposure a bit from its peak last year. It’s currently below the midpoint of our historical range, focused in the middle of the curve, the five- to 10-year maturities. We hold a small exposure to the front end of the curve – maturities shorter than five years – but have recently reduced it, as the very short maturities appear overvalued amid too much optimism around how quickly central banks will cut rates. In our view, when the Fed ultimately cuts interest rates – and if, as we expect, inflation lingers at levels higher than we grew accustomed to before the pandemic – yields in longer-maturity bonds could rise further, pressuring prices.

Another reason we favor intermediate maturities is that we are concerned about the long-term sustainability of federal deficits in some countries, particularly the United States. The steep and growing U.S. deficit could lead to heavier Treasury bond issuance and higher rates as the markets absorb that risk. We are beginning to diversify our interest rate exposure into high quality markets outside the U.S., including in Australia, Europe, and the U.K.

We do maintain a position in U.S. Treasury Inflation-Protected Securities to hedge against the risk of U.S. inflation accelerating.

Q: Shifting to market sectors, the allocation to agency MBS (mortgage-backed securities) is now a meaningful portion of the portfolio. How are you thinking about that market going forward?

Ivascyn: Agency mortgages historically have performed better amid low interest rate volatility. Currently, agency MBS trade at wide spreads that reflect high market volatility and reduced demand from banks and the Fed, which stopped buying the securities.

We find agency MBS valuations compelling and have been steadily adding to our significant positions. We think developed market central banks will likely loosen policy only gradually, leading to a more constructive environment of less interest rate volatility. This is normally a liquid market with implicit or explicit U.S. government guarantees that trades at very attractive spreads versus their corporate counterparts. Yet the market is very complex and security selection is important. We benefit from an experienced team of mortgage specialists who actively trade agency MBS, looking to add incremental return.

Q: Turning to other sectors of the market, where are you finding value?

Ivascyn: We continue to add exposure to non-agency mortgage-backed securities. Our focus remains on legacy mortgages that have built up significant equity, have low loan-to-value ratios, and therefore don’t rely on home prices continuing to go higher or even remaining stable to generate returns. PIMCO is one of the biggest, if not the biggest player in these markets not only in the U.S., but across the U.K. and key segments of Europe.

Other consumer asset-backed credit sectors we find attractive are high quality automobile and student loans. We are also actively positioned in other higher-quality structured products, senior collateralized loan obligations (CLOs), and diversified commercial mortgage-backed securities. These sectors benefit not only from reasonable underwriting quality and diversification, but are backed by hard assets that provide additional support should the economy slide into recession.

One area requiring caution is senior secured bank loans. Nearly all these loans have floating interest rates, leaving borrowers – many of which are smaller, heavily leveraged companies – facing sharply higher debt service costs than they had expected. If short-term rates don’t come down, we expect to see continued deterioration across that segment of the credit market, both on an absolute and a relative basis.

Q: What are your views on the financial sector?

Ivascyn: Most systemically important larger U.S. and global banks are well capitalized. Amid an uncertain economic trajectory, however, we have reduced our exposure overall, cutting our subordinated bank debt to the lowest level in many years. We have, however, been adding high quality bonds that are senior in the capital structure of the major global banks. We acknowledge that some smaller banks may still face risks, but we don’t anticipate major concerns in the financial sector; we’re simply seeing better value in other areas that may offer even more resilience.

Q: How is the Income Fund positioned in emerging markets (EM) credit amid geopolitical risks?

Ivascyn: We have continued to hold modest exposure to emerging markets, instead favoring more defensive sectors like agency mortgages and other structured products. EM debt remains an important diversifier, however. Our positions are focused on higher-quality, resilient segments of the market, including Brazil and Mexico, as well as targeted special situations in Eastern Europe and Asia.

We also hold a small, diversified basket of exposure to higher-yielding currencies, including currencies across Latin America. This was a meaningful positive contributor to returns last year.

Q: How would you sum up the outlook for fixed income?

Ivascyn: We’re excited about the opportunities bond markets present for 2024 and beyond. Yields and valuations look enticing from a historical perspective, even after adjusting for inflation, compared with public equities and other higher-risk asset classes. Following many years of low or even outright negative yields, we think value is back in high quality bonds in the U.S., U.K., Europe and Australia. It has been a bumpy ride and could remain bumpy for a bit longer, but this volatility presents perhaps the best opportunity for tactical exposures we’ve seen in years. We continue to leverage our global platform and look to generate strong risk-adjusted returns with a steady income stream in an array of economic environments.

DISCLOSURES

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A word about risk: 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. References to Agency and non-agency mortgage-backed securities refer to mortgages issued in the United States. U.S. agency mortgage-backed securities issued by Ginnie Mae (GNMA) are backed by the full faith and credit of the United States government. Securities issued by Freddie Mac (FHLMC) and Fannie Mae (FNMA) provide an agency guarantee of timely repayment of principal and interest but are not backed by the full faith and credit of the U.S. government. 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. Collateralized Loan Obligations (CLOs) may involve a high degree of risk and are intended for sale to qualified investors only. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received. CLOs are exposed to risks such as credit, default, liquidity, management, volatility, interest rate and credit risk. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. 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. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Diversification does not ensure against loss.

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