Politics, trade tensions and rising interest rates have all contributed to higher market volatility over the first half of 2018. The portfolio management team for the PIMCO Income Strategy, Group CIO Daniel Ivascyn and Managing Director Alfred Murata, discuss how they are positioning the Income Strategy for both upside potential and downside risk in a more volatile market.
Q: PIMCO’s latest Secular Outlook forecasts a new era of potentially radical change − and some “Rude Awakenings” for investors. How does this outlook affect the positioning of the Income Strategy?
Ivascyn: We think the next five years are likely to be very different from the post-crisis period of the last 10 years.
Since the financial crisis, PIMCO has characterized the macro environment as the “New Normal” or “The New Neutral” − a period of low growth, significant disinflationary pressure and relatively low volatility.
Now, the major central banks are trying to step away from the accommodation that they have provided to the markets for many years, and their influence is being quickly replaced by that of politics. Populist parties, for example, have already gained traction across the globe.
For both equity and fixed income investors, we think this means lower returns and, unfortunately, higher volatility. This combination creates a much more challenging investment environment.
With our Secular Outlook as the guidepost, we are taking a more cautious and defensive approach in the Income Strategy, while remaining poised to take advantage of market overshoots as they occur.
Q: How do you implement a more defensive approach in the Income Strategy?
Ivascyn: To be a bit more defensive in the current environment, we are maximizing flexibility, which includes increasing liquidity and increasing diversification within the strategy.
In our effort to become defensive, we are diversifying away from sectors that we think are prone to overshooting to the downside, like U.S. corporate credit, where issuance has been high and underwriting standards have deteriorated moderately. We’re also leveraging our team of over 245 portfolio managers around the globe to find many smaller opportunities across the global fixed income universe.
Unless we see a meaningful shift in market valuations, we plan to continue utilizing diversification to temper volatility.
Q: How has the Income Strategy’s positioning worked over time and year to date?
Murata: The Income Strategy is generally divided into two broad components. One component consists of higher-yielding assets, such as non-agency mortgage-backed securities and corporate credit, which we expect to do well if economic growth is stronger than expected. The other component consists of higher-quality assets, such as U.S. Treasuries, that we expect to perform well when growth is slower than expected. We think this combination maximizes the chances of achieving the primary objective of the strategy − consistent income. Over time, this philosophy has worked well and has helped reduce volatility in the portfolio.
So far this year, it has been a broadly challenging environment for fixed income with an uptick in interest rates, and that has been a drag on the higher-quality portion of the portfolio. On the plus side, the higher-yielding assets in the portfolio, such as non-agency mortgage-backed securities, have contributed to performance.
In addition, the yield in the portfolio has increased since the beginning of the year, and we continue to see prospects for capital appreciation in the future.
Q: How has the Income Strategy been navigating rising interest rates? How is it for investors looking to manage through volatility?
Ivascyn: We would characterize the Income Strategy as a strategy that has the tools to be quite resilient in the face of rising interest rates. When rates are rising, we believe the strategy is well positioned to maintain positive total returns at times, but in periods of significantly higher rates, total returns can be affected. This year, PIMCO’s Income Strategy has been resilient, performing relatively well versus traditional, broad fixed income benchmarks like the Bloomberg Barclays U.S. and Global Aggregate Indexes, which have returned –1.6% through June.
We have the ability to shift the strategy’s overall duration, or its exposure to interest rates, between zero and eight years, and over a full interest rate cycle we try to take advantage of that flexibility. Our current interest rate positioning is cautious mainly because our shorter-term view on the economy is constructive: We think global growth will remain positive, the risk of recession over the near term is relatively low, and the Federal Reserve is likely to continue gradually raising interest rates, with other central banks, like the European Central Bank and the Bank of Japan, likely to begin reducing their accommodation in the second half of 2019.
We continue to hold high quality bonds as a hedge against economic weakness and other surprises that could cause a flight to quality assets – as we saw with the surprise victory of a euroskeptic government in Italy in June. We expect the Income Strategy will continue to utilize its flexibility to navigate different interest rate environments, and we will consider multiple scenarios when positioning the strategy.
Q: Non-agency mortgage-backed securities have been a big component of the higher-yielding portion of the Income Strategy. Do you still find the sector attractive?
Murata: Yes we do for several reasons. First, we think the underlying credit fundamentals in the U.S. housing sector are very strong. Homeowners have more equity in their properties now than in the past, and all else equal, if a borrower has more equity, then default is less likely.
Another attractive feature of non-agency mortgage-backed securities is the relative stability of their yield profile. For the Income Strategy, seeking to capture this yield has provided a healthy cushion against downside risk. Even if housing prices were to drop, we would still expect higher yields from non-agency mortgage-backed securities than U.S. Treasury bonds.
Finally, the supply of non-agency mortgages has increased over the past year, after shrinking dramatically from about $2 trillion in 2007 to approximately $500 billion. However, new opportunities in the mortgage sector continue to arise, such as the introduction in the marketplace of “re-performing” mortgages, which are loans to borrowers who stopped making payments at some point but then resumed. There are approximately $300 billion of these re-performing loans outstanding. Because these mortgages tend to be sold in large volumes, we can use PIMCO’s size and resources to seek an advantage in this market.
Non-agency mortgages have been a strong contributor to the Income Strategy over time. So far this year, strength in the sector has helped to offset more challenged performance from duration and emerging markets positioning. Our flexibility to invest around the world has also been beneficial. The global opportunity set has been a powerful contributor to the strategy over time.
Q: What is your view on emerging markets for the strategy?
Ivascyn: We like emerging markets as a source of diversification. However, given our objective of generating consistent income, we do not have a large concentration in emerging markets because they can be quite volatile.
Still, significant dislocations in the sector can present opportunities. For example, Mexican assets were very volatile after the U.S. election in late 2016, which we found to be a buying opportunity. And again this year, we’ve seen unique or idiosyncratic situations in different emerging economies that have offered some attractive opportunities.
Q: Where do you see other potential opportunities for the strategy given the shift in PIMCO’s long-term outlook?
Ivascyn: Despite our risk reduction in corporate credit in general, we’re leveraging our entire credit analyst team to find targeted opportunities. For example, the financial sector has remained in risk-reduction mode since the financial crisis, which is quite good from the perspective of a fixed income investor. Recently, spreads have widened in segments of the investment grade corporate bond market, so we’ve also begun to deploy some capital there.
In the high yield and the bank loan markets, we see occasional opportunities in assets with strong collateral coverage and capital structures. We refer to these as “bend-but-not-break,” which are assets that we expect will likely perform well even in more difficult economic environments.
Because we think the U.S. housing sector remains healthy, we also invest in housing-related securities within corporate credit.
Q: How does the strategy balance upside potential and downside risk, especially in light of the outlook for more volatility?
Ivascyn: We are very focused on providing an investment strategy that offers high and steady income as well as attractive total returns, and we want to achieve these with as little volatility as possible.
When we believe we’re being compensated for taking risk, we don’t hesitate to be aggressive in the Income Strategy. At other times, when valuations appear stretched and fundamental risks are building, we want to play very good defense and we would categorize the current environment as a time to play defense. That said, having a good defense as an active asset manager – flexibility, liquidity and diversification – means you are ready to go on the offense when opportunities arise.
Importantly, our more defensive approach over the last several months is not a shift in philosophy. We are simply tailoring the strategy to the current market environment and opportunity set.
Q: What would you say to bond investors who are worried about rising rates?
Ivascyn: When you look at market pricing today, the financial markets are anticipating that yields will rise across most of the developed world. PIMCO also believes interest rates will go a little higher. However, we don’t think that a major increase in yields or a breakout to materially higher inflation is very likely over the next few years. In fact, yields have already risen to the point that we think interest rate exposure looks more attractive today than it has in the last 12 months.
For investors who are very concerned about the potential for a big rise in yields, we would suggest considering a less traditional bond portfolio, perhaps a strategy that has greater flexibility to reduce interest rate exposure – through outright negative duration – and may even have the potential to profit from a rising interest rate environment.
A mild or even moderately bearish view on interest rates, however, is consistent with an allocation to the Income Strategy, which is structured with the aim to be resilient in the rising rate environment that we have today.