View from the Investment Committee

On Path to Recovery, Patience is Key

Group CIO Dan Ivascyn discusses how PIMCO is navigating market volatility, and how patient, risk-aware investors may benefit from attractive opportunities emerging in higher-quality fixed income.

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David Fisher, Head of Traditional Product Strategies: Hi, I'm David Fisher, and I'm here once again, at least in a virtual sense with PIMCO's group CIO Dan Ivascyn, for a look inside PIMCO's investment committee or IC and a discussion about how the IC is managing portfolios in this challenging environment. Thanks for joining us, Dan. So first, given the volatility of the last couple of months, could you tell us a little bit about how the portfolio management team is managing in this environment?

Daniel J. Ivascyn, Group Chief Investment Officer: Before I begin, let me first thank all of our clients. This has been a very challenging time for all of our clients on both a personal and professional level. We're thinking about them and we're working very hard on their behalf, but it has been a challenging time. 

Shots from a PIMCO Forum and employees working.

First the foremost what we try to do here at PIMCO is to apply lessons learned from prior crisis environments. As you know, a lot of us at PIMCO here in leadership roles have been at the firm now for well over a couple of decades. 

We try to go back and use tools within the tool kit to navigate these periods, first by playing good defense, but also positioning ourselves to go on offense when we get paid to do so. We're also in a position to be liquidity providers for others that desperately need it.  And that continues to be the mindset. We continue to be very, very patient, with a healthy degree of humility around the extreme economic and market uncertainty that we're going to continue to face. But we are in the position to take advantage of dislocations and opportunities on behalf of clients across a wide range of strategies. 

David: So let's talk a little bit more about markets. We did see a broad selloff across global markets in March and fixed income was certainly part of that. We've seen a little bit of a recovery, but could you talk a little bit about what's going on within fixed income markets specifically.

Dan: Sure and I think it's important again to emphasize the unique aspects of this particular crisis environment. We saw a situation several weeks ago where there was a significant economic shock. A shock to people's work environments. And you had a situation where the highest quality segments of the market began to break down in terms of their overall functioning. And in fact, we noticed early on during the crisis days that the most dislocated sectors were areas that should be liquid and well insulated from credit loss, namely things like U.S. Treasury bonds and agency guaranteed mortgage-backed securities. 

In response to that extreme volatility, we have seen policy makers step in and provide tremendous liquidity support. And in the process, we have begun to see some gradual stabilization in the higher quality areas that I just talked about. 

So today, in terms of PIMCO assessing opportunities, we’re increasingly comfortable with higher quality risk. Risk that should be and is in many cases triple A from the perspective of risk of permanent capital impairment. And then sectors like agency mortgages, despite a considerable recovery of the last few weeks, look attractive. 

David: So let's talk a little bit more about the policy response. In particular, the purchases that the Fed and other central banks have been making. One of the unique aspects of the response this time is that the Fed purchases extend even into certain parts of the high yield market. So I’m curious to hear whether that affects the IC’s view of the opportunities within that sector of the market. Does it change our view on credit?

Photograph of Federal Reserve Chairman, Jerome Powell.

Shots of U.S. Federal Reserve building and European Central Bank building.

Dan: So there has been a massive policy response, both from the Federal Reserve, the U. S Treasury and other policymakers around the globe, extraordinary levels of support in historical context. We also believe that there's a willingness for policymakers to do more, if necessary. 

So from that perspective, our mindset has been to stay focused on more defensive assets, assets that should recover even well before we see a more broad based economic recovery because of this support in terms of overall market functioning. 

We are more cautious in the higher yielding segments of the market or the segments of the market that represent more significant credit risk. Although you're absolutely right that the Fed and other central banks have exhibited a greater willingness to come in and support areas like the investment grade corporate market or even small segments of the high yield market. Those programs are not, however, up and running yet. We don't fully understand at this stage the central bank's intent. The focus very well may be on ensuring basic market functioning as opposed to aggressive purchases, looking to drive spreads to very, very tight levels relative to their underlying credit risk. 

So I would categorize us as being much more aggressive in the higher quality segments of the market, where we expect more significant normalization in the coming weeks and months, much more cautious in areas where policymakers at best can provide indirect support, perhaps supporting liquidity but not significantly reducing the risk of permanent capital impairment or default or downgrades, leading to further stress under more negative economic scenarios. 

David: So just digging in a little bit deeper into your views on credit, could you be more specific on where within that sort of high yield spectrum, you think there might be some opportunities and where you think maybe we want to avoid those sectors? 

Dan: After seeing a pretty significant recovery off the lows within the high yield corporate space, and even the senior secured bank loan space, we’re less aggressive in those areas. A lot of the legacy instruments that were issued prior to this period contained weak covenants, had weak underlying fundamentals. And if we were to witness an economy, that's much weaker than even PIMCO’s base case, those areas of the market could continue to perform or could perform quite poorly.

I think it's important, though, to contrast what we're seeing in the new issue market. Within the new issue market today, the dynamic has changed significantly. This is a lender's market where in order for weaker names to come to market, investors are able to obtain terms that you haven't seen in many, many years. In terms of security packages, bond covenants or attractive yields, including these types of traditional investor protections. 

So again for new capital, for patient capital, the new issue market is looking increasingly attractive, and PIMCO has become much more involved in that space, at least on a targeted basis as we see these attractive transactions come to market.

David: So let's talk about mortgage-backed securities. This has been an area of conviction at PIMCO for some time. So how is the IC thinking of the impact of the crisis on the housing and mortgage markets, and will that affect PIMCO’s conviction? 

Dan: So let me just start with fundamentals. There will clearly be some cash flow disruption in segments of the mortgage markets, that would only be appropriate given the shock that borrowers are facing all around the country or in fact, even all around the globe. However, going into this crisis period, housing fundamentals in the United States in many other regions of the world were the strongest that they have been in some cases in a couple of decades. Very conservative lending coming out of the last crisis that occurred well over a decade ago. A steady period of rising home prices and therefore very high levels of borrower equity. And a tremendous degree of conservatism in terms of underwriting standards across the space. 

So that as a backdrop makes us continue to believe that these sectors are going to be quite resilient from the standpoint of ongoing performance and in avoidance of significant capital impairment. 

Also, I think it's important to note that some of the more recent volatility that we've seen within the mortgage space is not related to concerns around the economy, but rather has been the result of some deleveraging activity that has occurred in certain leveraged segments of the market. So there's been a lot of recent forced selling out of the REIT community, out of certain segments of the more levered hedge fund community, that can continue for the next several weeks, represent attractive opportunity for investors that have additional capital but isn't going to last forever. We think that this is going to be brief period of significant opportunity to acquire assets from forced sellers.

David: Lastly, let's talk about interest rates. I think the level of interest rates is a top concern for many fixed income investors. Our colleague Joachim Fels has talked about the concept of the New Neutral 2.0, or a period of extended, very low rates. So how is the IC thinking about this interest rate environment and in particular, what are the return prospects for fixed income and what is the role of fixed income in an investor's portfolio right now?

Dan: We do believe that at least over the short to intermediate term, inflation will be held in check.

Chart: The line graph shows the gradual decline (with peaks and troughs) of global real interest rates (%) from 1318 to 2018.

Interest rates, although they're quite low, will remain relatively range bound. From that perspective, we're not concerned about a massive or significant sell off in rates anytime soon. With that said, during this period of economic weakness, as we talked about earlier, we've seen significant policy accommodation. And that's going to manifest itself in significant deficits for many, many years to come.

So I'd categorize our short term views on interest rates as being somewhat neutral, respectful of what could be a volatile environment. But over the long run, a bit more caution. 

Now, in terms of the question around fixed income, what role it could play in a portfolio, I think it's important to first note that although the highest quality areas of global bond markets are at very, very low yields or even negative yields, we've seen massive volatility over the course of the last several weeks that have created very attractive opportunities across the broad global fixed income opportunity set. That's true of both public markets as well as private markets, where, despite the fact that government bond yields may have declined, yields and other even high quality segments of the market have moved in the opposite direction.

So again, with a more flexible approach, being able to target areas of dislocation or areas where we expect to see a bumpy path towards some stabilization. Not only are there attractive yields, but there's also attractive total return potential as well. Whereas spreads tighten, you could supplement enough attractive current income with significant total return potential also. So relative to the last few years, the opportunity set looks pretty darn attractive for a patient, defensive minded manager looking to benefit from what we think will be at some point later this year, or even into next year, a stabilization process that could lead to some pretty attractive returns. 

David: Thanks for joining us, Dan. And thanks to you, our viewers as well we truly appreciate your partnership during these challenging times.

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Recorded 22 April 2020

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. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations.

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