Markets have generally been risk-on since Donald Trump’s election as president. Yet tremendous uncertainty remains over future fiscal and monetary
policies, and volatility persists at high levels. As Portfolio Managers Dan Ivascyn and Alfred Murata discuss in the following Q&A, PIMCO’s
Income Strategy has a “bend-but-not-break” approach that seeks to generate consistent income with a stable net asset value whether growth is
stronger or weaker than expected.
Q: How have the elections affected the outlook for markets and economies?
The range of potential economic outcomes is complex and both left- and right-tail risks have grown. Pro-growth policies in the U.S., including major
infrastructure spending and tax cuts, could support riskier assets. But tougher trade policies could create foreign policy risks, triggering sharp risk-off
moves. In addition, Donald Trump’s presidential victory underscores the rise of populism, which has the potential to stoke volatility in 2017.
Moreover, the global economy faces three tricky transitions: a handoff from monetary to fiscal policies in developed markets; a move from globalization to
de-globalization, which could create headwinds for productivity and spark inflation; and the evolution of China’s foreign exchange regime toward a managed
or even free float.
We believe this environment favors active strategies. Risk management, including maintenance of sufficient liquidity and portfolio flexibility, is critical
to navigating markets that will likely be volatile over the coming months.
Q: How have you positioned the portfolio given increased volatility?
In our view, the best way to generate consistent income and stable net asset values is to divide the portfolio into two larger components. The first is
composed of higher-yielding assets that we expect will perform well if economic growth exceeds expectations. For instance, we have a significant position
in non-agency mortgage-backed securities. These are bonds backed by mortgage loans in the U.S. but do not have a government guarantee. They have attractive
yields and may be resilient even during slower economic periods.
The second component of the portfolio invests in higher-quality assets that we believe will do well if economic growth disappoints. Among our most
attractive investments in this category is Australian interest rate duration. If there’s a slowdown in Chinese growth, we think commodity prices would
weaken, reducing growth and interest rates in Australia.
Q: Alfred, could you talk a bit more about the core holding in non-agency mortgage-backed securities?
These bonds are backed by mortgage loans in the U.S. but don’t have a guarantee from government agencies such as Fannie Mae or Freddie Mac. As an investor,
therefore, you’re dependent on borrowers paying you back. So there are two main performance drivers: home prices and borrower quality.
What the market may not fully appreciate is that these borrowers have been making payments for 10 or more years. Moreover, we’ve been able to buy these
bonds at a significant discount to par value, typically around 75-85 cents on the dollar. Our strategy aims to realize about 85-90 cents on the dollar,
based on our assumption that housing prices will rise by about 3% annually.
Even if housing prices were to decline, we would still expect to receive yields that are positive and higher than those of U.S. Treasuries. Almost all of
our exposure across the mortgage market is in the most senior part of the capital structure. A strong preference for seniority in the capital structure is
a guiding principle of our bend-but-not-break strategy. It’s a means to help temper volatility and reduce the risk of permanent capital loss.
Q: Over the past year you’ve increased interest rate exposure from less than three years to just over three years of duration. Could you comment on
this and the outlook for rates?
The Income Strategy has taken advantage of the flexibility to adjust interest rate duration between zero and eight years, and to invest globally to seek
assets that could benefit from an increase in rates. As interest rates rallied over 2016, we reduced the portfolio’s interest rate duration from slightly
more than three years to about 2.5 years. More recently, with the selloff in interest rates, we’ve boosted it back to slightly more than three years.
Q: Dan, what are PIMCO’s broad views on the direction of interest rates? What’s the outlook for sectors such as investment grade credit and government
versus spread sectors?
Given the significant pullback in yields following the U.S. election, we’re becoming a bit more constructive on interest rate risk. As Alfred noted, we’ve
increased duration exposure to just over three years.
That said, I would still categorize our view on interest rate exposure today as somewhat defensive. There’s a lot of near-term uncertainty, and high
quality government bond yields remain a little low from a longer-term historical perspective.
As to investment grade credit, it’s important to consider default risk, or spread compensation, versus interest rate exposure. A typical investment grade
corporate bond with, say, a 10-year maturity, has a decent amount of interest rate exposure that has negatively affected returns of late. However, looking
out over the next couple of years, we think the risk of recession, both in the U.S. and globally, remains relatively low. We’re fairly constructive on
corporate credit in general. But it’s critical to be highly selective given a decline in issuance.
Q: Finally, many investors are wondering, Will a change in government policies lead to a potential increase in inflation?
While there’s certainly the potential for increased inflation, it’s important to keep in mind that policies haven’t been well defined, and even if they
were, implementation could prove challenging. While massive infrastructure spending could boost inflation, some trade-related proposals could slow growth
and reduce inflation. Indeed, we think that in a world with substantial debt, significant excess capacity, at least on a global basis, and challenging
demographics, there remains a meaningful risk of ongoing disinflationary pressure or even outright deflation risk in certain markets. Our flexible duration
targets allow us to try to insulate investors from a variety of inflation scenarios.