After years of relative calm, bond investors are suddenly facing the reality of rising bond yields in 2018. Below, the portfolio management team for the PIMCO Income Strategy, Group CIO Daniel Ivascyn and Managing Director Alfred Murata, discuss the latest market developments and the outlook for the strategy, including opportunities for income investors.
Q: It has been a challenging start to the year for both high quality and high-yielding bonds. Can you discuss the environment for bond investors?
Ivascyn: The primary challenge for fixed income investors lately has been rising yields. At the beginning of this year, the 10-year U.S. Treasury yield was a little below 2.5%, and now it is in the 3% range. When yields go higher, of course prices come down, and that typically puts pressure on bond returns.
A few unique developments also contributed to the uncertain environment during the first quarter. First, since the U.S. economy is at a very late stage in its economic expansion, many investors are wondering how much longer the expansion can last. Second, the Federal Reserve has been gradually reducing the policy accommodation in place since the financial crisis, reducing its balance sheet and increasing short-term interest rates. Finally, the tax package passed late last year in the U.S. and the government spending bill that followed have added considerable fiscal stimulus to the U.S. economy.
Fiscal stimulus this late in the cycle is quite rare and has made the Fed’s job of normalizing policy more difficult, creating at least the risk that the Fed will need to raise rates a bit more than the markets had anticipated a few months ago.
Q: The Income Strategy has been resilient this year compared with both high quality core fixed income and higher-yielding assets. What has worked for the strategy and what has not?
Murata: In positioning the strategy, we divide the portfolio into two broad components: one invested in higher-yielding assets and the other in higher-quality assets.
So far this year, we have seen a significant sell-off in Treasury bonds. So the higher-quality portions of the Income portfolios have performed negatively. But the higher-yielding portions of the portfolios have contributed some positive returns, which has helped keep portfolios more stable.
On a forward-looking basis, the positive is that the yield within portfolios has increased. In general, we are still finding attractive opportunities globally. So, overall, we think the strategy is well-positioned to achieve its primary objectives of consistent income and capital appreciation.
Q: What’s your outlook for interest rates and how could that affect the Income Strategy?
Ivascyn: Like many market participants, we are cautious on interest rates. With the Fed expected to continue raising the fed funds rate during the remainder of 2018 and even into 2019, we would expect interest rates to be higher 12 months from now. The U.S. 10-year yield certainly could be 3.25% and maybe even 3.5%.
Unlike many market participants, however, we believe the weakness in bond prices is related to this particular economic cycle. Over the longer term, we still believe secular forces like rapid technological change, aging demographics and globalization will keep rates relatively range-bound.
So even though we’re cautious on interest rates over the short term, we are not looking to avoid all interest rate exposure in the Income Strategy. Higher-quality assets, like U.S. Treasury bonds, can provide significant hedging benefits when risk rises and assets like equities and higher-yielding fixed income decline, such as in a recession. We think a mix of assets, including those with interest rate exposure, can reduce volatility overall.
Q: Non-agency mortgage-backed securities have been a core higher-yielding holding in the Income Strategy. What are your views on the sector now?
Murata: We continue to find non-agency mortgages very attractive for the higher-yielding portion of the Income Strategy. We think of the sector as a “bend-but-not-break” asset class: Prices could be volatile in the near term, but we believe loss of capital is unlikely. Even if housing prices were to decline, we think yields on non-agency mortgages will still be higher (after taking defaults into account) than Treasury yields.
The non-agency sector is continuing to shrink, however. The sector as a whole is down to about $500 billion from roughly $2 trillion in 2007. But we continue to find new opportunities too. Recently, we have found a similar opportunity in re-performing mortgages – loans that are making payments again after the borrowers missed a few payments. Large sellers of re-performing loans, including the housing agencies Fannie Mae and Freddie Mac, began auctioning pools of these mortgages last year; as a large asset manager, we can participate in these auctions and invest in the securities we find attractive, while selling the remainder in the secondary market.
Q: The Income Strategy has also had a core defensive position for some time in Australian duration as a hedge against a global “risk-off” environment. What are your views on it today?
Murata: We continue to find Australian interest rate exposure, or duration, attractive for the high quality portion of the Income Strategy.
If Chinese growth were to slow, which we think is possible, commodity prices would likely fall, growth in Australia would probably slow and then interest rates there would move lower. So having the position in Australian interest rate duration is a hedge against the risk of slower growth in China and its potential risk-off effects.
Q: What other fixed income sectors do you favor now? For example, do you still find emerging markets attractive?
Ivascyn: The ideal investment from our perspective is a “bend-but-not-break” asset – one with hard-asset coverage, or collateral, that is senior in the capital structure and fundamentally sound at this point of the economic cycle.
In addition to those assets, we look for ways to complement the yield or return in the strategy. We like select financial sector bonds, for example. Banks, insurance companies and specialty finance firms have increased their capital cushions and are more limited in their activities thanks to tighter regulation since the financial crisis, which are both good developments for bond holders. We have also found interesting diversification opportunities in emerging markets. Although this segment may be volatile as the Fed continues to take interest rates higher, we think it is a prudent and reasonable way to diversify risk.
Prudent diversification, especially at this stage of the cycle, is crucial. We do not want any of our exposures high enough that underperformance of certain sectors would put the Income Strategy’s objectives at risk.
Q: The costs of hedging U.S. dollar investments have risen lately for investors in Asia, Europe and Latin America. What is your view on global versus local income strategies for these investors?
Ivascyn: Given the flatter U.S. yield curve and the other costs of hedging, it is more challenging for investors accessing our strategy in different currencies to maintain the yield they are accustomed to. But we absolutely think it’s prudent for an overseas investor to consider the benefits that a global strategy can offer in terms of diversifying risks and taking advantage of opportunities across a wider range of assets.
Unfortunately, to get the higher yields that some investors are used to would involve taking higher risk. And in many instances, we are not comfortable taking those risks.
The real answer to the hedging issue depends on the particular country, a particular investor’s needs and how the Income Strategy fits into one’s overall investment portfolio. Our solutions group may be able to help institutional investors arrive at the right answer for them.
On a positive note, the current hedging dynamic has an upside: In managing the Income Strategy, we look for creative ways to find high quality assets that benefit from it.
Q: As the Income Strategy grows, investors often ask how you manage the size of the portfolio. Does size have an impact on how you invest?
Ivascyn: We have no concerns whatsoever about managing the Income Strategy as a function of its size. If we feel at some point in the future that size inhibits our ability to do that, we would halt new investment into the strategy for a period.
In fact, we try to use our size to take advantage of unique value propositions for investors. In some cases, we can access certain assets – like re-performing mortgages – or types of trades that smaller managers and smaller strategies cannot.
Q: On a related topic, how do you manage liquidity in the Income Strategy, especially given the possibility that volatility may increase?
Ivascyn: One of the most important capabilities for an active asset manager is careful, sophisticated liquidity management. The markets today are generally less liquid than in the past as tighter regulation since the financial crisis has discouraged banks and broker-dealers from providing liquidity when sentiment shifts across markets. The Income Strategy seeks to maintain a very strong liquidity profile, and we have given up a little bit of yield in today’s low-volatility bond market in exchange for that flexibility. But there will be a point in the future - whether three months, six months or even three years from now - when volatility will pick up again. Our goal is for the Income Strategy to not only withstand that volatility but also use the liquidity that we’ve accumulated to go on the offensive and generate higher yield for our investors when the market turns.
Q: Looking ahead, what are your base-case and extreme, or left tail, scenarios, and how do you think the strategy would perform under those conditions?
Murata: To start with our base-case outlook, we think volatility will pick up over the next year, but only modestly. Treasury yields may oscillate, but 12 months from now they are not likely to be far from current levels. In corporate bonds and credit, we expect some volatility in the near term, but not a significant movement overall.
In this scenario, we would aim to achieve attractive yield in the Income Strategy, with some capital appreciation on top of that.
In our left tail scenario, we’re most concerned about the potential for a big sell-off in risk assets. If risk assets, like global equities, fall significantly in the year ahead, the higher-yielding portion of the portfolio could also be down. That is why it is so important for us to diversify credit risk and allocate to higher-quality bonds.
Ivascyn: We think global economic growth is likely to be healthy over the short term. But with the economic expansion in its 10th year and the Fed, and perhaps other central banks, looking to reverse policy accommodation, we also have a list of small risks that could potentially create negative surprises.
As a result, we have been gradually reducing risk in the Income Strategy and across other PIMCO strategies to mitigate the potential effects of economic weakness in the future. We are not rushing to cash or to high quality bonds. We are simply becoming more cautious as valuations remain a little stretched from a historical perspective, and risks are steadily building.
Rising rates may mean some pressure on bond returns. But the Income Strategy is designed to be flexible and resilient. The strategy remains diversified across regions and markets, drawing on PIMCO’s best investment ideas from our portfolio managers and credit analysts around the world.