Higher volatility and rising interest rates in the late stage of the business cycle can present opportunities for fixed income investors. Portfolio managers for the PIMCO Income Strategy, Group CIO Daniel Ivascyn and Managing Director Alfred Murata, discuss how they are balancing defense and opportunity in the Income Strategy.

Q: Volatility picked up again in the third quarter of 2018, and we saw it continue in October. What are you expecting in the markets as we come to the end of 2018?

Ivascyn: In managing the Income Strategy, we take a long-term view. We try not to get caught up in the day-to-day or even month-to-month market moves. That longer-term philosophy has helped the strategy deliver on its income and capital appreciation objectives over its history.

We’ve been positioned ahead of the current market environment, as we came out of PIMCO’s annual Secular Forum in May expecting volatility to increase as we leave the post-financial-crisis decade behind. That positioning proved prescient moving through the volatility of the third quarter and in October.

Going into year-end, we see many sources of political uncertainty, in particular: the divided Congress in the U.S., the recent election of a populist president in Brazil, and ongoing political tensions around the globe, including Italy’s interactions with the European Union regarding its budget. With the U.S. Federal Reserve on a tightening campaign, the markets are tending to amplify these uncertainties.

As a result, this is an environment where we think investors want to be careful, and should look to bonds to lower the risk of their overall portfolios.

Q: Have you made any significant changes to the positioning in the Income Strategy over the third quarter? 

Murata: The strategy is now more balanced between its two main components: higher-quality assets and higher-yielding assets. Higher-quality assets are likely to perform well if economic growth ends up being weaker than expected, while higher-yielding assets should perform well if economic growth is stronger than expected. Since 2016, we have been reducing the higher-yielding portion of the portfolio, which has resulted in a closer balance between the two components today.

Although we have been reducing credit risk overall in the portfolio, we are taking advantage of opportunities that tend to have idiosyncratic risk. PIMCO’s resources, including more than 200 portfolio managers around the world, help us to find these opportunities in the $100 trillion global bond market.

Q: Can you discuss how the Income Strategy has performed so far this year and why?    

Ivascyn: Interest rate risk and credit risk are typically the main drivers of returns in the fixed income marketplace. In 2018, both of these main drivers of returns have experienced challenges, as interest rates have increased and credit spreads have widened. 

In the Income Strategy in particular, the strategy has been conservatively positioned with respect to both interest rate duration and credit risk, which has helped it to preserve capital during the recent period of market volatility. The strategy has attempted to take advantage of the flexibility of the global mandate and the idea generation provided by our portfolio management team to take advantage of other opportunities, such as investing in the mortgage credit sector, instead of focusing on the traditional risk factors of interest rate risk or corporate credit risk.

Q: Can you talk about diversification within the Income Strategy and how that has affected performance?

Murata: Diversification, which results in having many different drivers of returns, has been integral to the Income Strategy’s success over the years. With diversification and flexibility, we can seek to achieve the objectives of the strategy even if one particular asset class doesn’t perform well in a given year. That has been especially important in this uncertain market environment.

The benefits of diversification also allow us to find attractive opportunities over a long-term holding period. For example, in 2013 and 2014 when we invested in emerging markets, our investments were a bit early, but we continued to hold our positions and eventually they contributed to performance.

Q: Taking a closer look at the different bond sectors within the Income Strategy, how do you think about emerging markets, and what do you look for as an investor?

Ivascyn: We look at the full global opportunity set when putting together the Income Strategy, and emerging market bonds, whether denominated in U.S. dollars or local currencies, have been part of that. PIMCO has invested considerably in additional resources in emerging markets over the past couple of years, and we are quite focused on it as a firm.

Like the lower-quality segments of the high yield corporate bond market, emerging markets tend to be volatile. For that reason, we keep the overall size of our position small, particularly the local currency component.

Because emerging markets are prone to overshoots and big shifts in sentiment, they can present attractive opportunities. More recently, market volatility led to reasonably strong performance.

So, in keeping with our contrarian leanings, we think emerging market bonds make sense for the Income Strategy in small quantities. And over the next couple of years, we expect the sector to be a source of positive returns.

Q: What is your current view on corporate credit, especially with spreads at or near all-time lows?

Murata: With valuations stretched, we are cautious on corporate credit now. One big challenge we see for the sector is very high issuance, particularly in BBB rated bonds, which could be vulnerable to credit rating downgrades in an economic downturn. Leveraged loans are another area we are watching for similar reasons.

We also see some investors taking on more risk to generate higher yields lately. Retail investors seem to be turning to higher-yielding bonds because yields on bank deposits are still not high enough to fund their retirements; on the institutional side, we’ve seen a shift toward investing in private equity strategies and in hedge funds.

So overall, we think it makes sense to be more cautious in corporate credit now and have some dry powder in the portfolio so that we can play offense when opportunities arise.

Q: How do you find opportunities within the corporate market, given valuations and where we are in the business cycle?     

Ivascyn: As Alfred touched on, with valuations stretched and volatility increasing, we’re quite underweight corporate credit compared to other higher-yielding sectors. I think this is probably the most significant differentiator between PIMCO’s Income Strategy and competitors.

That said, we do find opportunities. We start with bottom-up credit analysis to find value, relying on PIMCO’s credit research team, which has expanded significantly across the globe over the past few years. In addition, we have an initiative across the full income team to look for assets with certain resilient characteristics, regardless of size – what we call “bend but not break” assets. We look for issuers with sufficiently hard assets or sufficient overall assets, or investments that are high enough in the corporate capital structure, that we think the risk of capital loss is very low. These bend-but-not-break assets are likely to continue to perform well even if conditions deteriorate ‒ in a recession, for example.

This is likely to remain a key feature of the Income Strategy, and some of these assets have contributed to returns in recent years.

Q: Turning to the securitized sector, including mortgages, where are you seeing opportunities? 

Ivascyn: We continue to like housing-related investments, and despite significant paydowns on our existing securities, we’ve been able to increase our allocation to the sector this year.

We have done this in part by actively sourcing new investments. For example, we became involved in direct residential mortgage and commercial mortgage originations. Across various PIMCO strategies, the firm is active in nearly every aspect of the mortgage market, and we’ve successfully leveraged our relationships in the sector over the course of the last few years to find very attractive housing-related collateral in the U.S., the U.K. and certain areas in Europe.

In the process, we have avoided segments of the market that we think offer much weaker credit protection or are prone to downside risk when market sentiment changes.

Sourcing investments is one way we can use the size of the Income Strategy to our advantage, and we think we’re able to generate a very attractive value proposition for our investors. Our ability to source investments is one reason why we believe the Income Strategy has the potential to be a strong performer on a risk-adjusted basis.

Q: What can investors expect for the Income Strategy in the year ahead?

Ivascyn: Looking ahead, PIMCO expects some moderation in growth across the globe in 2019, but we still forecast generally positive growth. We also believe that inflation will be relatively contained − we may see an uptick, given the late stage of the business cycle in most developed economies, but we think the major central banks have inflation generally under control.

What all this means for investors is that interest rates over the long term will likely remain range-bound. Rates have already risen from their historical lows, particularly in the U.S., and higher rates, while painful in the short run, mean both higher income and higher return potential in the long run, which is a good thing for a fixed income investor.

There will likely be more volatility, but volatility represents opportunity in the context of a flexible bond approach like the Income Strategy. We are confident that our increased flexibility, our focus on resiliency, and our defensive posture on credit risk globally have positioned the Income Strategy to distinguish itself further in the years to come.

The Author

Daniel J. Ivascyn

Group Chief Investment Officer

Alfred T. Murata

Portfolio Manager, Mortgage Credit


PIMCO Japan Ltd
Toranomon Towers Office 18F
4-1-28, Toranomon, Minato-ku
Tokyo, Japan 105-0001

Financial Instruments Business Registration Number: Director of Kanto Local Finance Bureau (Financial Instruments Firm) No.382. Member of Japan Investment Advisers Association and The Investment Trusts Association, Japan.

Investment management products and services offered by PIMCO Japan Ltd are offered only to persons within its respective jurisdiction, and are not available to persons where provision of such products or services is unauthorized.

Past performance is not a guarantee or a reliable indicator of future results.

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 the current low interest rate environment increases this risk. Current 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. 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. 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. 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. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

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