Political uncertainties and the ongoing pandemic are complicating a global economic recovery. This creates risks for investors, but we see opportunities as well. Here, Dan Ivascyn, who manages PIMCO Income Fund with Alfred Murata and Josh Anderson, talks with Esteban Burbano, fixed income strategist. They discuss PIMCO’s economic and market views along with the current portfolio positioning.
Q: What is PIMCO’s broad economic outlook?
Ivascyn: Our longer-term outlook is cautious, given a range of disruptive factors that we discuss in our recent Secular Outlook, “Escalating Disruption.” These include geopolitical tensions (particularly between the U.S. and China), populist pressures, and technological change. Central banks are likely to be less effective in engineering economic and market outcomes, leading to greater reliance on fiscal spending to help drive growth – and in the U.S., the fiscal policy outlook is unclear.
Over the next five years, we expect lower returns and elevated volatility across both fixed income and equity markets. This would be a challenging environment, and investors may need to think a little more defensively.
In the near term, we are cautiously optimistic on growth over the next year or so. However, this base case outlook relies on COVID-19 containment, timing of a vaccine rollout, and effective therapeutics. If these efforts gain traction in the first quarter of next year, and if we see a decent amount of additional fiscal stimulus, then we would expect the fairly strong recovery in the U.S. to continue. However, we likely won’t see 2019 growth levels until late 2021.
Overall, we expect this recovery will be bumpy and uneven, with many sectors of the economy remaining under stress.
Q: Could you share our views on interest rates?
Ivascyn: Interest rates are low, having come down a lot, particularly across the developed world. We think that inflation will remain in check for the next couple of years, which means that yields will likely be relatively range-bound. We’ve seen interest rates rise a bit more recently on better vaccine news, but we think the ultimate increase will be fairly moderate. Overall we’re fairly defensive on interest rate risk.
In the Income portfolio, we continue to favor U.S. interest rates. We remain underweight the Japanese government market. We’re getting some duration exposure from targeted investments in emerging markets as well. In general, we believe high quality bonds will continue to provide risk mitigation characteristics across portfolios, but perhaps not to the same degree as they have in the past. We also look for other assets to help reduce overall volatility.
Q: What are your overall views on credit markets, given the strong performance we’ve seen in the second and third quarter of this year?
Ivascyn: We’ve seen a significant snapback from the very wide spread levels we saw in late March. But some sectors have tightened or reverted back to more historical norms more quickly than others. Active management, rigorous bottom-up credit analysis, and diversification across alpha sources and risk factors are critical.
After adding some corporate spread duration to the portfolio coming out of March, we’ve recently become a bit more defensive. We’re still long key segments of the credit sector, but we’re reducing positions that we acquired several months ago that have done well, but today represent, in our opinion, a bit more risk relative to potential future reward.
Q: What are your views on mortgage-backed securities (MBS) today?
Ivascyn: As we have for many years now, we favor the housing sector within the Income Fund and we’ve been adding risk in this space. After market volatility and some forced deleveraging in March, the housing market has come back strong, with price appreciation across most of the U.S. and strong or stable markets elsewhere in the developed world.
This isn’t surprising: Since the last financial crisis, the sector has been heavily regulated, and both rating agencies and investors have approached it with a high degree of conservatism. So coming into the pandemic, housing fundamentals were quite strong. Homes are quite affordable, with low interest rates reducing borrower debt payments, and the recent price appreciation contributing to equity buildup. All these dynamics create a powerful fundamental environment for attractive ongoing performance.
I’ll note that within the Income portfolio, most of our housing-related investments are not reliant on home prices continuing to rise, although prices could gain further. But even if home prices weaken, the overall strength in borrower equity should provide resilience in this sector.
Most of the non-agency MBS positions in the Income Fund are backed by pools of loans that were originated prior to the last financial crisis and the borrowers have built up considerable equity. So they’re very diversified, seasoned pools of risk, in which the vast majority of borrowers are continuing to make payments on the loans.
We also hold positions in agency MBS, which today are an attractive alternative to U.S. Treasury exposure with a stronger yield profile. They have more cash flow uncertainty than Treasuries, but benefit from implicit government backing.Footnote1 Also, the Federal Reserve is aggressively buying agency mortgages to maintain liquidity in the system, and we expect that to continue. Nearly all of our portfolio exposure in agency mortgages is in high quality pass-throughs.
Q: Turning to the corporate credit market, where are you are finding opportunities and what concerns you?
Ivascyn: The corporate credit sector has bounced back significantly since the Fed provided a lot of liquidity to the market, which means generic beta is less interesting today than it was a few months ago. Remember that going into 2020, corporate credit fundamentals were relatively weak after years of aggressive underwriting, deteriorating credit standards, and few investor protections. Then this year there’s been a lot of lending, increasing leverage ratios across some of the riskier credits. Recently we’ve seen more distressed situations and restructurings, which have led to very low recoveries.
Given the market rally, some of the tactical investments we made from late March into May of this year have performed well. But we have become much more defensive and selective in terms of risk and exposure, and in the coming months, we will likely begin reducing some of our existing positions and rotating toward more resilient areas. We will also be watchful on the U.S. policy outlook and its potential impact on corporates. If we see less robust fiscal stimulus than markets may have expected, for example, then the more fragile areas of corporate credit become even more vulnerable.
Within the corporate credit opportunity set, we still like banks. Although the earnings model is challenged, banks remain highly capitalized from a historical perspective, and their management teams in the U.S. and across other areas of the developed world, such as Europe, continue to exhibit conservatism.
Q: What are your views on inflation? How are you positioning the Income Fund?
Ivascyn: Debt levels are very high across both private and public sectors. Debt was high before the pandemic, and it’s only gotten higher. This prompts central bankers to try to create higher inflation going forward. Our base case is no significant inflation pressure over the next couple of years, but over the longer term, we see elevated risks to both inflationary as well as deflationary scenarios (although an extreme scenario appears less likely). And markets often react before the actual inflation exists; expectations could change pretty quickly.
We look to hedge the portfolio against inflationary scenarios, for example via U.S. Treasury Inflation-Protected Securities (TIPS). Although this sector may take patience to deliver on its return potential, we feel it is an attractively priced hedge and have added some exposure this year. In addition, we are targeting segments of the corporate universe and the emerging markets that could benefit from more reflationary scenarios as well.
Q: How is the Income Fund positioned in emerging markets? And what are your views on currencies?
Ivascyn: Nearly all of our emerging market (EM) exposure is in sovereign or quasi-sovereign bonds in some of the larger, more liquid, higher-rated countries. We have very little EM corporate exposure, which tends to get quite illiquid during times of stress.
Emerging markets tend to be very sensitive to economic shocks. If COVID-19 lingers longer than we anticipate, if there are negative shocks to the global economy, if trade frictions heighten, then emerging markets will likely underperform. But under a sustained global recovery that we anticipate continuing into next year as our base case, we think the EM sector’s valuations and return potential are quite attractive. We continue to have exposure in places that have been fairly stable over the last few quarters, acknowledging the potential for volatility in this sector.
Lastly, we also have some EM currency exposure and are tactically underweight the U.S. dollar, in light of our economic outlook. By historical metrics, valuations suggest the dollar is a bit expensive versus a small basket of emerging market currencies – and a few developed market currencies as well. That said, we don’t currently expect a sustained, multiyear period of dollar weakness.
Q: To sum up, what is your overall approach in the Income Fund today?
Ivascyn: The Income Fund is quite flexible, with access to a global opportunity set. This is critical in a world where we expect lower returns, more volatility, and central bank influence that helps drive down yields and spreads across riskier assets. We’re emphasizing prudent diversification and bend-but-don’t-break investments, but we’re also aggressively seeking areas of the market that provide attractive incremental returns. And as always, we have an eye toward downside risk mitigation and capital preservation.
We’ve had a big rally in interest rates over the last few years. Given the starting point for rates, we think risks are fairly symmetric, maybe even a little bit asymmetric toward higher rates. This means it’s prudent to have a flexible fund that focuses on maximizing income and preserving capital, but doesn’t rely on duration or on continued spread tightening for performance. As always, the Income Fund seeks a responsible income stream consistent with PIMCO’s top-down approach.
1U.S. agency mortgage-backed securities issued by Ginnie Mae (GNMA) are backed by the full faith and credit of the United States government. Securities issued by Freddie Mac (FHLMC) and Fannie Mae (FNMA) provide an agency guarantee of timely repayment of principal and interest but are not backed by the full faith and credit of the U.S. government.
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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. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. government. 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. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. 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. Diversification does not ensure against loss. Management risk is the risk that the investment techniques and risk analyses applied by PIMCO will not produce the desired results, and that certain policies or developments may affect the investment techniques available to PIMCO in connection with managing the strategy.
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