SUMMARY
- In seeking to achieve its objectives, the strategy is divided into two general components: higher-yielding assets that are expected to benefit when economic growth is robust, and higher-quality assets that are expected to benefit if economic growth is weak.
- We remain cautious on interest rate risk and have been emphasizing curve positioning, limiting exposure to long maturities that can suffer more from a surprise increase in inflation.
- Given the $100 trillion global multi-sector opportunity set, and with U.S. interest rates more than doubling since bottoming in July 2016, we believe the strategy is well positioned to continue to find attractive opportunities from diversified sources and meet its objectives going forward.
In the following Q&A, portfolio manager Alfred Murata discusses where we are seeing investment opportunities for the Income Strategy and how we are positioning portfolios for rising rates.
Q: How does the Income Strategy balance the primary objective of delivering consistent income with the secondary objective of long-term capital appreciation?
A: The strategy aims to meet these objectives by utilizing a multi-sector, benchmark-agnostic approach that takes advantage of PIMCO’s global resources to source the best income-generating ideas while emphasizing quality and remaining senior in the capital structure. Our Income Strategy does not aim to outperform a benchmark, but rather it looks to provide our investors with consistent income. This allows us greater flexibility to source ideas from the entire fixed income market.
In seeking to achieve its objectives, the strategy is divided into two general components: higher-yielding assets that are expected to benefit when economic growth is robust, and higher-quality assets that are expected to benefit if economic growth is weak. We believe this is the best approach in order to achieve the strategy’s objectives across different market environments.
Q: Many investors are concerned about the prospects of rising interest rates and their effects on a bond portfolio. How are you positioning the Income Strategy for a rising rate environment?
A: For active bond managers, there are a variety of ways to navigate a rising rate environment and mitigate the risks associated with rising rates.
The Income Strategy has the flexibility to tactically manage duration exposure based on PIMCO’s macroeconomic outlook. Typically, we have had lower interest rate exposure when rates are low and less attractive. Conversely, we have typically increased duration exposure as rates rise and become more attractive. The strategy has historically been defensive around interest rate risk and has used its flexibility to adjust duration when we do not believe it is compelling to hold.
Another strategy to navigate rising rates is to think about duration in a global context. The Income Strategy invests across the global fixed income market, so we can diversify interest rate risk. For example, over the past few years we have been investing in Australia, a high quality, developed market where interest rates have been falling due to a slowdown in the economy.
Additionally, rising rates typically coincide with a stronger growth environment, and the strategy focuses on investing in securities, such as non-agency mortgage-backed securities (MBS), that can benefit from a stronger economy. If rates were to rise along with an upswing in growth, we would expect a greater return on the securities that benefit from a stronger economy.
Q: You mentioned that the Income Strategy utilizes a flexible duration band. How are you managing interest rate exposure in the portfolios?
A: The Income Strategy has the flexibility to actively manage its duration in a band of 0 to +8 years. The strategy tactically manages duration and is currently emphasizing high quality countries that have relatively higher yields, such as Australia and the U.S. As interest rates have risen throughout this year, we have added U.S. duration as we believed it was a good opportunity to add high quality income in the portfolio, while also hedging against a risk-off event. Although we have added U.S. duration to the portfolio, we remain cautious on interest rate risk and have been emphasizing curve positioning, limiting exposure to long maturities that can suffer more from a surprise increase in inflation.
We also continue to find it attractive to invest in Australian interest rate duration, as Australian government bonds offer similar yield relative to the U.S., while also offering a high quality buffer against downside risk in the event of a global slowdown.
Additionally, the portfolio has a negative duration position in Japan as a hedge against global yields rising. We think that the risk of this position is asymmetric with limited downside risk. If global yields continue to rise, we believe it will put pressure on the Bank of Japan to revisit its yield curve targeting program and allow yields to rise.
Q: Given the amount of inflows that we’ve seen into the Income Strategy, can you provide some background as to PIMCO’s experience in managing such a large pool of assets?
A: PIMCO has experience in dealing with relatively large strategies. We are comfortable with recent inflows and the overall size of the Income Strategy. While the assets under management appear large in absolute terms, compared with the U.S. and global bond markets, they are relatively small (see figure). Given the $100 trillion global multi-sector opportunity set, and with U.S. interest rates more than doubling since bottoming in July 2016, we believe the Strategy is well positioned to continue to find attractive opportunities from diversified sources and meet its objectives going forward.
In addition, PIMCO has made and will continue to make significant investments in resources to help support the strategy. The Income Strategy’s flexibility and broad opportunity set enable it to leverage PIMCO’s global resources, including 240 portfolio managers and more than 60 credit analysts.
DISCLOSURES
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. 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.
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.
This material contains the current opinions of the manager and such opinions are subject to change without notice. This material is distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
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