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Investors are increasingly looking for income solutions to meet a variety of investment goals. As PIMCO’s Income Strategy approaches its 10-year anniversary, Portfolio Managers Dan Ivascyn and Alfred Murata discuss their approach to income investing and how they find opportunities in the low interest rate environment.
Murata: We have two goals in managing the Income Strategy: to generate an attractive, consistent income stream and to maintain stability in the net asset value of the portfolio. The best way to achieve our two objectives, from our perspective, is to divide the portfolio into two components. The first consists of assets that we think will generate attractive income if economic growth is stronger than expected. And the second consists of assets that we think will do well if economic growth is weaker than expected, which provides a downside hedge for the portfolio.
Some income funds focus mainly on corporate bonds and can invest without limit in high yield securities – an approach that can result in a portfolio with concentrated credit risk. At PIMCO, we are not just trying to generate the highest income without concern for principal preservation; instead, we are focused on diversifying the portfolio across many sectors and countries, and mitigating downside risk is critical for us. In addition, over the long term, we strive to generate attractive absolute returns and a positive total return.
Ivascyn: While we expect global growth to continue to be low within a broader historical context, we do forecast it to move a little higher in 2017, with the U.S. economy growing approximately 2%‒2.5% after inflation, the eurozone around 1%–1.5% and Japan around 0.5%–1%. The UK’s decision in June to leave the European Union (Brexit) is likely to have a modest negative impact on growth in Europe over the near term. We also think global central bank policies will continue to diverge. If the effects of Brexit are fairly contained within the UK and Europe, as we expect, the U.S. will likely remain on a very gradual tightening cycle, while Europe, Japan, Australia and China continue with accommodative policy in an effort to support their economies.
Murata: We aim to put together a global income portfolio in a way that’s consistent with these top- down economic views. Reflecting our outlook for positive growth in the U.S. and a continued recovery in the housing market, we currently favor U.S. non-agency mortgage-backed securities, which are bonds backed by residential mortgages that do not have any type of government guarantee, and other high quality sectors such as investment grade corporate bonds.
Our allocation to non-agency mortgage-backed securities represents the higher-yielding component of the portfolio. The securities provide an attractive yield in this environment in the mid-single-digit range and offer the potential for price gains if U.S. housing prices appreciate more than expected. Our forecast is for home prices to rise 3%‒4% annually over the next two years, and importantly, even if home prices drop, these securities should still provide positive yields.
For the higher-quality and more defensive component of the portfolio, we like Australian interest rate duration. This reflects our view that the slowdown in China’s economy should keep commodity prices low in general, leading to slow growth in Australia. As a result, the Reserve Bank of Australia (RBA) may continue cutting interest rates, which would create the potential for capital appreciation in Australian fixed income exposures. In the meantime, Australian interest rates are relatively attractive: The RBA’s target cash policy rate is significantly higher than rates in most other developed economies.
Murata: To generate consistent income, or yield, in this environment, we think you need to be as flexible as possible, and the Income Strategy has a great deal of flexibility. Importantly, the strategy can vary its duration, or sensitivity to changes in interest rates, from as low as zero to as high as eight years depending on our view of the current environment. So we can adjust portfolio duration to hedge against interest rate risk.
In addition, the Income Strategy has the flexibility to invest in the $100-trillion global fixed income market, so we are able to take advantage of many different sectors to help generate income and try to preserve capital. Our allocation to Australian interest rate duration is an example of how we employ the Income Strategy’s unique flexibility.
Ivascyn: We always want to make the Income Strategy as resilient as possible in order to help preserve capital. We say the strategy is designed to “bend but not break,” which means it has the flexibility to adapt to and navigate challenging environments – the volatility that followed the Brexit vote would be a good example – because it can move through different sectors and regions. In a volatile market environment, given its income orientation and global exposure, the Income Strategy can at times be a bit more volatile than a traditional core bond strategy. However, by combining the global income orientation with the defensive component of the portfolio, which has greater potential to perform well during periods of stress, we have been able to provide a consistent income distribution and attractive risk- adjusted total returns over a variety of market environments.
On the flip side, volatility can also present opportunities because markets often overshoot, or overreact. Emerging markets are a good example. Although we have been cautious in our emerging market positioning in the Income Strategy, we have found some interesting opportunities when investors have been too pessimistic. For instance, the strategy has benefited from select exposures to high quality quasi- sovereign securities in emerging markets like Russia.
When we take positions in more volatile sectors, our exposure tends to be small so that any downside move does not significantly affect our broader portfolio goals. In fact, we believe the strategy is currently more diversified than at any time in its history, which reflects PIMCO’s view that no particular market sector is massively overpriced or undervalued.
Ivascyn: Active liquidity management is critical for our income-oriented portfolios as we strive to meet our objectives of generating consistent income and attractive total returns. Markets today are less liquid than they were in the past, partly due to changes in banking regulation since the financial crisis. As a result, we are currently holding more cash in the strategy than we have in the past.
We also have a much higher hurdle in investing: We are always looking for liquid instruments to express our investment views, and we invest a small amount of the portfolio in less liquid segments of the market only when we have the potential to receive significant compensation.
Reduced market liquidity also generally coincides with higher market volatility, and that can provide a tremendous opportunity to an active investment manager with ample liquidity – what we call “dry powder.” We used some of our liquidity to buy high quality assets at very attractive yields when volatility spiked in February this year.
Murata: One of the keys to maintaining liquidity in the Income Strategy is the higher- quality, defensive component of our portfolio. Because this portion of the portfolio is constructed with the goal to perform well during periods of market stress, it can provide not only downside risk mitigation to the strategy but also liquidity.
Ivascyn: The Income Strategy is designed to be a broad fixed income solution for many types of investors. It may be a natural option for income-oriented investors – including those planning for retirement – who are looking for reliable income with an emphasis on risk management. For many investors, the Income Strategy may serve as a complement to core fixed income allocations in the years ahead. As interest rates hit bottom and slowly begin to rise, income, as opposed to capital appreciation, will likely be a larger component of total return in the bond market, which means bond investors may want to maximize the potential for income in their portfolios.
The Income Strategy aims to leverage the best ideas of PIMCO’s 250-member portfolio management team in a way that’s consistent with our top-down, macro-oriented investment process. We will continue to position the strategy not only seeking to generate consistent income in an ever-changing market environment but also to preserve capital and even go on the offensive when the market compensates investors for it.
Group Chief Investment Officer
Portfolio Manager, Mortgage Credit
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All investments contain risk and may lose value. 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. The strategy may invest in high-yield, lower-rated, securities which 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. 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. 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. 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 opinions of the manager and such opinions are subject to change without notice. This material has been 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. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2016, PIMCO.