In the following Q&A, portfolio managers Daniel Ivascyn and Alfred Murata answer four key questions about our Income Strategies.
Q: In today’s environment, what has led you to de-risk portfolios and take on a more defensive posture?
A: While we believe the probability of a recession over the near term is relatively low, we do see risks rising on the horizon as central banks around the world begin tapering balance sheet support and uncertainty in China’s political and economic course increases following the National Party Congress. At the same time, risk assets continue to do well, driving valuations to new highs and volatility to new lows. In this environment, it doesn’t take much in terms of negative surprises to upset markets. For this reason, we see this as an opportunity to gradually lower the risk in our portfolios, adding higher quality assets and liquidity, in order to be more defensively positioned in the event of a market correction. This would not only allow us to help protect the portfolio but to also go on the offensive when opportunities arise.
Q: How are you adjusting your portfolio positioning in the Income Strategies?
A: Within our Income Strategies, our top priority is to provide consistent income and long-term capital appreciation. We look to balance higher-yielding securities that do well in positive economic scenarios with higher-quality securities that do well during times of market stress.
The higher-yielding part of the strategy follows a “bend-but-not-break” philosophy where we expect mark-to-market volatility but we want to prevent permanent capital loss. For this reason, we focus on defensive, high quality, short-dated and default-remote corporate and structured credit. For example, we continue to see value in non-agency mortgage-backed securities (MBS), which have attractive yields and may be resilient even during slower economic periods.
In the higher-quality part of the portfolio, we have added U.S. interest rate duration as a way to be more defensive against potential left-tail scenarios. We also find it attractive to invest in Australian interest rate duration. If there is a slowdown in Chinese growth, we think commodity prices would weaken, reducing growth and interest rates in Australia.
Q: Given our constructive view on non-agency MBS, what is our outlook for this sector?
A: We continue to see value in non-agency MBS. These are bonds backed by mortgage loans in the U.S. that don’t have a guarantee from U.S. agencies such as Fannie Mae or Freddie Mac.1 Because of this, investors depend on borrowers to pay them back, and careful evaluation of the credit risk for each underlying mortgage loan is important. At PIMCO, we have deep resources to analyze these bonds in terms of the impact of home prices, loan-to-value ratios, homeowner FICO scores, etc.
One aspect that we find very attractive about these bonds is that they are legacy securities issued before the financial crisis. So, many of the underlying borrowers have been making mortgage payments for 10 years or more, which improves credit quality. In addition, we are looking to buy these bonds at around 75-85 cents on the dollar, so there’s potential for price appreciation if home prices in the U.S. continue to do well.
Q: With the flexibility of the Income Strategies, where are you looking to take advantage of opportunities and where do you see value for income investors?
A: It’s important to stress that when taking a view on a particular sector of the fixed income market, or even on overall duration exposure, it is only one of the tools we use to seek strong risk-adjusted returns for our clients. In the current environment, while we have somewhat less conviction on any one sector, we are looking to leverage the full extent of PIMCO’s resources to find attractive opportunities within each sector. This includes input from over 200 PIMCO portfolio managers around the world who help contribute to our thinking and the stress-testing of our portfolios.
We believe that in this environment an investor should look to take advantage of multiple strategies to keep a portfolio well diversified so that it is resilient in times of market stress. These include select opportunities in corporate credit and emerging markets where we can leverage PIMCO’s strength to influence terms, get attractive prices and large shares to maximize value for our investors. These are just a few examples of ways in which our global multi-sector and flexible strategy seeks to generate attractive risk-adjusted returns for our clients.
1 Guarantee is based on agency corporate health, and is not explicitly guaranteed by the U.S. government. During the recent financial crisis, the U.S. government affirmed its implicit backing through the conservatorship of the agencies.