Strategy Spotlight

Three Decades of Delivering the Benefits of Core Bonds: PIMCO’s Total Return Strategy

In this uncertain environment, a core bond allocation remains as important as ever.

Many investors are assessing their bond allocations as the Federal Reserve gradually raises U.S. interest rates and equity markets have recently set record highs. Scott Mather, PIMCO's CIO for U.S. core strategies, explains the role core bonds can play amid the uncertain outlook for both bonds and equities, and discusses PIMCO's Total Return Strategy, which has been navigating changing environments for 30 years. He co-manages the Total Return Strategy with Mark Kiesel, CIO global credit, and Mihir Worah, CIO asset allocation and real return.

Q: What is the role of a core bond allocation in an investor's portfolio today?

Scott Mather: This is an exciting time to be an investor, but it's also a very uncertain one. Risks to both the upside and downside are much higher than they were even a year ago.

After about a decade of near-zero interest rates in the U.S., the Fed has started to reduce its extraordinary accommodation by raising rates as the economy strengthens. A new administration also wants to increase fiscal spending and reform the tax code, both of which could propel growth higher. Yet there are downside risks: political polarization, stock markets at record highs (along with high valuations for most risk assets broadly), rising geopolitical tensions and inflation surprises, among others.

With so much uncertainty, a core bond allocation may be able to offer some relief: the potential for stability within a broad investment portfolio. A high quality, diversified core bond strategy aims to provide attractive returns through a combination of income (yield) and capital appreciation, while preserving capital. It can also offer a very important benefit today: diversification relative to an investor's equity allocation, which can help smooth overall portfolio returns.

That ability to mitigate downside risk and diversify investors' portfolios has been – and continues to be – one of the main benefits of core bond strategies through both good and bad market cycles.

In this very uncertain environment, we think a core bond allocation remains as important as ever.

Q: How has that role evolved over the past 30 years?

Mather: The role of the core bond allocation has evolved with the bond market itself. Back in 1987, when PIMCO launched Total Return (this month marks the strategy's 30th anniversary), the bond market was very different from the $100 trillion global marketplace we see today. For decades, governments and high grade companies had been the main issuers, and institutions looking to meet long-term liabilities, namely life insurance companies, had been the primary investors.

As U.S. inflation and interest rates fell from double-digits in the 1980s, that changed dramatically. The universe of issuers expanded with the development of mortgage-backed securities, fixed income futures and options, asset-backed securities, high yield bonds and emerging market bonds. PIMCO was a pioneer in seeking to maximize the potential return of bonds by focusing not just on yield but also on price appreciation. Our Total Return Strategy was one of the first to bring this new approach to a broad range of investors, including individuals. 

Since then, this type of active, diversified, intermediate-term approach to bond investing has sought to provide many investors with the benefits we now associate with bonds, and as a result has been an integral part of many investment portfolios – the core bond allocation.

Q: How has Total Return navigated interest rate and market shifts over three decades?

Mather: Thirty years ago, there were fewer than 100 investment options in Morningstar's Intermediate-Term Bond category in the U.S. Today, there are over 1,000, but just 36 have had the longevity of Total Return. Across many different market environments, the Total Return Strategy has generally provided strong performance over time.

To achieve that performance, we actively manage the strategy, taking a conservative, long-term approach with a strong emphasis on risk management. Total Return is a high-quality strategy, and unlike some competing strategies, it has not relied on taking credit risk as the sole driver of relative performance. Rather than swinging for the fences with a single trade idea, we rely on many diversified sources of return. To determine our positioning and select individual securities, we draw on PIMCO's time-tested investment process that combines top-down macro insights with bottom-up credit research and rigorous quantitative analysis. It is a process that has been honed for decades – drawing on PIMCO's team of more than 230 portfolio managers and 50 credit analysts – and underpins the resilience of Total Return.

Total Return's long track record has provided many examples of the strategy's strength through changing environments, in particular interest rate increases and the volatility that typically comes with them. Our sustained focus on a core tenet of Total Return – to seek a diverse set of alpha strategies that can provide a consistent anchor in investors' portfolios – has helped us to navigate evolving market conditions, regardless of the direction of interest rates or credit spreads. That is also why we feel confident in the strategy as we look ahead.

Q: What is PIMCO's outlook for interest rates and fixed income?

Mather: We expect the Fed to continue gradually raising rates in the U.S. this year and next. And as the global economy strengthens, we expect central banks elsewhere to begin withdrawing their supportive monetary policies. The European Central Bank is likely to begin by the end of this year and announce a plan to wind down its large quantitative easing (QE) program, and the Bank of Japan has already turned to yield-curve targeting in an effort to avoid cutting interest rates further.

The reduction of monetary stimulus in all these economies will be a very important development. Generally low volatility has been a major feature of markets for the past five years or so, thanks to the unprecedented central bank support, and broad risk-taking has been rewarded. As this support is withdrawn, with the Fed leading, the result is likely to be higher market volatility and greater focus on fundamentals. In this environment, we as active managers can aim to protect investors' capital and deliver better risk-adjusted returns than our benchmark.

Q: Where do you see opportunities for core bond investors in the near and medium terms?

Mather:  Low rates have affected all markets. Easy central bank policies have in effect pulled forward future returns by supporting valuations across asset classes. As a result, returns are likely to be lower going forward, so alpha will be particularly important in meeting investors' return goals.

So, where do we see opportunities to add value for investors? Given the low level of yields, we are underweight interest rate exposure overall, but prefer U.S. rate exposure to that of other developed regions, particularly the U.K. and Japan. We prefer the intermediate portion of the yield curve for rate exposures, as both the front and long ends appear less attractive.

Over the medium term, we think inflationary pressures could gain momentum, so TIPS (Treasury Inflation-Protected Securities) offer attractively priced hedges against the possibility that inflation expectations push bond yields higher (much as they did in the second half of 2016).

As equity markets have set all-time highs, corporate bond spreads have tightened significantly. As a result, corporate credit has become less attractive from a valuation perspective, even as the current business cycle remains on solid footing. Within corporate credit, however, we see opportunities in select sectors, particularly financials, where balance sheets are generally healthy.

To diversify corporate spread risk, we favor non-agency mortgages to gain exposure to the strong U.S. housing sector. We see value in the sector given the pent-up demand for housing and the potential for 2%–3% annual appreciation in home prices (and possibly more). We also find agency mortgages to be a compelling alternative to credit as a diversifying source of yield.

Finally, we continue to emphasize a strong dollar theme, primarily against a basket of Asian emerging market currencies.

Uncertainty notwithstanding, there is no shortage of opportunity in the bond market today. We believe that by targeting these opportunities in an actively managed, high quality, diversified approach, the Total Return Strategy can continue to help investors reach for their long-term goals for years to come.

The Author

Scott A. Mather

CIO U.S. Core Strategies

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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. 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. 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. 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. 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. 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. 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.

Alpha is a measure of performance on a risk-adjusted basis calculated by comparing the volatility (price risk) of a portfolio vs. its risk-adjusted performance to a benchmark index; the excess return relative to the benchmark is alpha.

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. Forecasts, estimates and certain information contained herein are based upon proprietary research 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. ©2017, PIMCO.