Chris Dialynas, Saumil H. Parikh
PIMCO’s Unconstrained Bond Strategy employs substantial investment flexibility while also providing investors with the traditional objectives of bond investing: capital preservation, liquidity, income and diversification. And it offers the potential for compelling risk-adjusted returns over the long term and proactive downside risk mitigation. In the following interview, Chris Dialynas, portfolio manager, Saumil Parikh, portfolio manager, and Lisa Kim, product manager, discuss the strategy’s investment approach and how it might fit into a comprehensive asset allocation plan.
Q: How “unconstrained” is PIMCO’s Unconstrained Bond Strategy?Dialynas: There is fairly wide discretion in the strategy. First, it is not tied to a traditional bond index. Compare that to PIMCO’s best-known strategy, Total Return (TR), managed by Bill Gross. While TR is certainly able to take exposures in a wide array of fixed income sectors, it is benchmarked against the Barclays Capital U.S. Aggregate Index (BCAG).
Taking the comparison further, while the Unconstrained Bond Strategy has guidelines, it has extremely broad latitude within its investment parameters and has less constrained limits on the concentration of sectors in its portfolio. For example, there can be up to 50% exposure to emerging markets (EM) and there is no limitation in non-U.S. dollar securities of developed markets.
But, perhaps most importantly, the Unconstrained Bond Strategy has considerable flexibility in taking interest rate exposure in terms of overall portfolio duration. While the Total Return Strategy maintains interest rate exposure within 2 years above or below that of the BCAG – which has a duration of 4.5 years as of March 31, 2010 – the duration for the Unconstrained Bond Strategy can range from −3 years to +8 years.
Ultimately, both strategies can play a core role in investors’ portfolios. The Total Return Strategy embodies active management relative to its benchmark in terms of duration, curve positioning, sector allocation and security selection. As interesting opportunities continue to develop in emerging and other non-U.S. markets, and in light of concerns about rising interest rates in some of the developed economies, the Total Return Strategy will seek sound investments around the world and the Unconstrained Bond Strategy will have additional flexibility to “skate to where the puck is going,” as Wayne Gretzky famously said.
Q: What is appealing about a strategy not tied to a traditional bond index benchmark?Parikh: Traditionally, a number of bond investors have adhered closely to index levels, nervous about drifting too far from their visible guide. But
restraint may bring rise to a relatively rigid portfolio construction process.
Active management is a much more critical element in determining the absolute return potential, and this is a concept shared across PIMCO strategies. We believe the Unconstrained Bond Strategy is particularly suited for active management. In a nutshell: Our investment ideas are best expressed not in a benchmark-relative context, but in the bigger picture of absolute performance.
In general, there is greater latitude to vary risk exposures over time versus a traditional portfolio benchmarked to an index. Though the strategy is not explicitly insured against downside losses, the ability to tactically manage positions free from benchmark limitations may allow us to add value even under challenging bond market conditions. With access to the broad spectrum of regions, sectors and currencies of the fixed income markets, we have available the full opportunity set to use, or just as important, to not be beholden to use.
This is an important consideration. As many economies and markets recover from the worst of the financial crisis, many investors have turned their attention to the creditworthiness of governments. The fiscal support needed to contain the financial damage and kick-start global growth has been considerable with material implications on the structural composition of traditional bond indices. In particular, the massive increase in government borrowing by some advanced economies has led to a greater proportion of sovereign risk in the index. Effectively, this means that strategies tied to the index may carry rising exposure to large debt issuers whose magnitude of debt burden may exert a deteriorating credit quality dynamic. The onslaught of public borrowing could also negatively impact the return potential through higher yields – and lower prices – as purchasers demand higher yields to compensate for higher risk associated with overleveraged countries characterized by excessive debt accumulation.
Case in point is the embedded exposure to Greece and other fiscally weak countries that raise the specter of solvency issues – that is to say, concerns over whether a country is capable of servicing and ultimately repaying its debt. The handful of weaker euro countries, namely Portugal, Italy, Greece, Spain and Ireland, represent approximately 10% of the total Barclays Global Aggregate Index, a commonly used benchmark against global bond portfolios.
By divorcing the portfolio from the passive structural risk embedded in the benchmark, we can look to implement our strategies with an eye on both positive absolute return and capital preservation.
Q: Yet there are some limitations to PIMCO’S “Unconstrained” Bond Strategy. Why?Parikh: While the portfolio isn’t tethered to a bond index benchmark, it does have investment guidelines. These include limitations on duration, sector allocation, industry weighting, issuer concentration and average credit quality. For example, we generally limit the Unconstrained Bond Strategy’s foreign currency exposure to 35% and are a 40% maximum in high yield bonds.
By the same token, the portfolio targets a risk profile that is core bond-like and largely distant from equity-like risk, which is reflected in its low correlation to equities. 1
Q: Is the Unconstrained Bond Strategy designed for those seeking an alternative allocation, or can it be used as a core holding?Kim: Let’s start by defining alternative investments. They constitute a general investment category, which captures asset classes beyond traditional fixed income and equities. Alternatives are often used to diversify an investor’s overall portfolio. They may incorporate a wide variety of risk factors and often employ a high degree of investment discretion. By these measures, the Unconstrained Bond Strategy can be considered alternative.
Since the inception of the Unconstrained Bond Strategy, it has been less positively correlated to the bond market. It has also exhibited a low correlation to equities, hedge funds or commodities. 1
In thinking about where this strategy fits in an investor’s asset allocation, consider why investors buy bonds in the first place. Typically, they are looking for (1) capital preservation, (2) diversification from equities, (3) income, (4) liquidity and (5) impact mitigation from an economic downturn. A core fixed income strategy and the Unconstrained Bond Strategy should really be no different in how they address each of the first four concerns. However, a core fixed income product is primarily designed to exhibit attractive return potential in a deflationary or falling interest rate environment, and while the Unconstrained Bond Strategy is also designed to exhibit attractive return potential when rates fall or deflation sets in, it may exhibit neutral or marginally positive return potential in a rising rate environment. This is due to its ability to defensively look to reduce or even eliminate interest rate risk.
Another factor in determining how the Unconstrained Bond Strategy might fit in a portfolio is to consider whether investors have strong concerns about the BCAG over their investment horizons, either due to sensitivity to potential increases in interest rates or its high concentration of sovereign-related risk.
Q: Following the impressive 2009 rally in spread sectors, are you finding any value in the near-term, or have the opportunities evaporated?Dialynas: Core Europe and certain emerging markets like Brazil offer opportunities right now. They offer relatively attractive yield potential with potentially less risk than the U.S., which could be vulnerable to the conclusion of the Federal Reserve’s unorthodox monetary policies and the consequences of the large-scale buildup of public debt. Also, given the current state of the U.S. yield curve with short-term interest rates anchored near zero, we’re finding pockets of value globally, in both developed and developing economies.
In Europe, the re-pricing of sovereign risk beginning with Greece will in all likelihood have broader repercussions on the region’s growth, inflation and the path of monetary policy. The euro zone remains a bifurcated region where the ongoing weakness in the peripheral nations is testing the foundations of a single currency integrated economic region. We expect the strains surrounding the crisis in Greece and European peripherals will lead to increasing contagion risk that may undermine the credibility of the euro. Given this economic backdrop, we are supportive of longer-term core European rates and find a short euro currency position attractive.
We also see select opportunities in corporate bonds, but careful credit selection is imperative. We believe prospective returns will be determined less by overall sector strength but more by security-by-security analysis. We continue to emphasize the financial sector, particularly the large, well-capitalized banking and financial institutions that have the opportunity to take advantage of the historically steep yield curve and the positive effect that it has on their balance sheets. We are also focused on stable credits located in or likely to benefit from higher-growth areas of the world.
We feel taxable municipal and particularly Build America Bonds (BABs) are another attractive area. The BABs allow state and local municipalities to issue debt subsidized by the federal government, but they currently carry higher yields and have the advantage of an expanded investor base beyond traditional retail demand, including tax-exempt and even foreign investors. We view BABs as an attractive relative credit opportunity with yield spreads currently higher than similarly rated corporate bonds. Specifically, we favor revenue-backed BABs issued by essential service providers, such as water and sewer and public power utilities. These providers typically have a monopoly on the service they provide and have strong debt service coverage. We also like BABs that are secured by dedicated taxes, such as property taxes or sales taxes. In addition, the recently announced recalibration of municipal ratings by the ratings agencies (to align the sector closer to corporate credits) will likely provide ratings upgrades to select issuers.
Q: Where are you finding longer-term investment opportunities?Parikh: We expect the impact from the banks and sovereign deleveraging will remain far beyond the cyclical horizon, leading to muted economic dynamics generally in advanced economies. Over the secular horizon, we favor certain EM securities. We like sectors and names that are strategically important in their respective countries, and we focus on nations that entered the financial crisis from a position of strength and still have sound balance sheets in part due to fiscal discipline. In general, we believe there is potential for additional yield compression compared to developed countries, given our secular view that select EM nations are in a development breakout phase. We feel these EM credits provide good diversification benefits and over time we expect them to benefit from a broadening investor sponsorship on sustained flows into the EM asset class.
On the currency front, we are long a basket of Asian currencies, anchored by the Chinese yuan and with satellite positions in the South Korea won and Taiwan dollar. We believe these regions’ currency appreciation is a natural response to the fundamental need of China to shift from an export-oriented toward a more consumer-led economy. The Asian region has fared relatively well recovering from the latest bouts of global recession, and has the resources, labor force and rising total factor productivity that we believe will lead to a currency correction. We also hold positions that may benefit from expected weakness in the British pound and euro currencies.
Q: Are there any more latent opportunities you are watching?Dialynas: We are still short Agency mortgage-backed securities (MBS), which now trade near their most expensive levels ever, and in some cases have comparable yields to duration-equivalent Treasuries with very poor price dynamics. We think more favorable opportunities to own these securities could arise later this year, now that the Fed has ended its mortgage purchase program. We do see opportunities in mortgage coupon selection. We also find some value in high-quality non-Agency asset-backed securities that have attractive credit support from the quality of the underlying collateral.
Thank you all for your time. 1 Bonds, equities, hedge funds and commodities are represented by Barclays Capital, S&P 500, HRFI Fund Weighted Composite Index, and Dow Jones UBS Commodities Index, respectively.
Past performance is not a guarantee or reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk; 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. 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. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Build America Bonds issued by state and local governments are taxable issues. 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. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market.
Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. Barclays Capital Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities. The Dow Jones UBS Commodity Total Return Index is an unmanaged index composed of futures contracts on 19 physical commodities. The index is designed to be a highly liquid and diversified benchmark for commodities as an asset class. Prior to May 7, 2009, this index was known as the Dow Jones AIG Commodity Total Return Index. The HFRI Fund Weighted Composite Index is comprised of over 2000 domestic and offshore constituent funds. All funds report assets in USD and report net of fees returns on a monthly basis. There is no Fund of Funds included in the index and each has at least $50 million under management or have been actively trading for at least twelve months. It is not possible to invest directly in an unmanaged index.
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