The recent equity-led spike in market volatility has been a timely reminder of the uncertainty that may arise when unusual late-cycle fiscal stimulus in the world’s largest economy is paired with monetary tightening by the Federal Reserve and other central banks. PIMCO’s base case still envisions an orderly transition as central banks tread the path to policy normalization. However, we think these macro developments raise the tail risks of higher inflation and higher bond yields on one hand if growth accelerates, and wider credit spreads and lower bond yields on the other if central banks overdeliver on monetary tightening.
Unconstrained: Maintain a strong defense while seeking opportunity
One thing seems evident: The period of central-bank-driven low volatility may well be ending. But higher market volatility need not be all bad news for bond investors. Certain investment approaches – including well-designed benchmark-unconstrained bond strategies – may benefit from greater investment flexibility to defend against scenarios that are challenging for bonds while potentially capitalizing on market shifts.
In our view, the key objective of an unconstrained bond strategy is to complement a traditional bond allocation while maintaining a low correlation with stocks. Untethered to traditional bond benchmarks, unconstrained bond strategies can respond to current changing market conditions in various ways, such as:
- By avoiding certain fixed income exposures – for instance, positioning more defensively on duration during periods of rising rates
- By investing opportunistically in credit markets – focusing on sectors that offer value and resilience while avoiding exposure to areas that appear overvalued
- By seeking to take advantage of opportunities in currency and volatility markets
- By using the “risk budget” tactically to seize opportunities in the markets – pivoting to high quality investments to preserve capital when entry levels are less attractive, and then striking when the iron is hot
Positioning for unsettled markets
We have recently favored more cautious positioning on duration, specifically going long U.S. duration and short UK, European and Japanese duration. Inflation-protected securities have also been attractive given emerging inflationary pressures and attractive breakeven valuations, and these securities have performed well relative to nominal Treasuries in recent months. We have selectively taken exposure to credit sectors that tend to do well in periods of strong growth and rising rates, along with active positioning in the U.S. dollar versus a basket of emerging market currencies. Given our view of the potential increase in volatility, we have favored tactical reductions in structural option volatility allocations.
An unconstrained approach is not just about defense, however. We are still seeing attractive investment opportunities across the global fixed income markets. We are placing less emphasis on directional strategies and focusing more on relative value opportunities in rates and currency markets. Within credit, we are cautious on generic corporate credit and are instead focusing on active sector and issuer selection. We view a focus on capturing lower-risk forms of carry and tactically managing portfolio volatility as prudent in today’s market.
In short, we think an unconstrained approach may be one way for bond investors to embrace volatility.
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