In an environment where rates are rising, valuations are stretched and volatility has reemerged, demand is growing for bond solutions with the flexibility to respond to shifting market conditions. PIMCO designed its benchmark-agnostic Dynamic Bond Strategy (formerly Unconstrained Bond Strategy) a decade ago to address the needs of investors facing uncertain environments like we’re seeing today. Dynamic Bond Strategy is our most flexible bond strategy, capable of implementing the full breadth of PIMCO’s expertise across the global fixed income markets to offer defense in scenarios that are challenging for bonds while positioning to benefit from market shifts. In this Q&A, PIMCO’s CIO of non-traditional strategies, Marc Seidner, explains this distinctive strategy and why it may be a valuable complement to core bond allocations today.
Q: What type of bond strategy do investors need to address the current market environment?
A: We believe markets are transitioning from the central-bank-driven low volatility of the past few years to a period of higher volatility, and that investors need to be prepared for that transition. As a flexible multi-sector bond strategy with a global opportunity set from one of the world’s premier bond managers, Dynamic Bond offers key benefits to investors in uncertain markets – including the potential to be more defensive than traditional core bond strategies when rates rise. In this way, it may complement core bond exposure and diversify interest rate risk. Importantly, while Dynamic Bond is designed to maintain a low correlation to both equity and bond markets to help diversify portfolio risk, it is rigorously risk-managed to maintain core-bond-like volatility and downside risk mitigation.
Q: Dynamic Bond is a benchmark-agnostic strategy in the Morningstar nontraditional bond category. How do the portfolio managers approach investing given the broad guidelines of the strategy?
A: Dynamic Bond Strategy is flexible in two key ways that drive our investment approach.
First is the flexibility to determine the appropriate “home base” – our target range for duration and spread risk – in any given macro environment. The strategy’s “home base” is forward-looking and relies on PIMCO’s time-tested macro investment process to determine the appropriate target range for duration and spread risk for the market conditions ahead. We review this target on an ongoing basis and adjust for any significant changes in our secular (longer-term) outlook. In this way, we seek to optimize the portfolio to maintain core-bond-like volatility and maximum return within that level of risk.
Second, we utilize the flexibility around the home base to take advantage of tactical and idiosyncratic opportunities across the global fixed income markets. This ability to go where the opportunities are across the global bond universe allows us to emphasize segments that we believe offer the most attractive return/risk characteristics while providing diversified exposure across global interest rate, credit and currency markets. Moreover, Dynamic Bond Strategy’s ability to go long and short across the full spectrum of global fixed income markets – together with its wide duration range (-3 to +8 years) – allows it to navigate a wider variety of market conditions than benchmark-constrained strategies. Because the strategy’s positioning reflects PIMCO’s active views, the primary risk to performance is driven by the extent to which markets evolve according to the firm’s projections.
Dynamic Bond Strategy is founded on PIMCO’s 45-plus years of experience in actively managing bond portfolios. We rely on our value-oriented investment expertise to construct a portfolio that is well-diversified across various risk factors, utilizing both structural and tactical trades that the portfolio management team has identified from a global opportunity set.
Q: How is the strategy positioned today?
A: For our “home base” positioning in the environment this year, we have kept a cautious stance on both duration and spread risk given our expectation for rising rates and higher market volatility, instead focusing on relative value opportunities and bottom-up issuer and sector selection.
Overall, we have kept the net duration of the strategy low but positive at around one to two years, adjusting the exposure tactically in response to valuations. We have stayed long U.S. duration via a mix of nominal Treasuries, focused on the belly of the curve for optimal carry and roll-down; agency mortgage-backed securities (MBS), which we’ve gradually increased given their attractive yield pickup versus Treasuries and more defensive positioning versus investment grade credit; and U.S. Treasury Inflation-Protected Securities (TIPS), given their attractive valuations and the U.S. economy’s potential for higher inflation. On the short side, we added a short duration position in Italian government bonds early in the year given tight valuations and the potential for political risk. This position worked well, and we have since trimmed it to take profits. We also maintain a short position on 10-year Japanese rates as an efficient way to hedge the portfolio against high rates globally.
The current relative value positioning produces positive carry as a base case when rates remain range-bound and has the potential to produce positive returns across different growth scenarios. In the event of a global growth slowdown, bond yields would likely fall, and U.S. rates would have the largest room to rally versus other countries. And if growth were to accelerate globally, rates in the U.K., the eurozone and Japan have more room to sell off than U.S. rates, in our view.
As for credit risk, we have kept overall credit duration exposure around four to five years, down from eight to nine years in 2016, when credit valuations were much more attractive. We are focusing primarily on non-agency mortgages, select investment grade securities and sovereign hard currency bonds in emerging markets. We find corporate credit valuations unattractive at current spread levels and have been reducing exposures there. Our preference for non-agency mortgages reflects a favorable blend of fundamentals, valuations and technicals and their relative resilience across a number of macro scenarios. We have taken a defensive stance on high yield by hedging the position with high yield index derivative contracts. Broadly speaking, we expect to remain selective in our credit investments, focusing on certain subsectors and bottom-up issuer selection.
Overall, the Dynamic Bond Strategy portfolio is running at the lower end of its risk budget, with an average duration of 1.1 years – with plenty of dry powder to add risk. We believe this is an attractive investment proposal in the current environment.
Q: What differentiates Dynamic Bond Strategy in the broader landscape of unconstrained bond investing?
A: In our view, the main distinction lies in our approach: While some competitors tend to have a tilt toward either global macro or credit, Dynamic Bond Strategy takes a more balanced approach, seeking a blend of structural and tactical opportunities across rates, credit, currency and volatility markets.
Because Dynamic Bond Strategy is more focused on the best opportunities to generate alpha and less focused on credit beta, we believe this is why it has had a lower correlation to equity markets (as proxied by the S&P 500 or MSCI World) than those competitors that strategically focus on credit exposures. We incorporate both top-down and bottom-up ideas to source diversified exposures across all fixed income risk factors.
PIMCO’s position as one of the world’s premier fixed income managers is critical to this approach. The strategy has great latitude to benefit from our time-tested investment process, global resources and veteran portfolio management team. PIMCO’s industry-leading expertise, with 250 portfolio managers and more than 60 credit research analysts, brings a distinctive breadth and depth of experience to the day-to-day management of the strategy.
Lastly, our time-tested risk management aims to defend the portfolio against downside risk. As we discuss in more depth below, the portfolio management team and risk managers are “joined at the hip” to ensure that the strategy focuses on risk factors that drive returns and that portfolio risks are sufficiently diversified.
Q: How should I think about Dynamic Bond Strategy in the context of my broader portfolio?
A: Dynamic Bond Strategy seeks to complement a core bond portfolio. It looks to retain the long-term benefits of core bonds – modest volatility, liquidity, low correlation to equities – while maintaining tactical flexibility over shorter time frames. And because this flexible strategy allows us to reduce exposure to credit risk as well, it may provide an additional diversification benefit from equity markets and versus more credit-focused fixed income strategies (see Figure 1).
Q: How do you ensure that the strategy’s flexibility does not result in too much risk?
A: At PIMCO we maintain a close collaboration between the portfolio management and risk management teams. Each investment strategy is assigned a dedicated risk manager, which fosters a true partnership between the portfolio management and risk functions while also ensuring the risk manager has the independence necessary to undertake this role.
We believe a rigorous risk management process is the foundation for generating attractive long-term risk-adjusted returns, particularly for strategies that are free from benchmark constraints. To this end, we continually review and discuss the strategy’s positioning, portfolio construction, and concentration and liquidity risks, as well as the results of forward-looking stress testing. The risk manager is involved throughout the process, and no significant positioning shifts are made without input from the risk manager into how the proposed changes will affect the strategy’s risk profile. Moreover, our team of credit research analysts research and rate every holding in the strategy.
We’re also cognizant that investors considering a “go anywhere” strategy like Dynamic Bond must have confidence that the portfolio management team has the requisite experience and skill in fixed income markets. The strategy’s senior portfolio management team – consisting of Managing Director Mohsen Fahmi, Group CIO Dan Ivascyn and myself – brings more than 30 years of investment experience and expertise, on average, in global fixed income, credit and nontraditional assets.
Q: Why did PIMCO change the strategy name to “Dynamic” Bond Strategy?
A: The recent name change to Dynamic Bond Strategy (from Unconstrained Bond Strategy) underscores the strategy’s continued focus on providing a responsive solution that seeks to offer defense in scenarios that are challenging for bonds while positioning to benefit from shifting markets.
We viewed “dynamic” as more apt than “unconstrained” to express the kind of flexibility the strategy employs: namely, the ability to dynamically shift across markets and positions as needed in any given macro environment. Moreover, we believe “unconstrained” did not sufficiently convey the intensity of risk management for the strategy. Dynamic Bond Strategy does not swing for the fences, but rather looks to achieve maximum return with core-bond-like volatility.
In today’s uncertain environment, a flexible bond strategy like Dynamic Bond may offer a compelling option for investors seeking to diversify their fixed income risk and achieve attractive returns.
Visit the PIMCO GIS Dynamic Bond Fund webpage for more information.
Dynamic Bond Fund