Strategy Spotlight

Income Strategy Update: Focused on Finding Opportunities in Today’s Markets

Looking across the global opportunity set, we see potential for attractive yield, though uncertainties surrounding the global recovery suggest this is a time to be cautious.

The uncertain economic recovery amid a continuing pandemic creates risks for investors, but opportunities as well. Here, lead portfolio managers for PIMCO’s Income Strategy, Dan Ivascyn, Alfred Murata, and Josh Anderson, discuss PIMCO’s economic and market views along with current portfolio positioning.

Q: What is PIMCO’s broad economic outlook?

Ivascyn: Our base case outlook is cautiously optimistic, with continued albeit varied improvement in how the coronavirus is treated and managed globally, including a vaccine perhaps early next year. We are beginning to see a bounce in economic growth up from dramatically low levels, largely driven by massive support from both monetary and fiscal policy. We expect a fairly sharp recovery, at least initially, before momentum tapers. The recovery will likely be uneven, both over time and across different regions of the world. In the U.S., we don’t anticipate returning to late 2019 growth levels until 2022.

Tremendous uncertainty remains around the outlook. Other factors outside the pandemic, such as geopolitics, could have an impact. And even with all the policy support, some areas of the economy will be permanently damaged. These risks of capital impairment make this an environment to tread carefully and keep a defensive mindset.

Q: What does this outlook mean for global bond markets?

Ivascyn: Many fixed income sectors have retraced a significant amount of the spread widening we saw in March, especially sectors where central banks are providing support. But that sector-level tightening can mask pockets of weakness. This combination – tighter overall spreads, but also areas that haven’t recovered (and may never recover) – complicates the process for investors targeting attractive yield along with resiliency within a portfolio.

In the corporate sector, central bank intervention has allowed a lot of high quality companies that were quite stretched to go to market and reissue debt, providing a bridge to the future, where we expect improving economic growth. However, the corporate sector in general was already highly leveraged going into this period. As debt levels increase further, we may see instabilities build in some parts of corporate markets over the longer term.

Amid an overall convergence in fixed income spreads, we’re seeing a number of attractive opportunities poised to deliver income and long-term price appreciation, but active management remains critical.

Q: What are the high-level investment themes in the Income Strategy today?

Ivascyn: In light of the strategy’s focus on generating an attractive dividend stream across market environments, even within a lower-yielding marketplace, and with long-term capital appreciation as an important secondary objective, we continue to have a high-conviction view on the mortgage-related sector. We believe these securities have potential to deliver not only yield but attractive total return, along with the ability to withstand a more severe downside scenario. It’s true that housing-related sectors have generally lagged a bit in the recent recovery, but after the significant spread convergence, we are seeing the high quality segment of the market as resilient risk assets pricing at very attractive levels.

In other areas of the market, we see attractive tactical opportunities in corporate credit. There’s been a lot of issuance in that space, and we have been able to obtain what we believe to be attractive terms within the new issue market and via reverse inquiries. But after the significant rally and spread retracement that we’ve witnessed, we’re now becoming a bit more cautious on that sector again.

We maintain minimal exposure to the more esoteric risks in structured products or in riskier segments of the emerging markets, for example, instead seeking more liquid, senior opportunities in these segments.

We also have a few investments that could benefit from U.S. dollar weakness. We don’t expect the dollar to collapse, but we do expect ongoing weakness due to COVID challenges and more aggressive policy support in the U.S. relative to the rest of the world.

Q: Let’s look more closely at housing-related sectors. What is happening in the U.S. agency mortgage-backed securities (MBS) market, and why do we still find it attractive?

Anderson: We view the agency MBS sector as a high quality market that currently provides attractive yield and price appreciation potential, particularly relative to U.S. Treasuries and other more liquid assets in the portfolio.

Agency MBS spreads reached dramatic highs during the liquidity-driven volatility in March – even wider than levels reached during the global financial crisis. Spreads have retraced since the Federal Reserve stepped in, but we still believe valuations remain attractive given the potential for further spread tightening amid continuing Fed support.

We believe active management is crucial to identify relative value within this sector. Currently, we’re focusing on lower coupon issues, which have lower expected paydowns over the next year or so.

Q: What is PIMCO’s outlook for non-agency mortgages, a sector in which we’ve had strong conviction for many years?

Murata: In our base case, we estimate U.S. housing prices will be flat over the next two years. Over the longer term, we think that house prices will gradually increase as interest rates remain at very low levels. But even in a much more negative scenario – if for example housing prices drop by 30% over the next two years – we believe that loss-adjusted yields on non-agency MBS would still likely be positive and continue to offer a stable cash flow. The yield profile in our base case outlook remains attractive, with further potential on the upside.

Non-agency MBS are a clear example of the “bend-but-don’t-break” investments we favor in the Income Strategy. Such investments tend to be resilient amid negative economic challenges. We favor non-agency MBS assets offering several features that should help them withstand a downside scenario. One feature is the underlying loans: We’ve focused on securities backed by a diversified pool of legacy first-lien mortgages that borrowers took out before the global financial crisis. Since then, these homeowners have built up substantial amounts of equity, making these positions much more resilient to potential weakness in the economic environment, in our view.

As with any investment, rigorous analysis is key to evaluating opportunities and risks. Our proprietary tools, such as our GeoScore mapping analysis, help us make highly granular assessments of housing markets and price trends around the world in order to identify properties and locations with attractive upside potential.

Q: What are PIMCO’s views on global corporate credit and how are they reflected in the Income portfolio?

Ivascyn: We think that the corporate credit opportunity set is quite interesting versus where it was a year ago. It’s become more of a lender’s market than a borrower’s market in the sense that lenders have more ability to influence terms. That said, investors have to be much more selective in corporate credit today than back in March. The spread convergence since then, driven by central bank and overseas purchases, is likely to be less impactful from here. And as I mentioned earlier, all of this new issuance means the sector is taking on even more leverage in an uncertain economic environment.

Overall, we remain cautious, but within the Income Strategy we have added some high quality corporate credit in the last couple of months. One area of focus continues to be the financial sector. We still think, despite earnings challenges across European banks in particular, and a more uneven picture in the U.S., that financials offer attractive starting capital positions. There is relatively little risk-taking in a historical context. Overall we still believe the financial sector, one of the more liquid areas of the corporate credit market, represents good relative value.

Q: How is the Income Strategy positioned in emerging markets?

Ivascyn: We haven’t made major shifts. This segment of the portfolio is still modest in size and serves as a diversifier. We find emerging markets (EM) to have more attractive valuations than many other spread sectors, at least from a longer-term historical perspective. This makes sense given the near-term uncertainty around COVID, policy, and politics – EM investments will likely be closely tied to local growth dynamics, with both notable upside potential and downside risks.

In the Income portfolio we’ve remained mostly in more defensive high quality EM sovereign bonds or quasi-sovereign bonds, and we are just fine-tuning our positions here. We are reluctant to move into less liquid segments of the market such as EM corporates.

Q: What are your views on duration in this environment?

Ivascyn: Interest rates are historically low, with many parts of the world offering near-zero or negative sovereign yields, and central banks seemingly focused on keeping them there. Over the short to intermediate term, we believe rates will remain relatively range-bound.

As always, we remain focused on delivering attractive income, and duration plays an important role within the portfolio even at record-low absolute yield levels. It serves as a hedge against the riskier segments of the portfolio, though it may not be as effective in the current environment. So, we have taken our interest rate exposure up a bit, mostly adding unhedged longer-maturity positions. We still prefer U.S. duration over other high quality interest rate markets because there is some room for nominal yields to compress if there are additional shocks to growth.

Q: To sum up, what is your overall approach in the Income Strategy today?

Ivascyn: We think this is a time to be a bit more cautious, given the rally in both fixed income and equity markets despite an ongoing pandemic and economic uncertainty. Monetary and fiscal policy support has helped the economy and markets, but we don’t want to count on it. We would like to have a few other layers of resiliency, and we’re taking a fairly defensive approach to income generation.

Looking across the global opportunity set, we see many ways to take advantage of the inherent flexibility in the Income Strategy. We’re pleased with its trajectory the past few months, and we will continue to leverage PIMCO’s investment process, focusing on bottom-up analysis and seeking attractive ideas around the world.

The Author

Daniel J. Ivascyn

Group Chief Investment Officer

Alfred T. Murata

Portfolio Manager, Mortgage Credit

Joshua Anderson

Head of Global ABS Portfolio Management

Related

Disclosures

London
PIMCO Europe Ltd
11 Baker Street
London W1U 3AH, England
+44 (0) 20 3640 1000

Milan
PIMCO Europe Ltd - Italy
Corso Matteotti 8
20121 Milan, Italy
+39 02 9475 5400

Munich
PIMCO Deutschland GmbH
Seidlstraße 24-24a
80335 Munich, Germany
+49 (0) 89 26209 6000

Zurich
PIMCO (Schweiz) GmbH
Brandschenkestrasse 41
8002 Zurich, Switzerland
Tel: + 41 44 512 49 10


PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Italy branch is additionally regulated by the CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are  authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Swedish Branch is additionally supervised by the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act. he services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser.

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 low interest rate environments increase this risk. 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. 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. 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. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. 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.

There is no guarantee that these investment strategies will work under all market conditions or are appropriate 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.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. 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 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. ©2020, PIMCO.

Income Strategy Update: Seeking Long-term Value in a Gradually Healing Economy
XDismiss Next Article
PIMCO