In the following Q&A, portfolio manager Alfred Murata discusses where we are seeing investment opportunities for the Income Strategy and how we are positioning portfolios for rising rates.
Q: How does the Income Strategy balance the primary objective of delivering consistent income with the secondary objective of long-term capital appreciation?
A: The strategy aims to meet these objectives by utilizing a multi-sector, benchmark-agnostic approach that takes advantage of PIMCO’s global resources to source the best income-generating ideas while emphasizing quality and remaining senior in the capital structure. Our Income Strategy does not aim to outperform a benchmark, but rather it looks to provide our investors with consistent income. This allows us greater flexibility to source ideas from the entire fixed income market.
In seeking to achieve its objectives, the strategy is divided into two general components: higher-yielding assets that are expected to benefit when economic growth is robust, and higher-quality assets that are expected to benefit if economic growth is weak. We believe this is the best approach in order to achieve the strategy’s objectives across different market environments.
Q: Many investors are concerned about the prospects of rising interest rates and their effects on a bond portfolio. How are you positioning the Income Strategy for a rising rate environment?
A: For active bond managers, there are a variety of ways to navigate a rising rate environment and mitigate the risks associated with rising rates.
The Income Strategy has the flexibility to tactically manage duration exposure based on PIMCO’s macroeconomic outlook. Typically, we have had lower interest rate exposure when rates are low and less attractive. Conversely, we have typically increased duration exposure as rates rise and become more attractive. The strategy has historically been defensive around interest rate risk and has used its flexibility to adjust duration when we do not believe it is compelling to hold.
Another strategy to navigate rising rates is to think about duration in a global context. The Income Strategy invests across the global fixed income market, so we can diversify interest rate risk. For example, over the past few years we have been investing in Australia, a high quality, developed market where interest rates have been falling due to a slowdown in the economy.
Additionally, rising rates typically coincide with a stronger growth environment, and the strategy focuses on investing in securities, such as non-agency mortgage-backed securities (MBS), that can benefit from a stronger economy. If rates were to rise along with an upswing in growth, we would expect a greater return on the securities that benefit from a stronger economy.
Q: You mentioned that the Income Strategy utilizes a flexible duration band. How are you managing interest rate exposure in the portfolios?
A: The Income Strategy has the flexibility to actively manage its duration in a band of 0 to +8 years. The strategy tactically manages duration and is currently emphasizing high quality countries that have relatively higher yields, such as Australia and the U.S. As interest rates have risen throughout this year, we have added U.S. duration as we believed it was a good opportunity to add high quality income in the portfolio, while also hedging against a risk-off event. Although we have added U.S. duration to the portfolio, we remain cautious on interest rate risk and have been emphasizing curve positioning, limiting exposure to long maturities that can suffer more from a surprise increase in inflation.
We also continue to find it attractive to invest in Australian interest rate duration, as Australian government bonds offer similar yield relative to the U.S., while also offering a high quality buffer against downside risk in the event of a global slowdown.
Additionally, the portfolio has a negative duration position in Japan as a hedge against global yields rising. We think that the risk of this position is asymmetric with limited downside risk. If global yields continue to rise, we believe it will put pressure on the Bank of Japan to revisit its yield curve targeting program and allow yields to rise.
Q: Given the amount of inflows that we’ve seen into the Income Strategy, can you provide some background as to PIMCO’s experience in managing such a large pool of assets?
A: PIMCO has experience in dealing with relatively large strategies. We are comfortable with recent inflows and the overall size of the Income Strategy. While the assets under management appear large in absolute terms, compared with the U.S. and global bond markets, they are relatively small (see figure). Given the $100 trillion global multi-sector opportunity set, and with U.S. interest rates more than doubling since bottoming in July 2016, we believe the Strategy is well positioned to continue to find attractive opportunities from diversified sources and meet its objectives going forward.
In addition, PIMCO has made and will continue to make significant investments in resources to help support the strategy. The Income Strategy’s flexibility and broad opportunity set enable it to leverage PIMCO’s global resources, including 240 portfolio managers and more than 60 credit analysts.