Russia’s invasion of Ukraine and the world’s subsequent sanctions and actions to curtail Russia’s access to the global financial system have thrown financial markets into turmoil. Here, Dan Ivascyn, who manages PIMCO Income Strategy with Alfred Murata and Josh Anderson, talks with Esteban Burbano. They sort out the changing calculus of the fixed income opportunity set, highlighting PIMCO’s economic and market views along with current portfolio positioning. This interview took place on 3 March 2022.

Q: How are the terrible events in Ukraine and unprecedented economic sanctions on Russia affecting PIMCO’s views on growth and inflation?

Ivascyn: The tragic situation in Ukraine has added extreme uncertainty to an already uncertain growth and inflation outlook. We are ratcheting down our growth outlook and boosting our inflation expectations for developed economies amid a rising risk of inflation. We have trimmed our growth forecast across the developed world by about a percentage point, slightly more in the U.S. And we believe inflation will linger this year at higher levels than we had forecast prior to the war, with much of it concentrated across Europe. For 2023, our base case calls for prices to stabilize, but there is a lot of uncertainty surrounding our outlook. We’ll refine our global macro outlook at our March Cyclical Forum, and share those views later this month.

Despite this uncertainty, we believe most markets appear generally fairly valued, and in some areas expensive, within a historical perspective. The flight to quality in bonds that we would normally expect in a global crisis has been tempered by expectations for central bank tightening, creating a concerning environment for risk assets. With elevated inflation lingering, central banks, particularly the U.S. Federal Reserve, will be forced to tighten, likely heightening the risk of recession.

We are focused on mitigating risk, preserving capital, diversifying prudently, managing liquidity, and fine-tuning the portfolio by adding select higher-quality risk.

Q: What is your outlook for central bank policy, and how is the Income Strategy positioned to navigate upside inflationary risks as well as rising rates?

Ivascyn: We believe that many major central banks will raise interest rates several times this year, but likely at a more gradual pace than they would have planned before the Ukraine crisis. Our latest forecasts call for central banks to tighten a bit less than what is embedded in markets. If the economy were to deteriorate significantly, we think central banks would likely slow the tightening process.

We remain broadly defensive regarding interest rate exposure in the face of extreme market uncertainty and what we believe are fairly full valuations. That said, in the Income portfolio, we have slightly increased our interest rate exposure in response to higher rates, rising geopolitical uncertainty, and an increased recession risk.

To help counter inflation risk – which the war in Europe has heightened – we hold duration in inflation-linked instruments, including a core holding in U.S. Treasury Inflation-Protected Securities (TIPS).

Q: What are PIMCO’s views on Russian assets, as well as European markets?

Ivascyn: From a financial, rather than moral perspective, we think investors should favor a wait-and-see approach. Governments are still clarifying sanction details, such as what can be traded and what cannot. Policymakers, particularly in Europe, have been cautious to date about sanctioning the Russian energy sector because higher energy prices could ignite global inflation and weaken demand. But much of the private sector is self-sanctioning, effectively boycotting Russia. If this continues or accelerates, it could stoke inflation in energy and commodity prices broadly. Reflecting the extreme near-term uncertainty, Russia’s energy complex is priced at distressed levels. Russian markets are frozen and positions are marked at extremely low levels.

With respect to Russian exposure, the Income Strategy has a roughly 2% exposure, primarily in sovereign and quasi-sovereign debt and currency forwards. That exposure was part of a diversified emerging markets basket, but it’s been a source of considerable near-term volatility. Most of the risk of asset impairment is behind us at this point. There are prospects for some improvement as sanctions are clarified.

Outside Russia, with respect to Eastern Europe, the Strategy has very limited exposure, roughly1%. In general we have seen more widening in spreads of risk assets across Eastern Europe relative to other areas of the developed world. European investment grade and high yield risk has underperformed its U.S. equivalents. We see value in what we believe are the most stable segments of that marketplace, including select senior financials. But again, we are very cautious, particularly on assets in Eastern Europe. This situation could deteriorate rapidly, so we are focused on capital preservation.

Q: How is the Income Strategy positioned amid significant uncertainty and challenging liquidity?

Ivascyn: Overall we believe the portfolio is well positioned for the current environment. Over the last year, we have been steadily reducing our credit exposure, improving liquidity, and focusing on sectors that we expect to be resilient in a challenged economy. Now we think it is time to become a bit more aggressive in what we see as higher-quality, potentially more stable areas of the opportunity set that have widened in sympathy with riskier assets. We are adding risk prudently, and maintaining a balanced approach with ample diversification and liquidity amidst a more uncertain environment. It is premature, in our view, to be aggressive in credit-sensitive areas of the market, such as unsecured high yield bank loans, that we believe could underperform if recession is the ultimate outcome.

The core of the Income portfolio remains in securitized credit, including seasoned residential mortgage-related exposure. Our non-agency mortgage-backed securities (MBS) allocation remains concentrated on legacy positions that have benefited from meaningful equity build up over many years of rising home prices, and now have low loan-to-value ratios that can help mitigate the risk of home prices falling.

Within U.S. agency mortgages, which is one area where market valuations have weakened somewhat, we are once again adding to our allocation in the Income portfolio. Last year, we reduced our allocation to agency MBS when valuations became expensive, largely as a result of the Fed’s bond-buying program (which is ending this month). But amid recent volatility – related to both Fed tapering and the Ukraine war – we’ve found agency mortgages have cheapened. In general, agency MBS can represent an attractive and liquid alternative to traditional credit assets to provide incremental return potential with meaningful downside risk mitigation.

Q: In addition to housing-related assets, what areas of the credit market does PIMCO find attractive?

Ivascyn: Despite the elevated risk of recession, we think it makes sense on a more tactical basis to begin to add higher-quality risk to portfolios. We are seeing opportunities in instruments that appear well-insulated from default or even downgrade. These kinds of assets were hard to source during 2021, when almost all asset prices rose as excess liquidity chased yield all over the globe.

We are seeing more value in select high-quality investment grade bonds and in senior risk within the asset-backed markets, including segments of the commercial mortgage-backed securities markets.

Within the corporate credit opportunity set, we are focused on a few key areas. Financials – with a tilt toward the U.S. – are a core overweight in the Income portfolio. Many banks globally have historically high capital levels and are taking relatively low risks – a result of post-global-financial-crisis regulation. This is reflected in the banks’ market resilience, even those across Europe – a resiliency we would not have expected in the past. Our focus is on senior risk, but we have a modest allocation to subordinated debt, which we see as an attractive high yield alternative.

On the currency side, we remain fairly neutral on U.S. dollar exposure, but hold a highly diversified basket of select non-dollar exposure.

Emerging markets (EM) valuations remain quite attractive. In fact, the bulk of our EM exposure, which resides outside of Europe, has performed well this year. Of course, this market segment can be prone to uncertainty, but it tends to have more valuation cushion than many areas of the developed world, and we think EM represents a prudent form of overall diversification.

Q: How should investors think about market volatility as they look for long-term income generation in their portfolios?

Ivascyn: Over the long term, to seek returns higher than the stated yield, you typically need volatility, which can lead to opportunities as markets overshoot fundamentals. Although it can feel challenging when you’re in the midst of it, periods of heightened volatility historically have tended to provide the opportunity to generate not only a consistent and high dividend yield, but total return as well. As an active manager with a flexible and global opportunity set, this environment allows us to source attractive risk after a couple years of tight spreads, but we approach this prudently, looking to preserve capital and remain nimble in this rapidly evolving market.