'Dramatic bonds repricing presents opportunities not seen in years'

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'Dramatic bonds repricing presents opportunities not seen in years'

Bonds have had a rocky start to the year amid rising inflation and interest rates followed by a growing threat of recession both at home and abroad.

Added to this is the threat of stagflation in major economies, which would see inflation remain at higher levels in the near term alongside slowing economic growth.

In a Q&A with FTAdviser In Focus, in partnership with Pimco, the asset manager's investment team explains what weighs heavily on their mind at the moment and how the Pimco GIS Income Fund seeks out opportunities in the market right now.

We see several opportunities in the market after volatility and uncertainty drove the second quarter sell-off.

FTA: What occupies the minds of your investment committee these days – inflation or the prospect of a recession?

Pimco: A combination of both. Recent macro data underscore our view that the war in Ukraine and sanctions shock, along with the Covid-19-related lockdowns in China, is stagflationary.

Our base case view is that US inflation likely peaked in June but will remain elevated well into 2023, perhaps even 2024, before it trends down toward central bank targets.

Although prices of some key commodities are declining and other price pressures have begun to dissipate, we believe inflation will remain a significant risk factor for investors, driven by uncertainty around the war in Ukraine, other geopolitical risks, and the evolution of Covid.

There is also an increasing trade-off between central bank tightening to contain inflation and resulting weakness in economic growth, employment, and credit fundamentals. This trade-off makes a minor-to-moderate recession increasingly likely and impacts our views on interest rate and credit exposure.

We see an elevated risk of recession in the near term – reflecting geopolitical tumult – stubbornly high inflation that reduces households’ real disposable income, and central banks’ intense focus on fighting inflation first. 

FTA: As yields are rising, how can investors know when is the right time to return to fixed income? 

Pimco: We know in a world like today where there is so much uncertainty it is hard to time an entry point perfectly, but value from a longer-term historical perspective has returned to the market.

The yield on core bond benchmarks has recovered from Covid-era lows, and in our baseline outlook we think that forward markets either price in or are close to pricing in what is likely to be the secular high for policy rates across different countries.

The market’s dramatic repricing presents better long-term opportunities for active investors than we have seen in years.

The volatility we have witnessed is creating the type of opportunity across sectors where not only can you generate an attractive yield without going down the credit spectrum too significantly, but you can also take advantage of a lot of this local volatility and provide some incremental pickup through relative value trading, through targeting even more resilient sectors.

And again, by doing some of that, investors can quickly get their yield level up into the mid-single digits, which from a historical perspective, once again is looking increasingly attractive.

FTA: The bonds market has seen big outflows as well as value drops, but some say ‘every downturn provides opportunity’. Where do you see opportunities in the market right now?

Pimco: As mentioned previously, we see several opportunities in the market after volatility and uncertainty drove the second quarter sell-off.

Early in the year and into the second quarter, investors focused on inflation and US Federal Reserve policy.

As the quarter progressed, though, their concerns migrated to the impact of policy tightening and geopolitics on economic growth and credit sector performance – concerns that persist today.

The market’s dramatic repricing, however, in our view presents better long-term opportunities for active investors than we have seen in years. Yields have risen meaningfully, spreads have widened and carry has increased, providing a potentially powerful source of return.

FTA: How have you responded to those opportunities within your GIS Income Fund?

Pimco: We are targeting higher-quality assets with spreads that have widened in sympathy with more credit-sensitive assets.

The recent sell-off opened an opportunity to add back credit risk in the front end of the yield curve, though we remain a bit defensive relative to our historical norm. We are also taking advantage of higher rates to gradually add a little interest rate exposure to the strategy.

 We have less exposure to more economically sensitive areas of the market, like lower-rated corporate credit risk, where we think underwriting standards have weakened.

We believe the result is a portfolio differentiated from other income-oriented strategies that tend to focus on more significant-sized exposure to the US corporate credit market – a differentiation which we believe should lead to a better portfolio.

FTA: What are the most exciting areas of the market for your fund right now?

Pimco: The market’s repricing makes us very optimistic about the income-generating ability of the GIS Income Fund over the next few years.

Yet it may be a bumpy journey, with ongoing bouts of volatility and a potential economic downturn. Our portfolio positioning reflects this.

We've continued to focus on cash flow seniority and add-in resilient sectors like agency mortgages, structured products and higher-quality banks, as well as a variety of macro-oriented relative value strategies.

Relative to many passive alternatives, we have less exposure to more economically sensitive areas of the market, like lower-rated corporate credit risk, where we think underwriting standards have weakened.

Agency mortgage-backed securities, which are issued by one of three quasi-governmental agencies, is also an interesting area. Prices have done a round trip. As markets seized during the first quarter of 2020, agency MBS prices became very attractive and we added above-average exposure.

This position worked well in the remainder of 2020 when the Fed proceeded to aggressively buy a significant portion of the available supply of agency MBS, driving spreads to tight levels where we sold a lot of that exposure (at least indirectly) back to the Federal Reserve.

More recently, amid concerns about central banks selling mortgages back into the market, spreads have widened and we are steadily adding back this risk. 

We expect emerging markets to offer good opportunities.

We're also actively trading this book and seeking to generate other forms of incremental return through selection of securities, coupons and maturities.

We think if inflation remains elevated, agency mortgage spreads can widen even further.

This sector presents an exciting opportunity to generate value, improve the portfolio’s downside risk profile and, through active trading, seek to generate additional return.

FTA: Are emerging markets attractive right now, given the price of commodities is high?

Pimco: We expect emerging markets to offer good opportunities, while we stress the importance of active investment to sort between the likely winners and losers in a difficult investment environment.

Some countries should benefit from demand for capital goods, and commodity exporters may benefit from improved terms of trade.

At the same time, other EM countries with weak fundamentals and policy frameworks may be further exposed in a world of shorter cycles and higher macro volatility. Commodity importers may also face significant challenges.

FTA: How have you responded to this dynamic within the GIS Income Fund?

Pimco: Within the emerging markets asset class, we look for prudent sources of diversification or additional return, but we usually operate in the higher-quality, more liquid segments of the market: sovereign risk, quasi-sovereign risk, and currencies of higher-quality countries.

We have little emerging market corporate credit exposure, and little local rates exposure, particularly in less liquid areas.

Over the last several months, we have reduced our exposure to emerging markets. Specifically, we pared back exposure to Asia, particularly to China and to Latin America.

We have had little exposure to eastern Europe and we continue to avoid that part of the world because it is inconsistent with the liquidity and volatility profile of the strategy.

Our allocation focuses on higher-quality areas, including Brazil and Mexico, with small positions in South Africa and Israel.

carmen.reichman@ft.com