Uncertainty always exists in financial markets. But the COVID-19-driven disruption and recovery have been unprecedented, generating a high level of macroeconomic volatility that risks spreading to asset prices. At the same time, extraordinary policymaker support has led to generally rich valuations, meaning investors may not be getting paid appropriately for the risks they are taking.

We see four major concerns for fixed income investors in this environment – low interest rates, the potential for higher long-term inflation, tight credit spreads, and the risk that volatility could rise. In our view, such a difficult backdrop calls for a flexible approach to building resilient portfolios, including by diversifying sources of return and emphasizing relative-value opportunities when generic beta exposures don’t look compelling.

Four challenges for fixed income investors

1. Historically low interest rates: Central banks are trapped by the need to keep interest rates low at the front end of global yield curves – both to prevent the disinflationary shock of COVID-19 from turning into a debt-deflation spiral, and to allow governments to borrow at affordable rates to fund fiscal stimulus. Despite an uptick in early 2021, interest rates remain at low absolute levels, and are negative in many regions. In fact, at the end of June 2021, close to 20% of the global fixed income market was composed of negative-yielding debt. For investors, starting yields have historically been a strong predictor of future five-year returns, as illustrated in Figure 1.

Figure 1 is a line chart showing that five-year forward global bond returns closely track starting yields on a U.S. dollar-hedged basis. Starting yields have fallen steadily from 9.0% in Jan. 1990 to 1.2% as of 30 June 2021, while forward five-year returns have declined from 7.72% in Jan. 1990 to 2.98% as of 30 June 2016. This suggests that forward five-year returns will continue to decline. The five-year rolling or forward return is calculated as the annualized forward-looking five-year historical total return for the Bloomberg Barclays Global Aggregate Bond Index. For example, the five-year rolling return as of January 2010 measures the period from January 2010 to January 2015. The starting yield is the yield to worst at a certain date. The figure is for illustrative purposes only.

2. Potentially higher longer-term inflation: The outlook for economic recovery and continued government fiscal support has stoked concerns about rising inflation. While PIMCO’s base case is that many near-term inflation pressures will prove transitory, we remain humble in our forecasts and believe the upside risks to longer-term inflation are worth considering. Unfortunately, many investors remain vulnerable to higher inflation given they are handcuffed to high levels of duration (interest rate risk) through their benchmarks, and because rising inflation expectations put upward pressure on interest rates (and therefore downward pressure on bond prices).

3. Compressed spreads: Spreads across credit sectors have narrowed from their March 2020 highs, returning to their historically low pre-crisis levels, amid large-scale central bank purchases. The European Central Bank, for example, now owns nearly 12% of the European investment grade corporate bond market with the potential to increase its ownership to 30%. While spreads in specific sectors could still tighten, there is likely limited scope for generic spreads to compress further (see Figure 2).

Figure 2 is a table ranking the current valuations of global investment grade credit, high yield credit, and equities on a percentile basis relative to their valuations over the past 20 years. As of 30 June 2021, global investment grade credit, as proxied by the Bloomberg Barclays Global Aggregate Credit Index, was at the 79th percentile of its 20-year valuation range; global high yield credit, proxied by the Bloomberg Barclays Global High Yield Index, was at the 85th percentile; and global equities, proxied by the MSCI World Index, was at the 92nd percentile, according to Bloomberg.

4. Potential for elevated volatility: As global economies transition from policy-induced growth to organic growth, there is no guarantee the journey will be smooth. The unleashing of pent-up demand and lockdown-driven productivity gains could lead to growth surprises (and inflation). On the other hand, increased savings rates and a prolonged reallocation of workers and resources could lead growth to disappoint. And while we don’t see a repeat of the so-called “Taper Tantrum” of 2013, when U.S. Treasury yields surged after the U.S. Federal Reserve referenced potential plans to taper asset purchases, an eventual reduction of central bank support could cause volatility to pick up.

The potential benefits of flexible fixed income

For an active manager like PIMCO with a robust top-down investment process, these challenging dynamics and the resulting potential for wider dispersion of returns across assets can create opportunities. We believe PIMCO’s flexible income strategies are well-positioned to take advantage of these opportunities.

PIMCO offers two types of flexible fixed income strategies – those that seek to provide an attractive and consistent level of monthly income while mitigating downside risk; and dynamic strategies tailored to pursue an absolute return target over market cycles with a focus on capital preservation.

To try to meet those objectives in today’s low-rate environment, PIMCO’s flexible fixed income strategies can tap sources of higher yield and focus on what are believed to be the most attractive opportunities across global bond markets. This includes securities in potentially higher-yielding sectors like emerging markets (EM), as well as higher-quality interest rate markets like the U.S., where rates have more room to fall during a negative shock. Other potential sources of return include capital appreciation due to yield curve roll-down, especially now on the steep intermediate (3- to 7-year) portion of yield curves globally.

Meanwhile, the risk of longer-term inflation can potentially be countered by taking short positions at the longer end of the curve, where yields would likely increase most in an inflationary environment. Flexible strategies can also seek geographic diversification of interest rate exposure, which could include other higher-yielding developed markets (DM) and EM local rates.

To navigate compressed spreads, active managers can allocate capital to credits which have lagged during the initial stages of the recovery, but which have strong fundamentals and should benefit from an economic reopening. Sectors such as airlines, lodging, retail, and real estate are particularly compelling as continued policy support and vaccine rollouts will likely lead to a global rebound this year from the pandemic-induced economic slump. Other opportunities include assets where spreads have not been compressed by central bank activity. These include U.S. non-agency mortgage-backed securities (MBS), given the strength of housing in the U.S., as well as higher-quality EM credits, though we stress the importance of bottom-up research for these securities.

Finally, given the potential for elevated volatility, an active manager like PIMCO can tilt a portfolio toward what we categorize as higher-quality “bend but don’t break” positions, prioritizing seniority and security where possible. An emphasis on liquidity may also allow managers to take advantage of dislocations and attractive new issuances.

Conclusion

Fixed income investors face hurdles to building resilient portfolios that meet their objectives. Low overall interest rates and compressed yield spreads portend weak returns in coming years. At the same time, investors may be exposed to rising longer-term inflation and increased volatility as economies recover and central banks reduce support.

PIMCO’s flexible income strategies seek to mitigate these risks and add value in part by de-emphasizing generic beta exposure to interest rates and credit spreads when these don’t look compelling. They may also diversify across a range of return drivers in interest rate, credit, and currency markets, and seize opportunities in volatile periods.

Traditionally, the role of fixed income has been to generate additional return while providing diversification to other parts of the portfolio. With a flexible approach, fixed income can still play this role.



1 Global fixed income market represented by the Bloomberg Barclays Global Aggregate Bond Index. It is not possible to invest directly in an unmanaged index.
2 Source: Barclays Live and ICMA, https://www.icmagroup.org/Regulatory- Policy-and-Market-Practice/Secondary-Markets/central-bank-corporate-bond-purchase-programs/, as of 31 May 2021.
The Author

Marc P. Seidner

CIO Non-traditional Strategies

Esteban Burbano

Fixed Income Strategist

Michael Biemann

Fixed Income Strategist

Disclosures

Sydney
PIMCO Australia Pty Ltd
ABN 54 084 280 508
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Australia
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PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs.

Past performance is not a guarantee or a reliable indicator of future results. This material is provided for information purposes and should not be construed as a solicitation or offer to buy or sell any securities or related financial instruments in any jurisdiction.

All investments contain risk and may lose value. 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. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. 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. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. 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. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. Diversification does not ensure against loss.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. The continued long term impact of COVID-19 on credit markets and global economic activity remains uncertain as events such as development of treatments, government actions, and other economic factors evolve. The views expressed are as of the date recorded, and may not reflect recent market developments.

Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no assurance that the desired results will be achieved. 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. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.

Yield to Maturity (YTM) is the estimated total return of a bond if held to maturity. YTM accounts for the present value of a bond’s future coupon payments. The measure does not reflect the deduction of fees and expenses and is not necessarily indicative of a bond or portfolio’s actual performance.

Bloomberg Barclays Global Aggregate (USD Hedged) Index provides a broad-based measure of the global investment-grade fixed income markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. The index also includes Eurodollar and Euro-Yen corporate bonds, Canadian Government securities, and USD investment grade 144A securities.

The Bloomberg Barclays Global High Yield Index is a component of the Multiverse Index, along with the Global Aggregate index. It represents the U.S. High-Yield, Pan-European High-Yield, U.S. Emerging Markets High-Yield, CMBS High-Yield, and Pan-European Emerging Markets High-Yield indices.

The MSCI World Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed markets. The MSCI World Index consists of 23 developed market country indices.

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