PIMCO recently introduced the PIMCO Mortgage Opportunities Strategy, an actively managed mortgage vehicle that seeks to provide attractive absolute returns across full market cycles. As lead portfolio manager Daniel Hyman and product manager Jason Mandinach explain, the unconstrained, flexible approach is designed to capitalize on the dramatic changes affecting housing and mortgage finance amid an uncertain interest rate environment.
Q: What is the PIMCO Mortgage Opportunities Strategy?
Hyman: This is an actively managed absolute-return mortgage strategy that aims to capitalize on dislocations in Agency and non-Agency residential and commercial mortgage-backed securities (MBS) markets, without the constraints of a 100% Agency MBS benchmark. The strategy is managed against a three-month Libor benchmark and can take both positive and negative duration positions.
Q: Why is flexibility so advantageous today?
Hyman: Flexibility is critical because mortgage investors face two key unknowns: the future of mortgage finance and the trajectory of interest rates. In addition, many mortgage investors are constrained by credit ratings and unable to capitalize on many of the most attractive opportunities. For example, the vast majority of non-Agency residential MBS that had been rated AAA before the financial crisis have since been downgraded to below investment grade. Our less constrained approach can evolve with developments in both the mortgage finance system and the interest rate environment, while also aiming to capitalize on what we think is one of the most attractive opportunities in global credit markets – below investment grade, legacy non-Agency MBS.
Q: How can you achieve diversification in a strategy restricted to mortgages and other fixed income securities?
Hyman: Our flexibility allows us to diversify across the most attractive opportunities in the entire securitized mortgage market – including Agency and non-Agency residential and commercial MBS. We use financial instruments to actively manage our exposure to risk factors such as interest rates, credit, yield curve, home prices and prepayment speeds.
Q: Could you discuss your investment process and philosophy?
Hyman: Investing in mortgages today requires insight into macroeconomic trends and detailed analysis of collateral and security structures within the MBS market. We believe that active relative value positioning works well in the highly liquid, interest rate sensitive Agency MBS market, while detailed loan-level analysis and security selection can lead to attractive return opportunities in the less liquid, credit intensive non-Agency MBS and commercial mortgage-backed securities (CMBS) sectors. These approaches also facilitate a focus on maintaining responsible levels of risk and a high degree of liquidity.
Our process starts with PIMCO’s macroeconomic views and the potential impact of policy initiatives on MBS valuations. This is the first step in defining our exposure to various subsectors of the mortgage market. Next, we do rigorous loan-level cash flow modeling and stress-test the mortgage credit side of the portfolio to identify securities with attractive cash flows across a variety of scenarios. In addition, we analyze the housing market down to the ZIP-code level.
In Agency MBS, we rely on PIMCO’s traditional relative value approach to seek attractive risk-adjusted returns while maintaining a high degree of liquidity. We use a long-term empirical approach, comparing prices today with where they’ve been historically and having a discussion as to why that may be. Through this process, we believe we can efficiently identify dislocations in relative value, as well as reasons why these dislocations may or may not be justified based on current developments in the mortgage market.
Q: You say current opportunities are attractive, but mortgage rates are near historical lows. Why invest now? What if interest rates rise?
Hyman: Return opportunities are attractive in Agency and non-Agency mortgage markets for very different reasons. In Agency MBS, while absolute yields are low relative to historical standards, opportunities from relative value trading have rarely been more attractive. In particular, by focusing on deviations in value within the highly liquid Agency pass-through market and capitalizing on the spread between these securities, PIMCO has sought attractive returns across numerous market cycles for more than three decades.
By contrast, non-Agency MBS provide some of the most attractive cash flows in global fixed income markets. As discussed earlier, extensive ratings agency downgrades and re-regulation have greatly diminished demand for these bonds. Years of pessimism regarding the U.S. housing market also have negatively impacted pricing. As a result, the sector has priced in a far more negative outlook for housing than we believe is realistic.
In addition, while the potential for a rising rate environment is an obvious concern, we believe our strategy could prosper if rates were to climb. For example, we could trim duration positioning and take a defensive posture by moving almost exclusively to floating-rate MBS, while shorting the Agency pass-through market. Or we could combine shorter duration Agency mortgages with mortgage credit bonds likely to benefit from an improvement in home prices if rates were to rise amid an improving economy. We are focused on non-Agency securities that offer structural seniority and that trade at a substantial discount to par, and these positions could increase in price in an improving economy.
Q: How does the PIMCO Mortgage Opportunities Strategy differ from long-only strategies or those that track a mortgage benchmark?
Mandinach: Many existing high-quality MBS strategies focus on either the Ginnie Mae MBS market specifically, or the broader Agency MBS market. Importantly, these strategies are typically benchmarked 100% to Agency MBS or GNMA MBS indexes. Today, our strategy targets about 50% to mortgage credit, although this ratio could change substantially as relative value opportunities change.
There are some other strategies that focus on the mortgage market, but are managed versus the Barclays U.S. Aggregate Bond Index. These strategies may emphasize mortgage credit a bit more than dedicated GNMA MBS or Agency MBS strategies, but they are still tethered to a traditional broad fixed-income benchmark.
The PIMCO Mortgage Opportunities Strategy seeks to operate outside the confines of traditional bond benchmarks. This allows us to do three things that traditional mortgage strategies typically don’t do. First, we can go wherever the opportunity is in the securitized mortgage market. (Strategies managed 100% against Agency MBS indexes or even the Barclay’s U.S. Aggregate Bond Index could have difficulty doing so, as neither include any non-Agency MBS, and the latter only has a small component of CMBS.) Second, this strategy can take both positive and negative duration positions, providing the flexibility to navigate the uncertain interest rate environment, while still aiming to deliver positive returns. Lastly, we can evolve with the mortgage finance system. As the discussion in Washington on mortgage finance reform progresses, we may see seismic shifts in the provision of mortgage credit and the opportunities in mortgage-backed securities.
Q: How does the PIMCO Mortgage Opportunities Strategy differ from PIMCO’s other mortgage-related approaches?
Mandinach: The key difference is that our Ginnie Mae and MBS strategies are benchmarked 100% against Agency or GNMA pass-throughs instead of three-month Libor. Rather than allocating 80% to 90% to Agency or GNMA MBS as we typically do in those strategies, we’re targeting a greater allocation to mortgage credit.
Q: How do you work with your co-portfolio managers, Alfred Murata and Joshua Anderson?
Hyman: As co-portfolio managers, we combine our expertise across subsectors of the MBS market to construct and maintain an optimal portfolio from a risk/reward standpoint. We’ve been working together since I joined PIMCO in 2008. I focus on Agency mortgages, where I’ve spent my career. Josh concentrates on CMBS and other structured credit, while Alfred handles non-Agency residential MBS. Both Josh and Alfred have been key portfolio managers on our distressed mortgage strategies and bring unique insights to the mortgage credit side of the portfolio
Q: What role might this strategy play in a client’s portfolio?
Mandinach: This strategy can play several different roles in a client’s portfolio. As investors search for yield, we continue to think that exposure to non-Agency MBS and other structured credit assets makes a lot of sense. They also can provide investors with more liquid exposure to a recovery in U.S. housing than many real estate assets.
Finally, in our view, this strategy may work well for clients seeking return opportunities in the mortgage market, but who are not necessarily comfortable taking on a great deal of interest rate risk. Through active management of interest rate exposure and the balancing of interest rate sensitive Agency MBS with more credit sensitive non-Agency MBS, this strategy will seek to generate attractive returns in the mortgage market regardless of the trajectory of interest rates.