From the October 2012 issue of Research Magazine • Subscribe!

Thriving Amid Low Rates

Income investors have been crushed by the depressed interest rate environment. The 10-year yield on U.S. Treasuries recently fell under 1.40%, cutting yield income even further. And more investors have been flooding into higher risk areas like emerging markets debt and high yield bonds.

In certain bond sectors, yields are falling but credit risk is rising. How can advisors navigate their clients through a bond market packed with risk?

Jon Short, managing director, head of global wealth management and head of PIMCO’s New York office speaks with Research. Previously, he was head of PIMCO’s institutional business group. Prior to joining PIMCO in 2005, Short held a variety of senior distribution and portfolio management positions at Fidelity Investments and Putnam Investments. He has 26 years of investment experience and holds an MBA from MIT Sloan School of Management. 

The interest rate on 10-year U.S. Treasuries has fallen below 1.50% to record lows. How much further can yields fall?

Several factors are holding the 10-year Treasury yield around this low level at the moment and likely will for some time: The Federal Reserve plans to keep interest rates near zero until the end of 2014, we still have very sluggish growth in the U.S. of only 1.5 to 2%, and of course Europe is still very much a concern. So the flight-to-quality bid continues to hold down the yield on the U.S.10-year Treasury. We’re not going to put targets on it because we are seeing some very volatile markets driven by global macroeconomic factors, but we don’t see any significant changes to these global concerns any time soon, so the 10-year will probably trade in this range for a while. [Relevant funds include: ZROZ or TENZ]

With global central banks buying sovereign debt, how much risk does this present for bond investors in the future?

Central banks have indeed embarked upon some extraordinary measures aimed at stimulating global growth. These unusual policy actions range from setting exceptionally low short-term rates and stating that they will remain low for an extended period of time to implementing various quantitative easing programs designed to lower longer term borrowing costs. As long as we continue to see sluggish global growth, or maybe even a slowdown, you can expect central banks to continue to deploy more policy tools to stem the pace of deleveraging and stimulate the economy. That said, even Fed Chairman Ben Bernanke has made the point that, although extraordinary Fed action comes with benefits, it also comes with costs and risks. Central banks are serving as a bridge, trying to help the global economy navigate this difficult period, but at some point the fiscal authorities need to get involved as well, otherwise the Fed’s actions could merely prove to be a bridge to nowhere.

The State Budget Crisis Task Force issued a report about trouble facing municipal bond investors. The unfunded liabilities for health care benefits for state and local government retirees ALONE amount to more than $1 trillion. If there are so many problems in the munibond market, how come it hasn’t yet showed up in their performance—which has thus far been decent?

We view municipals as a “safe spread” sector offering relative value within the fixed income market—that is, holding up within a wide range of possible economic scenarios. However, there are headwinds facing municipalities, particularly in the general obligation sector, so we have favored essential service revenue bonds, which are typically independent of taxing authority and retiree benefit concerns. Regardless of the exact size of the aggregate unfunded liability for government retirees, inaction could threaten the long-term solvency of many issuers. That’s a big part of why we favor revenue bonds over general-obligation bonds. Regardless of where you invest in the municipal market, however, the sector has become one of individual credits, as opposed to a credit market. What I mean by that is that idiosyncratic risk has greatly increased and more than ever you need independent research talent to identify the securities with the right fundamentals and the right risk-return profile.  [MUNI and SMMU]

A number of high quality stocks are now paying higher yields on dividends to their stockholders than they pay on their corporate debt. That’s the case for AT&T and McDonald’s and it’s the case for others. Does this make a case for keeping dividend paying Blue Chips?

First let me state that we think dividends are an important part of any portfolio. Our approach to deciding which companies to invest in—and importantly, how to investment in them—is global in nature and revolves around analyzing what part of the capital structure offers the most attractive risk/return opportunity. We see opportunities from a range of companies, including those with potential to increase earnings, and even some cyclical companies. And remember, dividends aren’t simply a developed-market phenomenon. A good example is Baxter Healthcare, which has a significant exposure to emerging markets and has shown it can increase its dividend over time.

TIPS are often used to hedge against future inflation, but TIPS are not necessarily a hedge against rising interest rates. Are there any strategies to combat both problems?

Guarding a portfolio against rising inflation should be an important part of any advisor’s strategy for clients. PIMCO expects global inflation over the next five to 10 years to be higher than it has been over the last 20 years. This view in part is due to the fact that we believe inflation may be one of the ways heavily indebted developed nations seek to “grow” their way out of problems. Also, emerging markets have exported disinflation for years, but with middle class in these economies expanding by up to 2 billion people over the next 20 years, commodity prices will likely increase. The core asset to hedge inflation is developed market inflation-linked bonds, such as Treasury Inflation-Protected Securities in the U.S. But investors can also look to real assets like commodities, as well as dividend-yielding equities and real estate investment trusts. ILBs in countries such as Mexico and Brazil are another option, we believe. [Active inflation strategy: ILB]

Since March, the PIMCO Total Return ETF (BOND) has been outperforming its much larger cousin, the PIMCO Total Return Fund (PTTRX). Both funds have the same manager, so why the performance difference and how do both funds compare to each other?

All of our ETF offerings are aimed at giving investors another way to access PIMCO’s investment process in a transparent and easily tradable format. We want our clients to own PIMCO strategies in the format and vehicle they prefer, so BOND is really another way for investors to access the Total Return strategy. It is also a separate fund with its own distinct holdings, but over time we expect performance to be generally in line with the performance of portfolios using the Total Return strategy.  

The vast majority of bond mutual funds underperform ETFs linked to bond indexes. Why is it so hard for typical bond fund manager to outperform?

We think the key to performance is active management—whatever format investors chose to use. Active management comprises many different factors, from seasoned portfolio managers, to best ideas, to deep research and above all, a meticulous investment process.

PIMCO’s investment process is at the heart of the firm and everything we do. The best example of this motivating principle is our investment forums. Each quarter, PIMCO investment professionals and guest experts from around the world gather in our Newport Beach headquarters to discuss and debate the dynamics of the global economy and markets. One of these forums, which we call the Secular Forum, is held annually in May, and helps us formulate our view of the global economy for the next three to five years—think of it as the investment guardrails; whereas the quarterly cyclical meetings help determine which lanes to drive in.

Another critical plank of the investment process is the Investment Committee, which includes the firm’s most senior portfolio managers. They meet up to three hours a day, four times each week, discussing, analyzing and assessing new investment themes and trade ideas. Also, we constantly self-critique our own ideas. All of this is complemented by a relentless focus on risk management. Bottom line: We believe the right manager using a disciplined investment process and controls can deliver value above and beyond a benchmark. [PIMCO’s active ETF suite: BOND, MINT, ILB, MUNI, SMMU and BABZ] 

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