Like just about every other fixed-income investor these days, PIMCO CEO and co-CIO Mohamed El-Erian is now asking a simple yet huge question: What exactly is going on in the bond market?
Yet unlike many others, El-Erian (left) has come up with some solid observations, answers and investment ideas.
“To say that bonds are under pressure would be an understatement,” El-Erian writes in his September viewpoint, “What’s Happening to Bonds and Why?” “Over the last few months, sentiment about fixed income has flipped dramatically: from a favored investment destination that is deemed to benefit from exceptional support from central banks, to an asset class experiencing large outflows, negative returns and reduced standing as an anchor of a well-diversified asset allocation.”
So what’s the takeaway for investors? After writing a long and reasoned report that explains just what is going on in the bond market, El-Erian ends up agreeing with the conclusions his co-CIO, Bill Gross, offerend in a baseball-metaphor-driven investment outlook published earlier this month.
“Specifically, fixed income investors should respect the technicals for now, emphasize the front end of curves on the basis of the policy pivot (from [quantitative easing] to forward guidance), and consider TIPS as a source of endogenous portfolio hedging,” El-Erian writes. “They should look to exploit large technical dislocations that are anchored by upcoming maturities and other self-liquidating characteristics. And, given that the bad technicals will run their course eventually, they should prepare to take advantage of broader overshoots that provide both attractive valuations and solid carry.”
Before the end of April, when the market started its gut-wrenching descent, “the combination of return generation and risk diversification was part of a broader virtuous circle for fixed income, which also included significant inflows to the asset class and direct support from central banks,” El-Erian writes at the start of his viewpoint, noting that in addition to delivering solid returns with lower volatility relative to stocks, the inclusion of fixed income in diversified asset allocations also helped to reduce overall portfolio risk.
That virtuous circle clearly was reflected in positive investment returns. Over the last 20 years, a diversified portfolio of high-quality bonds, as defined by the widely followed Barclays U.S. Aggregate benchmark, delivered strong returns, El-Erian notes. The benchmark’s annualized 20-year return delivered 6% while the 1-, 3-, 5- and 10-year returns stood at 3.6%, 5.4%, 5.6% and 5.0%, respectively.
But that was then.
“All of this changed markedly starting in April 2013,” says El-Erian. “Since then, the Barclays U.S. Aggregate has delivered a negative return of 4.5% (May through 6 September 2013) and bond funds have experienced sharp outflows.”
PIMCO’s CEO then reviews what he describes as the Federal Reserve’s “highly unconventional and experimental set of policy tools” used to repress interest rates.