Income Strategy Update: Investing in the Recovery

Most markets have more than fully recovered amid expectations for accelerating global economic growth, and a thoughtful approach is critical to navigating the coming years. Here, Dan Ivascyn, who manages PIMCO Income Strategy with Alfred Murata and Josh Anderson, speaks with Esteban Burbano, fixed income strategist. They discuss PIMCO’s economic and market views along with current portfolio positioning.

Q: What are the key investment takeaways from 2020 – a challenging year in more ways than one – and what is PIMCO’s outlook for 2021?

Ivascyn: 2020 was a reminder that there can be negative, once-in-a-career market surprises leading to powerful repricing of risk. The market volatility experienced last March highlighted the importance of proactive liquidity and risk management. It also underscored the importance of diversification for building a more resilient portfolio – of course, diversification has always been a hallmark of the Income Strategy.

Our base case economic outlook for 2021 is one of “Bounded Optimism,” with vaccine distribution likely to become more efficient; meanwhile, we expect fiscal and monetary policy to remain quite supportive. This suggests a more synchronized global recovery later this year, and some optimism for risk assets, but we believe a defensive mindset is warranted (read our latest Cyclical Outlook for details).

As the recovery gains traction, the effect of the fiscal stimulus, combined with some pandemic-related supply constraints, could culminate in near-term inflation pressure. But our general view is that powerful disinflationary forces remain, and that inflation will be reasonably well contained.

Risks to our outlook include ongoing political tensions between the U.S. and China, and fuller valuations in certain segments of the equity and fixed income markets – they are not necessarily in bubble territory, but they’re high from a historical perspective, and we still have a significant amount of near-term economic uncertainty. It may become more difficult to generate returns, so an expanded opportunity set and precise implementation are going to be very important.

Q: Could you expand on the outlook for accommodative fiscal and monetary policy, particularly in the U.S., and how this could affect bond yields?

Ivascyn: We expect increased fiscal spending largely focused on COVID-19 relief and infrastructure, but given the narrow Democratic majority, we don’t anticipate dramatic fiscal scenarios that would drive concern around the inflation outlook or debt sustainability.

We think central banks are going to continue to be quite accommodative and keep policy rates on hold for a few years. And in light of the 2013 taper tantrum, we think the Federal Reserve will be gradual and patient, and carefully communicate to markets about any changes in its balance sheet, such as purchases of Treasuries and mortgages. (For details, please read our recent blog post on Fed policy in 2021. ) Of course, even a gradual tapering of central bank policy could potentially lead to some market noise later this year or next.

Overall, although we expect bond yields to continue to trend higher in light of continued policy support, we think they will remain relatively range-bound.

Q: What are the high-level investment themes in the Income portfolio today?

Ivascyn: It tends to be more challenging to generate income in sectors supported by central banks, such as generic investment grade corporates and higher-quality segments of the high yield market, where spreads are quite compressed. So we broaden the opportunity set, looking tactically across nearly every sector of the global fixed income markets. The Income Strategy is probably the most diversified it has historically been from a sector perspective.

A lot of the easy money appears to have been made. The amount of spread compensation per unit of interest rate or credit exposure is quite low. And we see a number of risks in the marketplace, particularly in more traditional fixed income sectors. So we are flexible but also quite defensive, focusing on mitigating the downside as well as generating income. Duration in the Income portfolio is around two years overall, lower than many popular fixed income indices. And we look for investments that don’t rely on ongoing central bank purchasing activity to justify their valuations, focusing on hard assets, assets that have strong structural positions, and areas of the corporate market with stronger covenants or better overall fundamentals. And we are willing to give up a little bit of yield for that downside defense. Yet we believe our portfolio flexibility will enable us to do well versus passive and popular bond indices.

Q: What are PIMCO’s latest views on housing markets and related investments?

Ivascyn: We remain active in non-agency as well as agency mortgage-backed securities (MBS). The housing opportunity set continues to look quite attractive, and fundamentals remain strong overall in the U.S. and also in the U.K. and Europe. The sector was able to recover quickly in 2020 following the extensive deleveraging that temporarily dislocated prices in the first quarter. Yet we don’t see a lot of excesses in housing markets due to strict underwriting criteria and regulations put in place after the global financial crisis. This is supportive of our non-agency MBS positions, which have benefited from improving fundamentals. Importantly, these investments don’t require home prices to continue rising, but are expected to remain resilient even if home prices stay steady or even go down slightly.

In agency MBS, valuations have moved from very attractive in March 2020 to slightly attractive today, but we continue to view the sector as a high quality ballast within the portfolio. We continue to favor high quality agency MBS, which are supported directly by the Federal Reserve. Prepayments remain more elevated, but this means that these investments often exhibit some cash flow uncertainty that can lead to a premium versus many other high quality fixed income investments – a premium that PIMCO, with our large mortgage team and analytics resources, may be able to take advantage of. We also like the strong liquidity profile of agency MBS, meaning if we find something more attractive to invest in, it’s relatively easy to navigate within that marketplace. Nearly all of our agency mortgage exposure is in the most liquid agency pass-throughs or other related securities, which are directly purchased by central banks.

Given our macro outlook as well as the broad opportunity set for the Income Strategy, we see potential for the allocation to agency MBS to decline a bit relative to our historical peak allocation, but we still expect to maintain a strong allocation to this very high quality segment of the overall opportunity set.

Q: Turning to the corporate credit market, where are you are seeing opportunities and risks?

Ivascyn: We think that given economic recovery and fiscal support, corporate credit spreads will stay near current levels or maybe even go a bit tighter. Even so, the sector went into the pandemic highly leveraged and then took on a lot more debt as last year brought record levels of corporate issuance. Now, spreads in many segments of the market that were less directly affected by COVID-19 are back to even tighter levels than pre-crisis.

We added considerable exposure in investment grade segments of the market and some of the higher-quality segments of the high yield universe during 2020, but today we’re much more selective in that space, and even reducing some of the risk that has performed quite well.

Today, we are also focusing on credit segments more directly affected by the pandemic: hospitality, leisure, gaming, and retail sectors, and select REITs (real estate investment trusts), where we’re seeing many investments offering attractive spreads and investor covenants.

In addition, we continue to like the financial sector, particularly in the U.S., where we see very high capital ratios. A lot of the post-financial-crisis regulation has limited risk-taking across many financials, and the economic recovery we anticipate this year should bode well over the short term for earnings across the sector.

Q: Turning to the bank loan market, how do you weigh the potential benefits of senior secured loans against the risks?

Ivascyn: We think loan valuations look fair versus other areas of the credit market. These are floating-rate instruments that tend to do well when investors get concerned about interest rate risk, and we’ve seen volatility in these markets recently as the uncertain outlook has investor preferences shifting rapidly between floating- and fixed-rate instruments. We look at interest rate positioning independent of credit selection, so bank loans remain an important part of our broad opportunity set. Right now in the Income portfolio we hold a small tactical exposure focused on more liquid, larger, higher-quality names.

Q: What are our views on inflation-linked investments in the Income portfolio?

Ivascyn: As I mentioned earlier, while we may see some inflationary pressure later this year or early in 2022, we don’t think inflation is a major intermediate-term concern. After strong performance relative to nominal U.S. Treasuries over the last few months, we believe U.S. TIPS (Treasury Inflation-Protected Securities) are priced at levels closer to fair. We continue to have some TIPS exposure in the Income portfolio as a defensive allocation, but are shifting to a more neutral posture.

Q: How is the Income Strategy positioned in emerging markets? And what are our views on currencies?

Ivascyn: We are constructive on emerging markets. In our view, this sector will be an important diversifier and a way to enhance return potential given our broader macro outlook. Our holdings within this strategy tend to be in the higher-quality and more liquid sovereign and quasi-sovereign areas of the emerging markets, plus diversified exposures to some of the more liquid local rate markets or currencies.

We believe that accelerating global economic growth will tend to further weaken the U.S. dollar, so we have a negative U.S. dollar bias across the Income portfolio. Our currency exposure is in a combination of high quality segments of the emerging market universe and some developed markets as well. Still, the weak dollar positioning is a somewhat crowded trade today, so we don’t want to be too aggressive with sizing.

Q: To sum up, what is your overall approach in the Income Strategy today?

Ivascyn: Investors may find it more challenging to generate yield in a responsible fashion in segments of the markets that have been strongly supported by policymakers and are well represented in popular passive fixed income indices. We believe our flexible, global, risk-aware approach to managing a bond portfolio – which is not tethered to a particular benchmark – is appropriately designed to seek consistent income for investors and an attractive level of return on a go-forward basis.