One way to yield more from bonds than equities

Given the expectation of increased volatility at this later stage of an expansion, we see global fixed income as playing an increasingly important role in providing capital preservation, income and diversification. 

4 reasons for seeking income from the global bond market

1. An allocation to global fixed income has a proven history of generating a strong source of defensive income as well as providing total return. Over 10yrs the PIMCO Global Bond Fund has returned 8.67% annualized as of the end of March 2019, ahead of its benchmark of 6.58%.
2. A high quality, diversified core bond strategy aims to provide attractive returns through a combination of income (yield) and capital appreciation, while at the same time preserving capital.
3. Global bonds offer diversification relative to an investor’s equity allocation, which can be helpful in smoothing out the path of returns
4. The $US100 trillion dollar global bond market offers access to a broad array of countries and sectors, a huge opportunity set from which to source income ideas

The two charts below highlight the attractive diversifying features of core bonds. For example, a 60/40 allocation to equities and core bonds provides a similar return relative to a pure equity allocation while reducing the portfolio’s overall risk. 

Furthermore, the drawdown chart shows the substantially better capital preservation features of core fixed income relative to equities.

Chart 1: Core bonds as a key diversifier

Source: PIMCO. As of 31 March 2019. Indices used: Bonds – Bloomberg Barclays Global Aggregate Index hedged into USD, Stocks – S&P 500 Index in USD, Cash – FTSE 3-Month Treasury Bill Index. 60-40 portfolio is represented by 60% Stocks and 40% Bonds and 60+cash portfolio is represented by 60% Stocks and 40% Cash.

Chart 2: Global Agg USD Drawdown vs MSCI World Index Return Drawdown

Source: PIMCO. As of 31 March 2019. Indices used: Bloomberg Barclays Global Aggregate Index hedged into USD, MSCI World Index in USD. 

Generating alpha through the cycle

PIMCO seeks to identify favourable secular and cyclical trends, capitalizing on relative value opportunities, and avoiding credit events. The firm’s focus on generating alpha over a market cycle, which PIMCO defines as three-to five-years, simultaneously applies a disciplined approach to country research and a structured evaluation of security opportunities to help identify and act on market inefficiencies.

This process is designed to achieve an attractive level of income with a keen focus on capital preservation and total return. Importantly we set income targets that are attainable without the need to overstretch and put capital at undue risk.

Our total return approach revolves around the principle of diversification. By diversifying strategies, or relying on multiple sources of value, we are confident we will be able to generate a solid track record with a high degree of consistency. We seek to add value through the use of “top-down” strategies such as exposure to interest rates, changing volatility, yield curve positioning and sector rotation. We also employ “bottom-up” strategies involving analysis and selection of specific securities.

3 key philosophies for in investing in global bonds

Diversification of return drivers – We aim to diversify sources of active risk across a range of risk factors so as not to over-concentrate client assets into specific market risks. Having diversified allocations to various sectors including duration, credit, securitized and modest currency exposure allows us to drive returns and outperform benchmarks. A strict focus on process – PIMCO's global investment philosophy is designed to add value in all market environments and circumstances. At any one time, one or several of our strategies may be working to provide excess return. Our disciplined style works to limit the likelihood that any single strategy that falls out of favour would negate the positive returns from other strategies.

Staying liquid – Where PIMCO anticipates an environment of increased volatility in financial markets, this offers an opportunity for active management to outperform the benchmark by capturing upside from dislocations across the fixed income opportunity set.

Risk management – It features prominently in PIMCO’s investment philosophy and process and is critically important in managing strategies where a disciplined approach is key to long-term performance. 

Opportunities and risks in today's market

As an active manager, we see significant opportunity to add value as volatility increases. Today our global portfolios express the following themes:

1. Within global interest rates, we are emphasizing country selection and relative value positions
2. On spread strategies, we aim to generate high-quality income without relying on generic corporate credit
3. We have a preference for secured assets vs unsecured credit given valuations compensation for liquidity risk and seniority in the capital structure.
4. Within the corporate sector, we are focused on shorter-term bonds in companies where we see default risk as extremely remote. In addition, we continue to see financials as a sector offering attractive opportunities based on valuation.

Additionally, yields on global fixed income are higher than a few years ago and an actively managed global fixed income portfolio can offer a yield of 3.5-4.0% today in AUD hedged terms with a low volatility of around 2-3% which provides a good complement to riskier allocations such as equities.

In terms of what we are avoiding, financial markets have priced in the “synching lower” theme and central bank dovishness with a sustained move lower in global yields, while risk assets are generally back to or close to their early December levels. We continue to be concerned about the ongoing potential for market disruption as the result of recession risks, shifts in the balance between monetary and fiscal policy, trade tensions and political populism. Therefore, we continue to think it makes sense to stay closer to benchmark positioning in terms of top-down macro risk factors, to generate income without relying excessively on corporate credit, and to emphasize flexibility and liquidity in our portfolio construction, keeping powder dry to be put to use during periods of higher volatility and market dislocation.

While we think there is a good chance that the Fed is done hiking in this cycle, we also believe the market is premature in pricing in rate cuts. We plan to be close to benchmark on duration in light of the slower growth outlook and the Fed’s pivot driving the move lower in yields.

On spread products, we will aim to generate income without over-reliance on generic corporate credit, reflecting both bottom-up views and our concern about credit market structure and liquidity. While the baseline outlook for corporate credit looks fine, following the large growth of the market and increasingly crowded positioning in credit we want to ensure that our portfolios are not overly exposed in the event of a sustained period of credit market weakness, and we actively seek to take advantage of the opportunities that such an environment would provide. 

Traps to be aware of in global bond markets

• Understanding credit risk associated with individual bonds typically involves extensive credit research. Professional fixed interest managers typically have a team of credit research analysts to manage downside risks associated with credit defaults. Further professional management can also diversify credit risks by investing across a diversified portfolio of credits.
• We believe fixed income investors need to be careful when investing passively. A passive investor does not have the ability to adjust interest rate or credit exposure and could end up bearing the brunt of market-re-adjustments
• In an environment of low yields globally; many bond investors may be tempted to allocate to higher yielding securities. Over time this can be a good source of return but it also comes with increased volatility so investors need to factor in downside risks when evaluating fixed income opportunities. 

Want access to a steady stream of income?

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