Even if housing prices were to decline, we would still expect to receive yields that are positive and higher than those of U.S. Treasuries. Almost all of our exposure across the mortgage market is in the most senior part of the capital structure. A strong preference for seniority in the capital structure is a guiding principle of our bend-but-not-break strategy. It’s a means to help temper volatility and reduce the risk of permanent capital loss.
At the end of November, exactly a third of our portfolio was in non-agency residential mortgage-backed securities, with 9.4% in commercial mortgage-backed securities. More recently, we’ve added agency mortgage-backed securities, which composed 13.3% of the portfolio on 30 November.
Q: Over the past year you’ve increased interest rate exposure from less than three years to just over three years of duration. Could you comment on this and the outlook for rates?
Murata: The Income Strategy has taken advantage of the flexibility to adjust interest rate duration between zero and eight years, and to invest globally to seek assets that could benefit from an increase in rates. As interest rates rallied over 2016, we reduced the portfolio’s interest rate duration from slightly more than three years to about 2.5 years. More recently, with the selloff in interest rates, we’ve boosted it back to slightly more than three years.
Q: Dan, what are PIMCO’s broad views on the direction of interest rates? What’s the outlook for sectors such as investment grade credit and government versus spread sectors?
Ivascyn: Given the significant pullback in yields following the U.S. election, we’re becoming a bit more constructive on interest rate risk. As Alfred noted, we’ve increased duration exposure to just over three years.
That said, I would still categorize our view on interest rate exposure today as somewhat defensive. There’s a lot of near-term uncertainty, and high quality government bond yields remain a little low from a longer-term historical perspective.
As to investment grade credit, it’s important to consider default risk, or spread compensation, versus interest rate exposure. A typical investment grade corporate bond with, say, a 10-year maturity, has a decent amount of interest rate exposure that has negatively affected returns of late. However, looking out over the next couple of years, we think the risk of recession, both in the U.S. and globally, remains relatively low. We’re fairly constructive on corporate credit in general. But it’s critical to be highly selective given a decline in issuance.
Q: Finally, many investors are wondering, Will a change in government policies lead to a potential increase in inflation?
Murata: While there’s certainly the potential for increased inflation, it’s important to keep in mind that policies haven’t been well defined, and even if they were, implementation could prove challenging. While massive infrastructure spending could boost inflation, some trade-related proposals could slow growth and reduce inflation. Indeed, we think that in a world with substantial debt, significant excess capacity, at least on a global basis, and challenging demographics, there remains a meaningful risk of ongoing disinflationary pressure or even outright deflation risk in certain markets. Our flexible duration targets allow us to try to insulate investors from a variety of inflation scenarios.
Investors should consider the investment objectives, risks, charges and expenses of the funds carefully before investing. This and other information are contained in the fund’s prospectus and summary prospectus, if available, which may be obtained by contacting your investment professional or PIMCO representative or by visiting www.pimco.com. Please read them carefully before you invest or send money.
A word about risk:
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The strategy may invest in high-yield, lower-rated, securities which involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Inflation-linked bonds (ILBs) issued by the various governments around the world are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation. Repayment upon maturity of the original principal as adjusted for inflation is guaranteed by the government that issues them. Neither the current market value of inflation-indexed bonds nor the value a portfolio that invests in ILBs is guaranteed, and either or both may fluctuate. ILBs decline in value when real interest rates rise. In certain interest rate environments, such as when real interest rates are rising faster than nominal interest rates, ILBs may experience greater losses than other fixed income securities with similar durations. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and their value may fluctuate in response to the market’s perception of issuer creditworthiness; while generally supported by some form of government or private guarantee there is no assurance that private guarantors will meet their obligations. Sovereign securities are generally backed by the issuing government. Obligations of U.S. government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Diversification does not ensure against loss.
There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.
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