Bond Market Opportunities – A Q&A With Dan Ivascyn, PIMCO Group CIO

It’s very hard to time markets, but value from a longer-term historical perspective has returned to the bond market. In a Q&A, PIMCO Group CIO Dan Ivascyn discusses the investment landscape.

Can you share some of the topics that you’re discussing in the Investment Committee?

Ivascyn:  A lot of the past two years has involved talking about inflation. Increasingly, we are talking about what will likely be a pretty significant growth-versus-inflation trade-off. We’re spending more time talking about the risks of recession, the risks of meaningful slowing, and the impact on key sectors.

What do you make of the historic drawdowns that we’ve seen?

No one likes to see the type of repricing we’re seeing across nearly all financial markets, but it is leading to tremendous opportunity. It is really becoming a lender’s market, more so than what we’ve seen for much of the last decade. So we’re spending more time talking about actual, executable trades.

As you think about fixed income markets, what is the outlook, and how does this vary across sectors?

The outcome is highly uncertain over the near term – you can say the same about equities, commodities, cryptocurrencies, and other areas – but at least value has begun to return to markets. You’re getting paid more if you believe, like PIMCO does, that central banks will ultimately get inflation back closer to their target over the next couple of years.

 That’s a very important point. It’s hard to time an entry point perfectly, but we are becoming more constructive about interest rate levels more broadly. This volatility, although it feels terrible living through it, is creating potential opportunities across sectors that could generate an attractive yield without going down the credit spectrum too significantly. 

Think about a very high-quality investment grade bond – as an example, one that today might return 4%, 5%, even 6% in some cases. If we do get back to 2.5% or 3% inflation, that’s pretty good value relative to where we’ve been. There is a degree of optimism that we haven’t witnessed in quite a long time.

What is our outlook for credit markets?

Anytime you have a higher risk of recession, you want to be very cautious about credit-sensitive investments, but initial conditions are quite strong. The big challenge is that we have an inflation problem, so you have policymakers tightening when growth is already relatively low. And it’s been a long time since there has been a recession without massive policy support.

A lot of people invested heavily in credit-related assets over the last decade because they felt they needed to generate incremental return. And you have seen significant growth in some of the lower-rated or private segments of the corporate credit market. You’ve also seen a resulting deterioration of fundamentals in certain areas. Those areas warrant caution, especially those within the private space that haven’t repriced yet.

In contrast, when you look at household credit, asset-backed credit, mortgage credit, banking credit, or financial sector credit, that’s where you see resiliency and pretty attractive spread levels.

Where are we seeing pockets of opportunity, both within public and private markets?

On the public side, it’s a lender’s market. There are a lot of deals within the corporate space, even the financial sector, which we think will be quite resilient even during more volatile economic times. So we think in the investment-grade space, the higher-quality areas of the market make some sense to add potential yield. High-quality bank paper is one example. You could see one-and-a-half, even two percentage points above a Treasury yield.

We also think agency mortgage-backed securities are looking increasingly attractive. These are very resilient from a credit perspective, with a direct government guarantee or a strong agency guarantee. These sectors were quite rich when our central bank was buying up nearly all of the available supply, but at some point they will begin to reduce mortgage holdings. We think that is at least partially embedded in prices today, and spreads look quite attractive as a more defensive asset.

There’s been some widening in lower-rated, more credit-sensitive areas of the markets. Patient capital in private markets can take advantage of opportunities that are building and building fairly quickly. One of the most exciting areas of the market that we see over the next several years would be contingent capital vehicles to take advantage of the dislocation that’s almost certain to exist within the large stock of existing corporate credit assets.

Can you talk about housing and real estate?

Across the seasoned segments of the mortgage market, you’ve had massive deleveraging associated with a decade-plus of rising home prices. And from a credit rating or credit quality perspective, you’ve seen little to no fundamental deterioration. So even if you had a recession, even if you had a sustained period of weakness in the housing markets, we don’t think that that’s where the credit problem is going to exist this time. 

Looking at commercial real estate, it is typically viewed as a pretty solid inflation hedge, but you’ve got to be much more nuanced because there’s far greater connectivity today between commercial real estate markets and financial markets.  As you reprice debt because of rising real or nominal rates, it quickly flows through on the commercial real estate side. Similar to other private markets that are slow to react, we do think that there will be some interesting opportunities there over the next few years.

What can we expect from emerging markets during the next few years?

Geographic diversification and sector diversification aren’t sufficient. If we move to a bipolar world or a multipolar world where different countries are expected to pick sides and where you have sanctions and other policy uncertainty, you really have to think about diversification across multiple dimensions.

Emerging markets look very intriguing from a valuation perspective, but there’s also a tremendous amount of idiosyncratic uncertainty. This can lead to attractive opportunities, but you’ve got to be very careful, very selective in terms of the country, and then when you get to the particular country, what particular instrument or area of the market that you’re operating in. Be careful, but don’t avoid the asset class, because we think it will be quite target-rich

What are your views on active versus passive management in this environment?

This is one of the most target-rich environments for active management that we’ve seen in a long time. Lots of volatility should create opportunity for active managers. You’ve seen this in the most flexible mandates within the alternatives universe this year.

We have flat yield curves with higher yields across the board. The idea is that you don’t have to extend duration tremendously to generate attractive returns. Now, in the front of the yield curve, you can focus on higher-quality relative-value strategies within less credit-sensitive, more liquid and resilient segments of the market.

We think that investors will increasingly get paid to be flexible. In the longer term, there’s going to be a lot of regulatory focus around areas like climate, a lot of government involvement in markets around capital investments in energy, defense, a lot of desire for resiliency.

And anytime you have these frictions in markets, it should lead to periods of dislocation, periods of opportunity to generate structurally attractive return. But to do that, investors likely need to lock up their money a bit, be more patient, and think about contingent capital vehicles to supplement their core allocations to fixed income or to other areas of the financial markets.

How can investors know when is the right time to return to fixed income?

Well, I think it’s a good time to consider now. We have been steadily adding back some interest-rate exposure. It’s very hard to time markets, but value from a longer-term historical perspective has returned to the market. Fixed income has begun to trade a bit differently as people shift their attention a bit from inflation toward risk of recession. And we do believe fixed income from this point forward will exhibit some more of its old-fashioned qualities.

Any final thoughts?

I would just say, be patient. After the type of negative financial market performance over the last several months – and we’re not just talking fixed income or public equities, but also venture capital, growth equity, crypto, etc. – there’s a tendency to want to say, “I’m done with it, I’ll just go into cash.” And it would be unfortunate to do that at a time when there’s finally more value across the opportunity set.

The same is true of public equity markets as well. So we do think investors should, if they’ve left the market, consider returning, and if they’re in the market and they’re having trouble staying in the market, to really try to be patient.

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