SUMMARY
- In an uncertain market, investors looking to de-risk or keep “dry powder” for future buying opportunities typically liquidate some of their assets, and many automatically turn to traditional cash strategies, including money market funds.
- Yet, actively managed ultra-short and short-term bond strategies typically offer investors higher yields than traditional cash strategies with only a modest increase in risk.
- In today’s market, as uncertainty increases and interest rates rise, PIMCO’s short-duration strategies offer investors the opportunity to play both defense and offense and actively manage their short-term allocations.
As the global expansion begins its 10th year, valuations for risk assets are stretched, market volatility has increased and interest rates are rising. As a result, many investors are looking for defensive strategies to reduce risk. Jerome Schneider, head of PIMCO’s short-term portfolio management team, and Tina Adatia, fixed income strategist, explain the role active short-duration fixed income strategies can play in weathering the uncertain environment and discuss the current investment opportunities in short-term bonds.
Q: What is driving the uncertainty in the financial markets, and how can investors navigate through it?
A: An increase in uncertainty is one of the few certainties on our cyclical horizon, and an uncertain environment can present both challenges and opportunities.
After many years of keeping interest rates at historical lows, central banks are gradually removing monetary accommodation, which is driving much of the uncertainty in markets today. On top of that, the global economy looks close to running at full capacity, inflation has started to rise, and valuations in equities and credit are near all-time highs. It is not surprising that investors are becoming more cautious, and the markets are more easily rattled. On the flip side, however, this increase in volatility can present opportunities for patient investors to add value through structural mispricings or by adding attractive assets when prices drop.
In this type of environment, investors looking to de-risk or keep “dry powder” for future buying opportunities typically liquidate some of their assets. Many automatically turn to traditional cash strategies, including money market funds, which seek to preserve capital although typically at the expense of low or even negative inflation-adjusted returns that generally diminish the purchasing power of their cash.
In our view, an allocation to cash and short-term investments should be a key component of an active asset allocation process, not an afterthought. For example, investors can potentially lessen the erosion of real capital by using actively managed ultra-short and short-term bond strategies. Typically, these strategies offer higher yields than traditional cash strategies with only a modest increase in risk.
Q: Short-term interest rates have already increased significantly. What does PIMCO expect going forward?
A: We expect the Federal Reserve to stick to its current plan and hike interest rates two to three more times in 2018. Looking further out to 2019 and 2020, however, the policy picture is more uncertain. Over the longer term, we continue to expect the neutral policy rate – the level that does not stimulate or suppress growth – to be lower than pre-2008 levels. Our estimate for the real neutral policy rate in the U.S. is in the range of 0% to 1%.
From their lows in 2016, short-term rates have already risen more than 1%, as measured by the two-year Treasury yield (through 30 March 2018). We think this rise in yields has largely priced in the impact of late-stage fiscal expansion in the U.S. (the recent tax cuts and government spending increases) and the associated increase in Treasury bond supply. While some upside to global yields remains, we do not think that we are at the start of a secular bear market for bonds.
Q: How can investors limit their exposure to rising interest rates in this environment?
A: Investors may want to consider reducing their interest rate exposure by allocating to actively managed short-duration strategies, which typically invest in high quality short-term bonds. Figure 1 shows how three of PIMCO’s short-duration strategies have performed since July 2016 through March of this year, over four rate hikes by the Fed. All three strategies – Short Asset Investment Fund (PAIDX), Enhanced Short Maturity Active ETF (MINT) and Short-Term Fund (PTSHX) – outperformed the FTSE Three-Month Treasury Bill Index, as well as the intermediate-term Bloomberg Barclays U.S. Aggregate Index and the Bloomberg Barclays Government/Credit 1-5 Year Index.
Q: Many investors feel like they’re playing defense when front-end rates increase. Is it possible to play offense in this environment?
A: Absolutely. We are positioning our short-term portfolios with the goal of not only navigating the increases in front-end rates but also ultimately benefiting from them.
Most bond yields rise when the Fed raises rates, but fixed-rate bonds with maturities of two years or less tend to be more susceptible to volatility while interest rates recalibrate higher. So we have a meaningful allocation to floating-rate securities, which have coupons that reset periodically based on prevailing interest rates, to help limit interest rate risk and also add to yield as rates rise.
Similarly, we view the increase in volatility at the front end of the yield curve as an opportunity for active management. One example currently would be to buy zero- to 18-month corporate bonds, which can provide higher yields than typical cash investments for investors who have the ability to take on a small amount of additional credit and maturity risk. Providing they hold up well to independent credit analysis, many of these bonds can offer attractive yields of 2.50% and higher with limited interest rate exposure.
Investors who rely on money market funds, which are limited in the type of securities they can invest in, or passive strategies, which track indexes, cannot fully take advantage of market opportunities like this that stem from changes in supply and demand when rates rise. Traditional cash investments are slow to react to higher yields (in the case of time deposits), and liquidity may be limited, as with certificates of deposit (CDs), which generally penalize early withdrawals and thus discourage investors from redeploying cash to higher-yielding securities as rates rise.
Q: How have PIMCO’s short-duration strategies performed for investors over time?
A: PIMCO’s suite of active ultra-short and short-term strategies have historically delivered returns with limited volatility and low exposure to interest rates. Figure 2 shows the five-year performance for our MINT, PAIDX and PTSHX versus their Morningstar category.
PIMCO is one of the largest managers of ultra-short and short-term bond strategies, with more than $100 billion in short-duration assets under management, while MINT and Short Asset Investment Fund are among the largest funds in their categories. Through many different environments, our strategies have offered investors attractive return potential and low volatility, along with low interest rate exposure. In today’s market, as uncertainty increases and interest rates rise, these strategies offer investors the opportunity to play both defense and offense and actively manage their short-term allocations.
DISCLOSURES
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.
Past performance is not a guarantee or a reliable indicator of future results. The performance figures presented reflect the total return performance for the Institutional Class shares (after fees) and reflect changes in share price and reinvestment of dividend and capital gain distributions. All periods longer than one year are annualized. The minimum initial investment for Institutional class shares is $1 million; however, it may be modified for certain financial intermediaries who submit trades on behalf of eligible investors.
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Differences in the Fund’s performance versus the index and related attribution information with respect to particular categories of securities or individual positions may be attributable, in part, to differences in the pricing methodologies used by the Fund and the index.
There is no assurance that any fund, including any fund that has experienced high or unusual performance for one or more periods, will experience similar levels of performance in the future. High performance is defined as a significant increase in either 1) a fund’s total return in excess of that of the fund’s benchmark between reporting periods or 2) a fund’s total return in excess of the fund’s historical returns between reporting periods. Unusual performance is defined as a significant change in a fund’s performance as compared to one or more previous reporting periods.
Exchange Traded Funds (“ETF”) are afforded certain exemptions from the Investment Company Act. The exemptions allow, among other things, for individual shares to trade on the secondary market. Individual shares cannot be directly purchased from or redeemed by the ETF. Purchases and redemptions directly with ETFs are only accomplished through creation unit aggregations or “baskets” of shares. Shares of an ETF are bought and sold at market price (not NAV). Brokerage commissions will reduce returns. Investment policies, management fees and other information can be found in the individual ETF’s prospectus. Investing in the bond market is subject to certain risks including the risk that fixed income securities will decline in value because of changes in interest rates; the risk that fund shares could trade at prices other than the net asset value; and the risk that the manager's investment decisions might not produce the desired results. Buying or selling ETF shares on an exchange may require the payment of brokerage commissions. Due to the costs inherent in buying or selling Fund shares, frequent trading may detract significantly from investment returns. Investment in Fund shares may not be advisable for investors who expect to engage in frequent trading. Different fund types (e.g. ETFs, open-ended investment companies) and fund share classes are subject to different fees and expenses (which may affect performance). They may also have different minimum investment requirements and be entitled to different services. Net Asset Value (NAV) represents an ETF’s per-share value. The per-share value of an ETF is calculated by dividing the total value of the securities in its portfolio, less any liabilities, by the number of ETF shares outstanding. ETF shares are valued as of the close of regular trading on the NYSE Arca (normally 4:00 P.M. Eastern Time) (The “NYSE Close”) on each business day. The Fund’s Net Asset Value, shares outstanding and total net assets are calculated as of the close of regular trading on each day that the NYSE Arca is open, and do not reflect security transactions or Fund shares created or redeemed on the date stated. Such transactions are recorded on the next business day and reported on the website the following business day. Returns are average annualized total returns, except for those periods of less than one year, which are cumulative. Market returns are based upon the midpoint of the bid/ask spread at 4:00 pm Eastern time (when NAV is normally determined for most ETFs), and do not represent the returns you would receive if you traded shares at other times. Current holdings are subject to risk. Holdings are subject to change at any time. An investment in an ETF involves risk, including the loss of principal. Investment return, price, yield and Net Asset Value (NAV) will fluctuate with changes in market conditions. Investments may be worth more or less than the original cost when redeemed. ETFs are subject to secondary market trading risks. Shares of an ETF will be listed for trading on an exchange, however, there can be no guarantee that an active trading market for such shares will develop or continue. There can be no guarantee that an ETF's exchange listing or ability to trade its shares will continue or remain unchanged. Shares of an ETF may trade on an exchange at prices at, above or below their most recent NAV. The per share NAV of an ETF is calculated at the end of each business day, and fluctuates with changes in the market value of the Fund’s holdings. The trading prices of an ETF's shares fluctuate continuously throughout the trading day based on market supply and demand, which may not correlate to NAV. The trading prices of an ETF's shares may differ significantly from NAV during periods of market volatility, which may, among other factors, lead to the Fund’s shares trading at a premium or discount to NAV. Premiums (when market price is above NAV) or discounts (when market price is below NAV) reflect the differences (expressed as a percentage) between the NAV and the Market Price of the Fund on a given day, generally at the time the NAV is calculated. A discount or premium could be significant. Data in chart format displaying the frequency distribution of discounts and premiums of the Market Price against the NAV can be found for each Fund at www.pimcoetfs.com.
A word about risk:
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. 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. 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. Entering into short sales includes the potential for loss of more money than the actual cost of the investment, and the risk that the third party to the short sale may fail to honor its contract terms, causing a loss to the portfolio. 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.
Bloomberg Barclays 1-5 Year Government/Credit Index Is a broad-based benchmark that measures the non-securitized component of the Barclays U.S. Aggregate Index. It includes investment grade, U.S. dollar-denominated, fixed-rate Treasuries, government-related and corporate securities that have a remaining maturity of greater than or equal to one year and less than five years. Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The FTSE 3-Month Treasury Bill Index is an unmanaged index representing monthly return equivalents of yield averages of the last 3 month Treasury Bill issues. It is not possible to invest directly in an unmanaged index.
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. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world.
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