Income Fund Update: Positioning for the Long Term

Events of the last several weeks have not changed our long-term outlook, but we have become a bit more cautious in the short term.

Following the volatility in the bond market over the past few weeks, U.S. Treasury yields are again near record lows. Here, Dan Ivascyn, who manages the Income Fund with Alfred Murata and Josh Anderson, talks with Esteban Burbano, fixed income strategist, about the interest rate rally, current positioning in the Income Fund, and PIMCO’s outlook.

Q: In the last two months, the Federal Reserve has cut its policy rate, trade tensions between the U.S. and China have increased, and the markets have priced in a much higher probability of a recession in the U.S. Have PIMCO’s views changed?

Ivascyn: When we hold our Secular Forum every May, we look at major trends impacting the economy and markets over a three- to five-year period or even longer. So the events over the last several weeks, while contributing to our long-term thinking, wouldn’t typically cause a major swing in our long-term mindset.

Recently, we have seen further slowing in growth around the world, more uncertainties around trade, and, perhaps less noticed, increasing discussion of the tools outside of monetary policy that governments can use to stimulate their economies. In addition to the significant deficit spending in the U.S. and talk of new stimulus from the Trump administration, fiscal stimulus is being discussed in Germany for the first time in many years, which would impact growth in Europe and around the world.

Since the financial crisis, central banks have been the key drivers of policy, but over the course of the next several years, fiscal stimulus may well replace monetary policy as a means of trying to maintain growth. We are concerned, however, about the current lack of focus on fiscal deficits and global debt levels, and another round of fiscal spending around the globe could be unfavorable for bond investors. So from a long-term perspective, we are closely watching this potential shift, especially in the low-interest-rate environment.

Over the shorter term – the next 12 to 24 months – we have become a bit more cautious in our outlook. We’re not yet ready at PIMCO to declare that a recession in the U.S. is imminent, but we expect the economic data to remain weak, especially while we have such uncertainty around trade.

Q: Turning to the Income Fund, how was the portfolio positioned earlier this year, and what changes have you made in light of recent market developments?

Ivascyn: From an asset allocation perspective, the portfolio has not shifted too much over the course of this year. That tends to be our approach: We want to find areas of the market that we think are structurally attractive, stick with them, potentially enhance returns, and be fairly measured in the amount of trading we do.

Our primary objective in the Income Fund is to seek a responsible and consistent dividend yield. Our secondary objectives over the long term are capital preservation and total return. We don’t think that these are mutually exclusive. We look for opportunities to generate attractive yields, in particular when frictions in the market drive yields higher, without exposing our investors to significant downside risk.

To that end, we have steadily added to our exposures this year in housing-related investments and financials. Both sectors have seen significant regulation since the financial crisis, and as a result, fundamentals are very strong. For banks, regulations have forced them to hold much more capital than they did before the financial crisis and have discouraged them from taking the risks they used to. Although the banking sector can be more volatile than other segments of the market, we see very low overall credit risk, even if the economy were to deteriorate. So that continues to be one of the highest-conviction trades within the fund, and, I think, a key differentiator versus other similar strategies.

We have also reduced interest rate exposure, or duration, a bit this year, and gradually shifted some of that exposure from U.S. Treasury bonds into agency mortgage-backed securities. To the extent that agency mortgage-backed securities continue to look attractive, we very well may add to our holdings.