14 APR, 2023
By Tiffany Wilding, Managing Director and Andrew Balls, CIO Global Fixed Income at PIMCO.
Uncertain environments tend to be good for fixed income, particularly after last year’s broad market repricing pushed current yield levels – historically a strong indicator of return – much higher. We believe bonds are poised to exhibit more of their traditional qualities of diversification and capital preservation, with the potential for upside price performance in the event of further economic deterioration.
In this current environment, and particularly given the banking sector challenges, we want to be careful in overall risk positioning. When uncertainty and volatility go up, liquidity – or the depth of trading in markets – tends to go down, and liquidity has deteriorated in recent weeks. We’ve been prioritizing liquidity more than usual in our strategies, focusing on more easily tradeable investments and preserving dry powder to seek to take advantage of opportunities that may arise from market dislocations.
Our longstanding concentric circles investment framework, written on the whiteboard in our Investment Committee room, continues to reflect a cautious approach. The framework starts in the middle with the relatively lower-risk short-term and intermediate interest rates, moving out to U.S. agency mortgage-backed securities (MBS) and investment grade corporate credit in the middle rings, to the riskier outer bands with equities and real estate. We continue to prioritize inner-ring investments in the current environment.
Central bank policy remains a crucial driver. Changing the price of borrowing at the epicenter creates ripples that expand outward. We see policy-related volatility going down this year as we approach the end of tightening cycles. That contrasts with last year, which saw a large repricing for the Fed and other major central bank rates.
We continue to expect a yield range of about 3.25% to 4.25% for the 10-year U.S. Treasury note in our baseline cyclical view, and broader ranges across other scenarios, with a potential bias to shift the range lower given increased economic and financial sector risks.
Depending on an investor’s objectives, there are attractive opportunities in short-term, cash-equivalent investments today given relatively elevated yields near the front end of the curve. Cash may not be subject to the same volatility as other investments. But unlike longer-term bonds, cash won’t provide the same diversification properties and ability to generate total return through price appreciation if yields fall further, as has occurred in prior recessions. Cash rates can also be fleeting, with the risk that yields may be lower when short-term holdings mature and cash needs to be reinvested.
The banking sector stress reinforces our cautious approach toward corporate credit, particularly lower-rated areas such as senior secured bank loans. These are floating-rate loans to lower-rated companies, which must pay more interest as the Fed has raised rates. That puts strain on those companies, particularly in a weakening economy.
Recent volatility could be a preview of what’s ahead for more economically sensitive parts of credit markets. We prefer index exposure via derivative instruments over generic individual issuer exposure based on valuation and liquidity. We aim to limit exposure to weak business models and companies and sectors vulnerable to higher interest rates. We retain a preference for structured, securitized products backed by collateral assets.
Within the financial sector, broad-based weakening in preferred shares and bank capital securities has made some of the senior issues from stronger banks look more attractive. Large global banks hold substantial capital and could benefit from the challenges facing smaller lenders. Valuation and the greater certainty of the senior debt’s place in the capital structure reinforces our bias for senior debt over subordinated issues. At the same time, the shock to the AT1 market may help create opportunity in the strongest issuers – especially if European regulators can take concrete steps to differentiate the eurozone and U.K. market from the challenged Swiss market.
We believe U.S. agency mortgage-backed securities remain attractive, particularly after spreads have widened lately. There may be technical pressures as the Fed lets agency MBS roll off its balance sheet. But these securities are typically very liquid and backed by a U.S. government or U.S. agency guarantee, providing resilience and downside risk mitigation, while prices can benefit from a complexity premium.
For some months, we have said it makes sense to focus on public credit markets now, where the price marks are up to date, and shift attention to private markets later, when marks become more realistic. Given their rapid growth over the past decade, private markets could face continued strain, which may be worse in the event of a harder economic landing. In recent weeks, the gap between public and private valuations has only widened. While the stock of these assets remains mispriced, the flow of new deals across private markets is beginning to look more attractive. We are increasingly prepared to deploy capital as opportunities arise.
We are seeing opportunities in areas where bank de-risking and reduced credit availability will likely have a pronounced effect. PIMCO has a history of partnering with banks to help solve their balance sheet problems, both in the U.S. and abroad. As regulatory and balance-sheet-related pressures increase, we expect that a broad range of lenders will look to recapitalize their businesses and will be more constrained in their ability to originate new loans even to the highest-quality borrowers.
The commercial real estate (CRE) sector may face further challenges, but we would stress that not all CRE is the same. We aim to stay in senior parts of the capital structure, in diversified deals. We differentiate that from lower-quality, single-asset or mezzanine-level risk, which we aim to avoid.
We believe it’s important to remain cautious in this environment, seeking higher-quality, more liquid, and resilient investments. Later this year, if the economic outlook reaches a point of greater clarity, accompanied by a repricing of economically sensitive market sectors, it could be time to go on the offensive.