Although the tide of rising interest rates that swamped bond investors appears to be nearing an end, there remains ample reason for caution, bond managers say.
The U.S. Federal Reserve’s decision on Sept. 20 to hold its key policy rate provided scant comfort to financial markets, as the Fed projected only modest relief by 2024 and didn’t rule out another rate hike this year.
The evolving interest-rate environment is reflected in the moves made over the past year or so by managers of the PIMCO Monthly Income Fund (Canada), sponsored by the Canadian arm of the U.S.-based bond-investing giant. At a combined $23 billion in mutual fund and ETF series, the fund’s go-anywhere mandate is the largest of its kind in the multisector fixed-income category.
Alfred Murata, portfolio manager and managing director with PIMCO LLC in Newport Beach, Calif., said the team was extremely cautious on duration at the end of 2021. Back then, the fund’s portfolio duration was just 1.3 years.
Since late 2021, Murata and his colleagues have raised portfolio-wide duration to just over four years. He said the team’s current view on duration is neutral to slightly positive.
Over at Toronto-based AGF Investments Inc., the $2.2-billion AGF Total Return Bond Fund currently has duration of five years, slightly lower than its blended market benchmark. (The Canadian investment-grade bond universe has a duration of about seven years.)
“We’ve been saying for a while now that we like being low-duration,” said Tom Nakamura, co-head of fixed income with AGF. “But as yields head higher, as we feel like we’re getting closer to the end of the cycle, we’d like that duration to go up.”
That time hasn’t yet come, Nakamura said. He cited the surprising degree of economic resilience to rising rates in Canada, the U.S. and to a lesser extent globally. While inflation is starting to come down, “it’s still at worrisome levels” and this will keep central banks’ policy rates elevated.
But with coupon rates of 4% or higher on U.S. Treasuries or Government of Canada bonds, “that’s a nice cushion to have” in the event of any further rate hikes that would lower bond prices, Nakamura said. And if central banks succeed in bringing inflation under control, he added, these coupon rates could generate after-inflation yields of 2%–3%. For investors who are currently underweighted in fixed income, he said, it’s a great time to add to holdings.
In the face of rate uncertainty and an inverted yield curve, managers are finding sources of return that are more attractive than making bold duration bets.
The PIMCO fund recently held about 80% of its portfolio in securitized assets, primarily those tied to U.S. residential mortgages. “The asset class we find most compelling on a risk-adjusted basis is agency mortgage-backed securities,” Murata said.
These securitized packages of loans are backed by the U.S. government or a federal agency, making them high-quality credit. In addition, Murata said, they have strong liquidity and offer a significant pickup in yield over U.S. Treasury issues.
Murata estimated that federally guaranteed mortgage-backed securities currently yield 150–175 basis points more than comparable Treasuries. After taking prepayment risk into account, he added, the yield pickup still is about 75 basis points.
The PIMCO fund also invests in non-agency mortgage-backed securities (MBS), which are backed only by the residential loans themselves. However, Murata said the fund holds non-agency MBSs that were issued before the 2008 global financial crisis, so the borrowers have been in their properties or held the loans for well over a decade. Consequently, many of the loan-to-value ratios are less than 50%, reducing the risk of default.
After considering default risk, in many cases you’re picking up 150–200 basis points of additional yield, Murata said: “That’s an asset class we think can be very resilient to the negative economic scenario and provide attractive yield pickup compared to investing in Treasuries.”
By reducing exposure to high-yield credits and emerging-market bonds, and holding more government-backed mortgage securities, Murata said, the fund has been able to reduce credit risk while the yield to maturity of the portfolio has increased dramatically. The portfolio’s yield to maturity rose to 6.7% in late September from 4% at the end of 2021.
Although the PIMCO fund holds only 15% in Canadian securities — versus 70% in the U.S. and the remainder in developed and emerging markets — almost all the fund’s foreign holdings are hedged back to the Canadian dollar.
The AGF Total Return Bond Fund offers more broadly diversified exposure, holding 48% in the U.S., 17% in Canada and the remainder in developed and emerging markets. The three largest currency exposures were 63% to the Canadian dollar, 17% to the U.S. dollar and 10% to the euro.
Overall, the AGF portfolio leans toward high credit quality with a tilt to government debt. A key consideration in the large allocation to U.S. securities is liquidity, Nakamura said.
As rates have gone higher, Nakamura and co-head of fixed income Tristan Sones concluded that yields on U.S. Treasury issues have become more and more attractive in risk-adjusted terms versus investment-grade or high-yield corporate bonds.
“We think that if we’re really focused on yield stability and safety,” Nakamura said, “we don’t really need to go far down the credit-quality spectrum to be able to get really adequate yields.”
That said, triple-B credits, which are at the low end of investment grade, recently made up 15% of the AGF portfolio, while more than 20% was held in high-yield or non-rated issues.
Nakamura said these holdings are part of the team’s diversification strategy: “That allows us to think about different parts of the market that may not be super-compelling to us right now, but we feel are not too risky [and] offer us adequate compensation in terms of yield.”