Following a challenging year, value has returned to the bond market, presenting investors with attractive opportunities to generate alpha heading into 2023. In the following Q&A, PIMCO Group CIO, Dan Ivascyn, discusses the investment landscape and shares his bond outlook.
Q: For many investors, it’s back to basics with respect to bonds, which have historically been known for income generation, capital preservation, and portfolio diversification. So, can you talk about why you’re excited today about bonds? And, what are the opportunities going forward, given heightened yield levels?
A: Sure. So, to your point, value has returned to the fixed income markets. Just thinking about nominal yields, we’ll start here in the United States, across the yield curve now, you could lock in a very high quality bond yield today. You could look for very high quality spread product, and very, very easily put together a portfolio up in the 6, 6 and a half, percent type yield range, without taking a lot of exposure to economically sensitivity assets.
Much better than cash, but also pretty good versus equities. So, those that have been in cash, looking for incremental return, fixed income’s looking quite attractive. So we do think it should be a call to action, these higher yield levels.
On the flip side, if you’re concerned about inflation, you can look at various inflation-protected securities, and generate an inflation-adjusted return, or real yield, of greater than one and a half percent, even in some cases close to 2 percent.
In fact, we haven’t been back to those real yield levels since, really, the years leading up to the global financial crisis.
Q: So, plenty of opportunity today, as you mentioned, but also, still sources of volatility happening in financial markets. So, maybe you can discuss the potential sources of volatility that you’ve been discussing, and how PIMCO as an active manager is very well prepared to navigate this volatility.
A: From a macroeconomic perspective, there is lots of uncertainty around the inflation dynamic. We and other forecasters are of the mindset that inflation will trend lower, but remain frustratingly high.
We do think this will be a theme in 2023, as investors begin to further appreciate the potential tradeoffs between central banks getting inflation back down towards target, and the inevitable weakness that’s going to cause on the economic front, with significant and elevated risks of a recession, which of course could have significant impact on the performance of economically sensitive assets, credit assets, and equities as well. And then plenty of uncertainty from a geopolitical perspective, significant uncertainty about politics, both global politics, national politics. And then, last but not least, just relates to market structure. There’s less transactional liquidity than there’s been in the past. Markets are prone to overshoot fundamentals, particularly when there’s a shift in activity. That can be a cost for those less-prepared, but also a tremendous opportunity for active asset management.
Q: You mentioned volatility is the friend to an active manager, but what are you doing to prepare portfolios to insulate against all the risks that you just described?
A: Well, first of all, liquidity. With good liquidity comes investment flexibility. We saw a situation creep up on the market in terms of the volatility in the U.K., the resulting technical flows across the LDI community, and a reminder, again, it’s critically important to be sufficiently liquid. Because, surprises can happen in markets. The good news is we’ve had a multi-year period, coming out of the Covid crisis of the first quarter in 2020, where there has been sufficient time, sufficient accommodation from central banks, to get into a position of more attractive or more abundant liquidity. And that’s been a key priority. So in addition to having macro views, we’re very, very focused on implementation and having that flexibility. Over the course of the last several weeks, we’ve been able to put some of that liquidity to work, because we have seen forced selling.
Having appropriate initial conditions is an important prerequisite to be able to go on offense, once valuations suggest you’re getting paid to do that on behalf of investors.
Q: One question that continues to be top of mind for investors relates to opportunities across public and private markets, just given the valuation shifts that we’ve seen. So, where are you seeing value today, and how should investors think about the balance of opportunities between markets?
A: Public markets tend to re-price, and tend to re-price very, very quickly. So, you’ve seen public markets lead in terms of prices going lower. That’s true of a fixed income instrument, it’s true of other permanent capital-type vehicles that trade on exchanges. So, we think if you’re putting money to work today, or if you’re thinking about putting money to work going into year-end, the public opportunity set does look more attractive today. But, there’s been a big stock of private issuance over the last decade or so. These markets have grown, and they’ve grown significantly. Perhaps they’ve grown a little bit too quickly, as a result of some weakening in overall underwriting standards.
So from an investor’s perspective, and looking to prepare for what could be a very attractive opportunity over the course of the next few years, we think allocations to private credit strategies, various other types of contingent capital strategies, look as attractive as they’ve looked, really, since the years leading up to the global financial crisis.
So, bottom line, public markets today, prepare for opportunities in the private markets over the course of the next couple of years, where we think it’s going to be a very, very target-rich environment, not just within corporate credit, but in real estate and other sectors and segments of the market that are being impacted by higher rates, lower public equities, wider spreads. They’re just reacting with a typical lag that you see in the stickier private market opportunity set.
Q: So what are the top things investors should keep in mind as we head into 2023?
A: Well, one is that 2022 very well, from a historical perspective could look like an exceptional year in terms of downside performance. There’s better value back in both fixed income and equity markets, and we think investors should be patient.
Very hard to call highs in yields, lows in prices. But with better valuations, 2023 should be a year with less volatility, and materially higher prospects for return. So, again, don’t try to time things. Be patient, but begin to return to a market that increasingly offers very, very attractive value from a historical perspective, and a fundamental perspective, as well.
