PIMCO: Bond Investors in for Rude Awakening

If fixed income investors continue to expect what they have been used to for the last five years, they are in for a rude awakening says PIMCO

Miriam Sjoblom 18 June, 2018 | 8:44AM
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Miriam Sjoblom: Hi, I'm Miriam Sjoblom, director of global fixed-income ratings in Morningstar's manager research group. I'm here today at the Morningstar Investment Conference for 2018 with Mohit Mittal, who is a portfolio manager and managing director at PIMCO. Among several portfolio management duties, one of them is also to comanage PIMCO Investment-Grade Corporate Bond, which we rate as Silver here at Morningstar. 

Thank you for joining us today, Mohit.

Mohit Mittal: My pleasure. Thank you, Miriam.

Sjoblom: PIMCO's just held its Secular Forum in which the team gets together and sets the investment outlook for the next three to five years. Can you talk about some of the key takeaways from that discussion and how they apply to corporate credit market?

Mittal: In order to provide the context of Secular Forum, I'll take us back a few years. In 2009, when we are coming out of the recession, we started talking about the new normal, where we said that we expect growth to be lower coming out of this recession than in prior recoveries.

In 2013, we added new neutral to it, which said that not only will the growth be lower, but also rates will stay low for a long period of time. In 2016, we started talking about stable but not secure, highlighting some of the changes that we are seeing in this world. In 2017, we shifted to the five key pivot Points that will, over the next few years, maybe adjust the course of this new neutral. 

Where we are now, in 2018, our main theme is rude awakening. Basically, the idea is that if investors continue to expect what they have been used to for the last five years into the next five years, they are in for a rude awakening. The key things to think about are the central bank policies. Basically, central bank policy has been extremely accommodative. It is starting to shift toward neutral to maybe restrictive by the end of our secular horizon.

We have to be mindful of trade policies. We have to be mindful of geopolitics. We have to be mindful of fiscal. On the fiscal side, we are running a large deficit at the time when growth is pretty strong. What does it mean for the secular horizon? Then lastly we have to be mindful of currency being used as a mechanism for a trade war. 

So the net of it, what it comes down to us, is that we are in for a rude awakening. As credit investors, what that means to us is that we have to be focused on being nimble. We have to maintain a high degree of flexibility in portfolios. We have to be ready to take advantage of opportunities as and when they come. That's kind of the main theme for the secular outlook for us.

Sjoblom: Drilling down a bit into your corporate positioning, can you talk about where you're seeing opportunities today and where you're treading more carefully?

Mittal: In the corporate sector, the opportunities that we are seeing are focused, in our mind, are sectors that are still in the early to middle stages of recovery and not in the late stage. One main theme has been the housing sector. In there, the key things to think about are, first is a consumer balance sheet. On the consumer balance sheet side, the aggregate debt to GDP has fallen from about 95% 10 years ago to about 77% now. Second thing is the consumer income statement, which means wages and jobs. Wage growth is starting to go above 3%. Job creation remains very strong at around 2  million new jobs. This provides a consumer a very high degree of balance sheet and income statement to afford housing. 

The other side of it is the housing construction. Now the new home construction in the U.S. is now running at 1.3 million new homes a year relative to pre-crisis levels of 1.8. We still, in our mind, have a lot of pent-up demand, which means that housing will do well, which means remodeling and reconstruction activity will remain quite strong. Those are the kind of sectors that we are finding opportunities in, building materials, title insurance, nonagency mortgages, and mortgage servicing companies. That's one thing.

Another thing that we have invested in is energy, particularly pipelines. To us, pipelines provide an attractive opportunity because of very strong asset quality, very strong asset protection, longer dated contracts, revenues being a function of volumes and not of prices, so that provides an interesting opportunity. 

Third opportunity that we have expressed in the portfolio is related to financials. In there, they are both U.S. financials, particularly in the senior portions of the cap structures. Then, more recently, given the weakness that we are starting to see in Europe, some of the subordinated portions, particularly in core European, Swiss, and French banks are starting to look interesting as well.

Sjoblom: What about where you're exercising caution?

Mittal: There are a bunch of sectors that we are quite cautious as well. The first theme for us on that front has been concerns about disruption. We are concerned about sectors that are at risk of being disrupted over the next three to five years. Retail has been one sector that we are concerned about. We have seen what Amazon has done to the sector. We're also concerned about some of the excesses that we are seeing in chemicals and petrochemicals and E&P related companies, wherein the old space of petrochemicals we are starting to see a lot of supply or build-out come into light over the next two, three years. If there is a shift in demand, then that sector may be due for a correction.

On E&P, we have seen a huge recovery in energy prices. Spreads have tightened, so to us that valuation does not look very attractive at current levels. Instead, we would focus on the pipelines. Those are kind of the main themes. Again, on the disruption theme, also, has been traditional television broadcasters being disrupted by Netflix and Amazons of the world. Basically disruption, weak asset quality, and then the last theme that we have, as far as things that we are concerned about, is risk of excess of leverage. That includes certain consumer and consumer-product-related companies. Those are the main sectors that we are underweight.

Sjoblom: Mohit, that's very helpful. Thank you for joining us and sharing your latest thoughts on corporate credit.

Mittal: My pleasure. Thank you very much.

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Miriam Sjoblom  Miriam Sjoblom is an associate director of fund analysis at Morningstar.

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