Where Bond Managers are Finding Value

Tanya Sanwal: Thank you very much for having me.

Luque: Tanya, my first question is because – for example, the PIMCO Income Fund is a flexible fund. So why is it so important to be flexible in the current environment with low growth and lower rates, low inflation?

Sanwal: Sure. Thank you. So flexibility is an idea that we've been talking to clients for quite long time now. So what does flexibility mean? It means a couple of different things. So firstly, being flexible in terms of looking globally and not having home bias; two, when we talk about flexibility, we emphasise taking advantage of multi-sectors in the fixed income market, not just being tied to one sector; and lastly, we talk about not being constrained by the benchmark and instead investors should focus on outcomes, whether that is income, whether they are looking for absolute return, so that's the approach they should take.

Now why that's particularly important in today's environment? I would highlight two things. So firstly, we just came out of our secular forum. This is when we talk about markets and economy, then return expectations over the next sort of three to five years. One of the big conclusions coming out of this was that we expect central bank policy rates to continue to be lower than what they have been historically and continued to be lower than what the market expects.

The implication of this is that asset class returns, whether that's stocks or bonds, are going to be lower and therefore, to generate an additional return over this lower beta, client will want to be more flexible. Take advantage of active management to beat that low beta return. So that's one of the reasons why flexibility is important. Again, secondly in the last several years, we've seen a lot of central bank action, deleveraging, create volatility, create deleveraging flows and investors are best served in being tactical and opportunistic and flexible to really take advantage of those changing valuations.

Luque: Perfect. In this very difficult environment, what are PIMCO's views about credit, about interest rate, guarantees?

Sanwal: Sure. So as I mentioned earlier, we just came out of our Secular Forum. This is a forum where we – which we do once a year, where our portfolio managers from around the world get together in Newport Beach, California and we think about economies, secular trends that will drive markets over the next three to five years.

Now, there were two main conclusions coming out of this. The first one was that we expect economies five years after the financial crisis to still have low growth and the growth differential between emerging markets and developed market is going to come down.

The second important implication coming out of this was the idea of the new neutral. So, here we are saying that because of secular headwinds like a high level of debt that still exist, particularly on public sector balance sheets, the fact that demographics are such that you're seeing more and more aging population. And a lot of regulation, which is curtailing the abilities of banks to lend and therefore credit creation, all of these factors will constrain central bank from raising rates. And even when rates do go up, the new neutral level will be below what has been the historic neutral level in markets.

So we are expecting real neutral policy rates to be about 0% relative to historically where they have been close to around 2%. So that’s pretty important; and the implication for asset classes then, whether it is bonds or equities is that returns are going to be lower. So we are forecasting bond return close to around 3%, stock market returns around 5%.

The good news is that volatility as well, we expect volatility to be lower in markets. So, overall, in this environment, we think it is very important that clients focus on active management, think about smarter ways to get the same beta exposure and again focus on outcomes as opposed to single sector strategies.

Luque: One of the particularities of the PIMCO income strategies, correct me if I am wrong, is that the weight of emerging markets has increased in these last months. Is that right? And if it is yes, then why?

Sanwal: Sure. So, yes, the Global Income Fund is a multi-factor strategy, and one of the areas that we can invest in is emerging markets. We do limit emerging market exposure to about 20%. Now, in the last year, in 2013, for example, you saw a lot of volatility in emerging markets. So that was driven because of Fed talking about tapering. You also saw some slowdown coming from China and we started seeing some political risk emanating in certain specific emerging markets. So, last year, we saw a significantly poor performance across the entire emerging market complex, whether it's local bonds or hard currency.

Coming into this year, when we looked at the valuation, the emerging markets looked particularly attractive. So, for example, in local currency the yield was about 7%, in hard currency the difference between emerging market sovereigns spreads to treasury was close to around 400 basis points and we felt that in certain countries, select countries where fundamental was still reasonably strong, the sentiment had overshot the fundamentals.

So, we started looking at the opportunity set and one of the areas that we found particularly attractive was Brazil. That is where we have increased exposure in the income fund. We invested in Brazil inflation-linked bonds, where the real yield was very attractive from a valuation perspective. We felt that from a fundamental perspective the country was quite strong, they have pretty low foreign debt to GDP, they also have very high foreign exchange reserves and this is an area where we tactically invested. Now in the last three months emerging market bonds have had a pretty strong rally, so that position has worked out quite well for us.

Luque: Okay perfect. Well, Tanya, thank you very much for your views on the PIMCO income strategies. Thank you very much.

Sanwal: Thank you for having me.