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By Eric Jacobson | 04-11-2011 05:22 PM

PIMCO Unconstrained Fund Shortens Up

PIMCO's flexible bond fund has a duration of almost zero with a large position in emerging-market currencies, says manager Chris Dialynas.

Eric Jacobson, our director of fixed-income research, recently visited PIMCO's offices and sat down with Chris Dialynas, the manager of the PIMCO Unconstrained Bond Fund, to learn more about how that flexible fund is positioned today.

Eric Jacobson: Chris, thanks so much for being with us today. We really appreciate it.

Chris Dialynas: Good to be here.

Jacobson: So, I want to ask you a couple of real basic questions about the Unconstrained Bond portfolio that you run. Can you give us just a little bit of a thumbnail? We've written and talked about it a lot, but thumbnail of the parameters within which you work not only in terms of interest rate sensitivity, but also sector allocations and risk?

Dialynas: Well, the fund by design is constructed to allow for a lot of flexibility. So, in the interest rate space that translates into, as you know, the ability to go negative in duration, negative three years in duration to positive eight years in duration. There is quite a bit of latitude with respect to high yield, to emerging markets, to credit generally. There is quite a large component for currency exposure, as much as 30%, but the fund at all times must be on average investment grade. So, while there are these rather wide ranges for investment in credit and in currencies, the fund must remain investment grade.

Jacobson: So, within the framework that you just laid out, obviously, there are number of funds that describe themselves on pretty similar terms, but do things pretty differently than you do. Could you just help us understand a little bit, perhaps through the prism of the last 18 months or so as we've talked about earlier, what that has meant in terms of some examples of sector exposures that you've put on, taken off, so forth?

Dialynas: Sure. The fund by design is supposed to be sort of a best ideas, best of PIMCO ideas fund. There have been quite a few ideas that we've generated in the past couple of years since the inception of the fund. For example, when the fund first started during the financial crisis, we believed that mortgage pass-through securities were quite attractive investments, and the fund really invested quite heavily in mortgage pass-throughs.

We also thought rates were going to be declining, so the fund had a duration of about five years. So, we had a very large component of mortgage pass-throughs, a long duration. Then as the Fed engaged in quantitatively easing I and started buying its mortgage pass-throughs, mortgage pass-throughs became quite rich. The fund sold its full position of mortgage pass-throughs, and in addition, went short about 50% of the fund in mortgage pass-throughs.

There was a time when we believed that interest rate risk in Germany was under-priced relative to the rest of Europe. We believed that there would be credit problems in peripheral Europe, so we invested in Germany under the presumption that as investors realize that what they thought was interest rate risk in the peripheral countries migrated into credit risk, that they would move that interest rate risk into Germany. They did that. German bonds richened quite a bit relative to U.S. bonds, and we then moved out of Germany back into the U.S.

So, there have been a lot of changes in strategies, a lot of repositioning. Our duration today is almost zero. So, we've gone from a duration of about five, five and half years, down to almost nothing today. We have quite a large currency position today in emerging-market currencies and that is based upon both the cyclical and secular view that we have here at PIMCO. So, the fund does move around a lot by design, and we'll continue to invest in that manner.

Jacobson: Just to key off that last part that you said, I think it's an interesting thing for people to try to understand. You had mentioned earlier, for example, that even though the duration of the portfolio, which is a very specific interest rate calculation that you can run on a portfolio, is that the level that it's at or I think you said it's close to zero, but it's slightly positive. You had noted earlier that because of the response that currencies have had to different factors in the marketplace, the fund has sort of behaved recently almost as though it's had a negative duration and in fact, that has worked out pretty well in recent months. Can you just explain the transmission mechanism there a little bit--in other words, what does that mean that it has behaved that way? Why did it behaved that way?

Dialynas: The fund is constructed, as you mentioned, with a very small nominal duration, but most of the duration in the fund is anchored at the short-end of the yield curve and most of the short position in the fund are longer in maturity. So, with the anchoring in the front-end and the rest of the yield curve moving, then as rates go up the short position pays off. The long position doesn't really move much because it's anchored by the Fed.

So, by construction even though it has a positive nominal duration, it's behaving as if it has a negative duration, and then the currency component varies somewhat independently of interest rates, but is and has been augmenting the returns that we've been able to generate because the currencies have been moving in the way that we've anticipated.

Jacobson: So, just to put that second part a different way, at least, during some short periods of time when U.S. rates were perhaps bumping up, or what have you, the currencies were rallying a little bit and helping the portfolio with generally positive return from that slice in addition to the anchoring issue?

Dialynas: That's right.

Jacobson: Generally some positive return even though rates were rising?

Dialynas: That's right.

Jacobson: Well, great. Thank you so much, Chris, for your time. We really appreciate it.

Dialynas: Thank you.

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