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By Miriam Sjoblom, CFA | 01-26-2012 09:00 AM

PIMCO's Kiesel: Taking a More Bullish Stance on Duration

The PIMCO Investment Grade Corporate Bond says a growth slowdown and resultant move by central banks have made the team more optimistic on duration. Plus he explains the fund's focus on bank bonds.

Miriam Sjoblom: Hi, I am Miriam Sjoblom, associate director of fund analysis at Morningstar.

I am here today with Mark Kiesel, who is portfolio manager of PIMCO Investment Grade Corporate Bond.

Thanks for joining us. Mark.

Mark Kiesel: Thank you.

Sjoblom: The way PIMCO looks at credit and corporates is a little bit different I think from some of your competitors, in that you start with the top-down macroeconomic view, and we've just gotten some news, yesterday, the Fed came out and said they are going to be hold through 2014, and maybe you could talk a little bit about PIMCO's macro view.

Kiesel: Sure. So, our macro view really is important, because it guides where we want to be in the capital structure in companies, where we want to be on yield curves, what countries we want to invest in, and also what industries.

Yesterday with the Fed keeping rates really low, and the ECB doing the LTROs, there is a very expansionary central bank. Central banks are now, their balance sheets are 20%, 30% of GDP, and what we think this leads to is reflation, which causes us to believe that the front end of curves are going to be anchored, and therefore we want to be out the curve in the 5 to 10-year part benefiting from roll down, as well as in some industries which may benefit from reflation, owning hard assets like pipeline companies and even oil companies.

Sjoblom: There was a sort of a shift last year in PIMCO's view. Can you talk a little bit about that and what that meant for the portfolio?

Kiesel: Sure. So we started last year off, and we were basically underweight duration on the view that we thought that the economy would be growing at or above trend. Recall, a year ago, the U.S. economy was growing at 3%-3.5%, emerging markets were booming, and then all of a sudden Europe came into the equation and really what became a situation where policymakers couldn't get ahead of the crisis. And so Europe really scared a lot of people and really impacted risk appetite and, I think, business and consumer confidence. And when businesses and consumers pull back like they did, that caused the economy to really take a nosedive, and so as a result, central banks had to come in and basically get much more aggressive. And therefore, because of that, the downgrade in the global growth expectations and the acknowledgment that central banks would really hold short rates down for a considerably longer period caused us to get more optimistic on duration.

The final piece of the puzzle is that emerging markets last year were tightening 12 months ago, and now we're seeing emerging-market countries ease. So, we think all of that leads to a more bullish duration position in portfolios.

Sjoblom: So, the duration positioning is a change, but when you look at the industry breakdown in the fund, there weren't drastic changes. You don't tend to make drastic changes to the exposures of the fund. Can you talk a little bit about how the macroeconomic view, even though it has changed somewhat, impacts what kinds of industries you want to be in?

Kiesel: Sure. That's a really good question, because PIMCO is different from some managers, in that we tend to take a very long view, secular view. We do that in terms of our credit investing as well. For example, the banks--the banks went through a very difficult time. But what has changed is the fact that regulation, we think, is actually a positive for banks, at least if you're in the top of the capital structure, because regulators are trying to make banks safer. So, basically what's happening is, a lot of this organic capital that banks are making through net income, it's not going out to shareholders. They are not buying their stock back, they are not paying it out in dividends. Regulators are trapping it inside the bank and also trying to restrict what banks can do going forward.

What this means is that the earnings volatility won't be what we've seen; you'll see a little bit slower earnings growth, more pressure on margins, but the positive news is that the banks are actually still very profitable and a lot of that capital will be retained inside the bank, which means that balance sheets will get much stronger. That's a long-term trend that we're going to be seeing, and that is a trend, which is very favorable for debt. So, even though last year the economy was somewhat weak, it didn't change the fact that over the next three to five years, banks are going to be safer, and bondholders should benefit in that secular trend, so we want to stick with that senior bank overweight.

Sjoblom: So, banks obviously struggled a bit this year, but you're sticking with it, maybe you could talk a little bit about from the bottom-up level, what you have been doing in the bank segment of the portfolio?

Kiesel: Well, I think what failed to realize is that bank capital has doubled in basically three years, and that's because the housing prices are no longer declining at the same rate. While they are still declining, you're actually seeing some signs of strength. In fact, in a couple cities, you've actually seen housing prices go up, like in Texas, New York, Washington. So what's happening is, we've gone through this crisis that started in 2006 with housing prices peaking. We're almost six years into it, and so now banks are actually organically starting to earn their way out of this.

The balance sheets are very strong right now in terms of Tier 1 capital, if you look at the major banks around the globe. The U.S. banks are probably going to get the Basel III faster than any other banks outside of Swiss banks, who are already there.

In addition, the liquidity is far improved from two to three years ago. So, banks are sitting on basically a war chest of cash right now. So, there's no refinancing issues. And finally, banks are issuing a lot less debt because their balance sheets are shrinking, so there's not the supply of debt outstanding.

Finally, the valuations are as compelling as they've been in a long time, so the fundamentals, technicals, and valuations all suggest that this is a sector that even though it did underperform last year, will probably do pretty well this year.

Sjoblom: Even there were things you were doing within the bank segment of the portfolio to upgrade quality.

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