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PIMCO Unconstrained's Dialynas on Interest Rate Expectations

Jason Stipp

Jason Stipp: I'm Jason Stipp for Morningstar. Investors have been focused on the equity markets as volatility has taken the markets up and down recently, but we also know that fixed-income markets have been very difficult for investors.

We're checking in today with Chris Dialynas. He is a manager on PIMCO Unconstrained. This fund has a flexible mandate to avoid trouble spots and seek out opportunities.

We're going to find out how he's positioned today. Chris, thanks for calling in.

Chris Dialynas: Thank you.

Stipp: First question for you, Chris. We know that there seem to be what we perceive as countervailing forces in the fixed-income market. So we have many managers positioning for what they expect will ultimately be a rising interest rate environment. At the same time we see that investors will, during times of market shocks, pile back into Treasuries and seek that flight to safety.

So, I'm wondering if you can talk about how you're managing in an environment where we're seeing these seemingly counter forces at work.

Dialynas: You're right. There are some countervailing forces at work with respect to the bond market in particular, the Treasury market. The problems in Europe where there are very significant imbalances of debt between the various countries and the EMU is causing quite an economic and political commotion in Europe that is resulting in a partial flight out of the so-called peripheral countries into higher-quality countries such as Germany or the U.S. So, the U.S. Treasury bond market has benefited from the problems in Europe.

The problems in Europe also lead to lower growth expectations globally and also that means in the U.S., which further reinforces a downtrend in interest rates, but very importantly as well, the Central Bank, the Fed, has been very aggressive in buying bonds in the open market, and as you know, they have made a commitment to keeping the policy rate essentially fixed for two years, and that has a very important impact on both the level of rates and on the shape of the yield curve.

So, what does that mean for the fund? The fund is currently running a duration of about two years, so that is long relative to its bogie, which is LIBOR, but not substantially long. Our expectation is that the 10-year Treasury rate will be range-bound somewhere between 1.75% and 2.75%.

So, not a substantial prospect for substantially lower rates nor higher rates. So, the two-year duration seems appropriate and enables the fund to capture yield in the portfolio, and we're primarily positioned on the intermediate part of the yield curve where the slope of the yield curve is quite steep and have a pretty significant weighting to mortgage pass-through securities as well.

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Stipp: Chris, it sounds like you're primarily focused in looking at that intermediate term and you have a forecast for what you expect to be some range-bound activity during that time.

When you're looking out longer term, and I know a lot of investors are concerned looking out in the future, that higher rates will come. How do you think about positioning for what could ultimately be, five years from now or 10 years from now, a very different interest rate environment?

And could change happen quickly? I think this is such a big worry for investors. They are concerned that they might not have time to act when rates start moving up?

Dialynas: That is the very, very, very important longer-term question, because clearly the policies that are being undertaken by the Monetary Authority in the U.S. in particular and in the U.K. are quite, as I mentioned, quite aggressive and ultimately inflationary if at all successful.

So, looking longer term, I think one needs to expect that rates will inevitably rise, and perhaps as you mentioned, rise rather quickly. So getting the timing right is very important, and this rate rise in the future, and again in the distant future, could occur in a relatively benign growth environment.

So, a rate rise in a relatively poor growth environment would obviously not be a good outcome from current policy attempts to resuscitate the economy. The fund itself can actually go to a negative duration, and the fund can use virtually every medium in the market to reposition itself. So, there is a lot of built-in flexibility with respect to guidelines but also with respect to the tools that the fund can use.

So, probably, not in the near future, but in the distant future, it is highly likely that the fund will become, if you will, a bear-market fund, a bear-market interest rate fund, and I would not be surprised if in the course of the next couple of years that the fund actually has a negative duration and is positioned for higher rates.

Stipp: So, Chris, what kinds of signs would basically prompt you to start making a move in that direction. What are you looking for? What warning signs would you have?

Dialynas: I think that one of the really important aspects to, at least government rates today, is again, the activities of the central bank. So, we have an election, a national presidential election and congressional elections next year, and there are mixed political perspectives regarding the activities of the central bank, and ultimately Chairman Bernanke's term will expire as well. So part of the interest rate puzzle is understanding what the central bank is doing and what it might do next.

Clearly, if the central bank, if the Fed, were to change its policy from trying to promote growth in employment as its main objective, then that would certainly be an important signal, and they might do that just by raising the structural unemployment rate--that is, rather than saying, it's 6%, they may say it's 7%, or we might end up with a much greater inflation than is currently expected, and either of those things would be signals that rates would be perhaps headed upward primarily because the capacity or the willingness of the central bank to continue to fund a very large government deficit starts to dissipate.

Our growth forecasts, our new normal growth forecasts for the next two, three, four years is not robust. So, I doubt that we will see a growth spurt that leads us to become defensive. It's more likely that there will be a reflation, an inflation that starts constraining central bank policy or a change in politics that inhibits the central bank from continuing to expand its balance sheet and perpetually purchase government bonds.

Stipp: So, Chris, we talked a bit more about macro issues. I'd like to turn and focus on your portfolio. So you mentioned earlier that you have a pretty flexible mandate and can invest in lots of different instruments to execute on your themes. Can you talk a little bit about where that flexible mandate has led you today, and also where it has led you away from--what you're avoiding?

Dialynas: As I mentioned earlier, we like mortgage pass-through securities--Fannie Maes and Freddie Macs. We also like and are invested in non-agency distressed mortgage securities. We like some emerging-market sovereigns like Brazil where we think the short end of the yield curve is quite attractive, basically a very, very high real interest rate country where we expect policy rates to continue to decline.

We're invested in Australia, in Canada, where we think the balance sheets are quite strong, and in the case of Australia, where nominal rates remain quite high.

And then importantly, we are invested in currencies of emerging-market countries, primarily Asian countries and primarily China, where on a secular or a longer-term perspective, we expect that the rebalancing of the global economy really requires a rebalancing of or a readjustment of the exchange rate between China and the United States, where the Chinese currency needs to revalue, and as it revalues--and it has been revaluing, but rather slowly--but as it revalues, that enables some of the other surplus countries to allow their currency to appreciate as well, and in so doing, result in a better balance of trade globally, but also lead to an appreciation of the currencies that we're long relative to dollars and euros primarily.

Stipp: What about areas where you have either trimmed or where you're avoiding? What trouble spots are you seeking to not be in right now?

Dialynas: We have been completely void--completely is probably too strong word--but essentially void of any risk in Europe, other than Germany, so we have for the past couple of years been completely out of Portugal, Italy, Spain, Greece, Ireland, and so that is definitely an avoid. We think the risks there are very asymmetric. So if you take country like France, which is arguably a very strong economy, and one that is logically quite closely linked to Germany, from a bondholders’ perspective, there just doesn’t seem to be enough yield to rationalize the investment relative to potential downside should the political element of the European Monetary Union become even worse. So, most of Europe is an avoid.

And then lower in the capital structure, high-yield in particular types of risks, are also an avoid for the fund at the present time.

Stipp: So, you kind of hinted at it a little bit, the last question I wanted to ask you, Chris, has to do with valuation. So we know, for example, and it's not a secret, that the fundamentals in emerging markets--and you mentioned a few in your answer of where you are seeking some opportunities--it's no secret that the fundamentals there are good. But how is the pricing, and how does valuation factor into the decisions you make and where you take investments? What's the part that valuation plays in the equation?

Dialynas: So, the valuation is critically important, and valuation from the perspective of the investor is obviously a risk-reward assessment relative to other opportunities in the market.

So, in the case of ... to go back to France for a second, it's highly unlikely that there are going to be significant problems in France, but again the valuation risk-reward doesn't seem particularly appealing. And it's the same analysis to emerging-market countries and to corporation in emerging-market countries--that is, how does it look relative to high yield? How do they look relative to investment grade credits? How they relative to European credit? What are the fundamentals versus what are the technicals? So the valuation of the various markets is incredibly important, so we can't just naively go into an investment, and in this case a country where the fundamentals appear quite strong, and in many of these countries our secular view, our long-term view, is that the fundamentals are quite good, but again it's quite good relative to what price?

So, the pricing is very important, and so in the case this fund, as I mentioned, most of the emerging-market exposure is really concentrated in the currency component of emerging markets as opposed to the bond component. There is certainly bond risk in the portfolio in emerging-market countries, but the preponderance of the risk is in the currency component.

Stipp: Chris Dialynas from PIMCO Unconstrained Bond, thanks so much for calling in today and for your insights on the current market and the positioning of the PIMCO Unconstrained Fund.

Dialynas: My pleasure. Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.