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Avoiding Pitfalls While Seeking Income

Eric Jacobson

Eric Jacobson: Hi, I'm Eric Jacobson with Morningstar.

We're here today with the fund managers of PIMCO Income, who are being selected as our Fund Manager of the Year for the Fixed-Income Award, the bond fund Award. We've got Dan Ivascyn and Alfred Murata from PIMCO, and they've been kind enough to join us in the studio here today.

Thank you both so much for being with us.

Daniel Ivascyn: Thank you, Eric.

Alfred Murata: Thank you very much.

Jacobson: Dan, I'll start with you. People very often purchase bond funds for income, but it's become a lot more common over the last several years--no small feat of Bill Gross and PIMCO Total Return being a leader in the field--for managers to focus on total return when managing bond funds. This fund is a little bit different in that it still has a very deliberate focus on income and even has a set dividend that you guys manage to.

Can you talk a little bit about the things that you do to differentiate the fund given the income focus that you have?

Ivascyn: That's very true. Unlike other PIMCO portfolios, a consistent dividend income is the fund's primary objective. That tends to have us focus on some of the higher-yielding opportunities within the fixed-income market. However, like all PIMCO portfolios, the critical secondary or additional objective is total return. We never want to sacrifice total return for the sake of generating income. And then, finally, we want to put together a portfolio that's consistent with PIMCO's macro themes. That's what really ties things together.

But in terms of the differentiating feature, it really is that we tend to focus on current yield a bit more than other portfolios. It tends to lead us into, again, some of the higher-yielding credit sectors over the course of time--or at times, slightly longer maturities.

Jacobson: Alfred, I'll ask this to you: How do you manage to avoid some of the pitfalls that have historically trapped some of the more income-focused funds in the mutual fund universe?

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Murata: A big focus in the fund is trying to avoid pitfalls. There are several main strategies that we have to avoid that. One is avoiding excessive concentration in one sector of the global fixed-income universe. So, by having a global opportunity set, this allows us to have the flexibility to diversify the portfolio, and invest in the most attractive asset classes around the world.

Second strategy that we have for the fund to avoid pitfalls is the fact that we're able to comprise a portfolio in two large buckets: one bucket for the a higher-yielding portion of the portfolio that will do well if you've got strong economic growth; another portion of the portfolio in higher-quality assets that will do well if you have weak economic growth.

So, if economic growth is strong, then we're going to be able to generate total return from the higher-yielding portion. If economic growth is weak, then we think that the higher-quality bucket of the portfolio will protect the portfolio against downside risk in that type of environment.

Jacobson: Dan, let's break that down a little bit. Because of that asset mix that you guys have, which includes more foreign bonds and high-yield debt, say, than funds that are benchmarked off of the Barclays Aggregate, which is sort of the S&P 500 of the bond market, we classify PIMCO Income as a multi-sector fund. The interesting thing about that is that category historically has had a little bit more conventional focus in terms of mixing high-yield, maybe some non-U.S., and even more emerging markets in the last many years, but still fairly conventional sectors. And your fund is a little bit different, given that it has a pretty large allocation to non-agency residential mortgages and commercial mortgage-backed securities.

Can you talk a little bit about the thinking behind having that as a major allocation?

Ivascyn: Eric, you're exactly right in terms of the lack of focus on a particular benchmark. We do try to be as creative and flexible in putting together a portfolio, and we do have a global opportunity set.

As Alfred just mentioned, we try to really leverage PIMCO's top-down investment ideas as governed by the firm's Investment Committee. One of the key themes the last few years has been the view that the U.S. housing market, and even other European housing markets, would stabilize and potentially go up in value, and that's what really has driven our focus on the non-agency mortgage segment of the marketplace.

That's an area, as you know, that was heavily dislocated during the crisis period of '07, '08 and '09, and presented an attractive opportunity to take advantage of investments that we thought were priced very attractively, but also would have equity-like tendencies if the housing market were to stabilize, and that's been an important source of price appreciation in recent years.

Jacobson: Alfred, as Dan just said, that market has been pretty strong for the last several years, and the non-agency market, especially the residential market, has evolved some. But certainly, the underlying loans and the securities, as a result, that you buy, they don't, obviously, carry a government guarantee, and there is definitely some measure of credit risk still inherent in this sector. Can you talk about what some of those risks look like?

Murata: So, as you mentioned, the bonds don't have government guarantees. What's very important in these bonds is analyzing the cash flows from the underlying loans. So, we were depending upon what's happening with the housing market in the U.S. to determine what's going to happen with those bonds, and performing loan-level due diligence on the underlying loans backing these mortgage-backed securities.

We think that given the resources that we have at PIMCO, we're able to add significant value by looking at these underlying loans, finding the best of these mortgage-backed securities to invest in. We're also able to buy these bonds at a substantial discount from par, around seventy-five cents on the dollar, and this enables us to get a very attractive return even if we don't get par back on these bonds.

So, the strategy that we have is not buying these bonds expecting that we're going to get par back. We understand that many of these bonds were not going to get a hundred cents on the dollar back, but if we buy them at seventy-five cents on the dollar and get eighty-five or ninety cents on the dollar, we think that's a very attractive investment for the fund.

Jacobson: So, you mentioned the fundamental underlying analysis. I take it, though, that there are exogenous risks, too, though in terms of, as Dan alluded to, the economy and so forth. Is that a concern for this sector, and how do you address that and think about it?

Murata: Yes, that is a concern for this sector, but given the substantial discount that we're able to buy these bonds at and the fact that we're able to focus on the bonds where the loans are in areas where we think housing prices will increase more than the national averages, we think this still provides a very attractive investment for the fund.

Jacobson: I mentioned, Dan, that this sector has evolved a little bit over the years. What kind of changes have you observed in the marketplace and what's available to you?

Ivascyn: The one attractive feature of the market in recent years is that prices have stabilized. Prices have gone up but the spread you earn versus higher-quality investments has narrowed, and a lot of that is because the housing markets are beginning to heal in this country. So, it's a better behaved sector. It's a sector that remains attractive, but its attractiveness versus other credit-related sectors has narrowed. So, we've begun, over the course of the past several months, to reduce our relative exposure to that asset class. It's something we would expect to continue to occur in the coming months, but it is a little bit easier-to-understand sector today, a better behaved area of the marketplace.

Jacobson: We have talked before about the size of that market, and if I recall correctly, a really rough estimate was about $600 billion in market value still out there in existence, and there are obviously a few different ways that the underlying mortgages can effectively sort of disappear, whether it's because of defaults or refinancings, or what have you. If you could try to characterize, how quickly is that market shrinking and giving less supply for you to acquire?

Murata: The market's shrinking by about $100 billion a year, and if you don't have new supply, then it's going to continue to shrink. If prices eventually increase, then we think that the supply will increase at that point, but at this point, we think it's good from an investment perspective. We are still seeing trades in the secondary marketplace. So, we're still able to buy some of these non-agency mortgage-backed securities. But overall, from a market technicals perspective, we think that these are very positive compared to many other asset classes where you're seeing a significant supply, like in the investment-grade corporate or high-yield corporate universe.

Jacobson: Just to clarify what you meant there--if I understand correctly, you're suggesting that if the pricing stabilizes, gets a little closer to par in the secondary market, it will be easier for new issues to come and add to that supply; that's what you're implying?

Murata: Correct.

Jacobson: Let's switch over for a minute to talk a more about the fund itself again, Dan. Whatever the risks are in the non-agency mortgage sector of the portfolio, you still have an interest in balancing those out, as Alfred alluded to earlier. What kinds of exposures do you use in the remainder of the fund?

Ivascyn: This is an important point. We think about the more-aggressive credit bucket. We look at non-agency mortgage-backed securities versus other alternatives, like high-yield corporate credit, investment-grade corporate credit, even lower-quality emerging-market bonds. And we've chosen in recent years to focus that component of the portfolio in non-agency securities, or to overweight that segment of the marketplace.

To supplement these types of exposures, we have a pretty substantial bucket in high-quality investments. So, we've run a pretty consistent position in Australian government bonds, high-quality instruments. That's a market that has slightly higher nominal yields than other areas of the developed world, and we think would provide a nice hedge if we were to get into a situation where global growth was much lower than we anticipated. Again, given the cautious view of PIMCO's Investment Committee, we think that's an important position, which would hopefully do quite well during an environment where some of our non-agencies weren't performing that well.

A second area that we focused on over the last few months has been putting on, again, a position in the U.S. Treasury bond market. For quite some time, we had next to no exposure to U.S. Treasuries because we thought yields were low versus other things we could do, given our global opportunity set, but after the recent backup in interest rates, that's an area of the marketplace that we think will begin to show defensive tendencies once again. So, we have a small position there and, again, hopefully a position where we could see rates rally if we were to get into a recession or a weakening housing environment as well.

Jacobson: We've talked in the past about how you dynamically re-adjust those exposures. Can you explain what might cause you to shift them around and what you're trying to achieve when you're doing that?

Ivascyn: As I mentioned earlier, what's very important for this strategy, although it's a little bit different than some other funds that we run, is to be consistent and be able to leverage PIMCO's macroeconomic process. So, to the extent the Investment Committee has a view that economic growth may be at risk of deteriorating further, that will cause us to pretty quickly upgrade the credit quality of our portfolio, look for assets that can help stabilize overall returns or volatility during periods of market stress. So, that top-down investment approach is still very much reflected in what we do, even though this portfolio is a little bit different than some of our other benchmark-type offerings.

The final point relates to the bottom-up element of the strategy. We have over 250 portfolio managers at PIMCO that are feeding us ideas in terms of securities they like or sectors they like. So, to the extent we see one area of the marketplace, perhaps non-agencies, continuing to outperform and therefore looking a lot less interesting versus other credit alternatives, we'll begin to shift assets in that direction.

This is not an aggressive trading strategy, where you wake up one day and all of a sudden things look a lot different, but we do try to be tactical, opportunistic, creative in our portfolio positioning, and we will shift to the extent our top-down or bottom-up views change.

Jacobson: Thank you both very much for joining us and congratulations again on winning Fund Manager of the Year for Fixed Income. We really appreciate you coming into the studio today.

Ivascyn: Thank you very much, Eric, and we're very appreciate of the recognition.

Murata: Thank you very much.

Jacobson: For Morningstar, I'm Eric Jacobson. Thanks for joining us.