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How This PIMCO Fund Is Prepared for 'The New Neutral'

Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Mohit Mittal. He's a managing director and also a portfolio manager at PIMCO on the Unconstrained Bond fund. We're going to talk about his outlook for the economy and how that is impacting his portfolio decisions.

Mohit, thanks for joining me today.

Mohit Mittal: Thank you very much, Jeremy.

Glaser: PIMCO has moved from the New Normal to the New Neutral. Can you talk to us a little bit about what that means and what your secular outlook for the economy is?

Mittal: Sure. Let me just quickly define what the New Neutral is for us. First, it consists of the outlook for growth being lower than what it has been in the past. So, our outlook is that real growth in the U.S. will be around 2% instead of 3% real that we have seen precrisis.

Second, it means that monetary policy will be set at lower real neutral rates. Historically, we've seen 2% real neutral rates. Moving forward, we expect real neutral rates to be in the zero percent range, which means that the [federal-funds] rate will finish [the taper] at around 2% instead of 4%, which many have been expecting.

Glaser: If you expect those long-term rates to be lower, what does that mean for positioning in terms of the duration [a measure of interest-rate sensitivity] of your fund? How are you thinking about that?

Mittal: As far as positioning of the fund, we like a modest to long position in U.S. duration because we think that the neutral rates will be lower than what even the central bank is forecasting. We like to have this modest overweight.

At the moment, our aggregate duration positioning is about 2.5 years coming from the U.S., Brazil and Mexico, and that 2.5 years is about 40% of the duration of an aggregate bond index.

Glaser: Now, what about credit risk? In that world, how do you think about taking that on?

Mittal: I think we like taking credit risk in select areas. We are not a big fan of taking large amounts of high-yield or bank-loan risk, but we do like taking credit risk in areas where we see value. The examples include peripheral European sovereign and financial credit risk. The reason we like that is because of what European Central Bank did and is doing with the targeted long-term repo operations. So, we think peripheral European sovereign and financials bonds will do well in that environment.

The second place we like taking credit risk is in nonagency mortgages in the U.S. We think U.S. housing is expected to continue to recover, not at the same high pace that it has in the last year, but still a modest 5 to 10 percentage points over the next 12 to 24 months. So, nonagency mortgages would be the another area.

A third area where we like credit is select emerging-markets sovereign debt. So these combined, offer value to us at the moment.

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Glaser: Let's take a look at those emerging markets some more. When you look across the emerging markets, how do you differentiate between maybe ones that you really could get some value, picking up some yield there, and others where you could be worried about that credit risk?

Mittal: We look at multiple things. We will look at the external debt. We will look at net external debt, net of foreign holdings. And at the same time, we will look at the current account balance or deficit of the sovereign.

So, on that metric, when we look at Brazil and Mexico, for example, we do find some value there. Even at an aggregate debt of about 40%-45%, the net external debt is much lower. So we find value there.

In the case of Mexico, the energy reform will be a positive over the long term to encourage foreign direct investments. So, in the case of Mexico we also like the currency.

So, it's a combination of balance sheet plus current account surplus or deficit that makes us want to have exposure to emerging-markets credit.

We have to be cautious on emerging-markets corporate credit, given the amount of issuance that we've seen in the last few years, but there are select quasi sovereigns that we find attractive.

Glaser: Now, throughout this conference there's been talk about the market being somewhat complacent, that we haven't seen the kind of volatility that was present a few years ago. How do you think about unconstrained portfolios in this more placid environment? When would you expect your fund to perform better? When would you expect it to maybe perform a little bit worse?

Mittal: I think you're absolutely right. There is a certain amount of complacency in the market. And the Unconstrained fund is a kind of strategy that is well-positioned to take advantage of both environments, when you have low volatility, as well as when you have high volatility.

With the low volatility that we're seeing right now, our focus has been to lower the maturity profile of our portfolio. So, the credit risks that I talked to you about, we're trying to have a much lower maturity profile so as to have the dry powder in a year or two years out when volatility starts to pick up.

And then during the periods of high volatility, there's an opportunity to either sell volatility through credit calls and puts to take advantage of volatility, or at the same time using credit or duration areas globally as volatility picks up to generate absolute returns.

Glaser: Mohit, I really appreciate your thoughts this morning.

Mittal: Thank you very much, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.