Peering Under the Hood of PIMCO's Real Return Team

Investors' concerns about inflation have waxed and waned since 2008's credit crisis, in large part thanks to the monetary stimulus efforts undertaken by central banks around the world. Those efforts have supported asset prices but haven't yet ignited higher inflation in developed markets, including the United States.

We recently conducted an in-depth interview with Mihir Worah, who heads up the real return portfolio management team at PIMCO, to get a better sense of how he has structured his team to navigate what could be a challenging environment ahead. Worah's team oversees a number of funds, including Morningstar medalists  PIMCO Real Return (PRRIX),  PIMCO Commodity Real Return Strategy (PCRIX), and  PIMCO Inflation Response Multi-Asset (PIRMX).  

We conducted our interview with Worah on July 9, 2013. All observations were current as of that date, and market conditions may have changed before this commentary was published. Part one of the interview focuses on Worah's team, its offerings, and its outlook on inflation expectations. The second part of the interview will run Tuesday, Sept. 17 as a Morningstar Fund Spy, and it will focus on portfolio positioning, recent performance for inflation-linked securities, and additional insight into the commodities market. The interview was edited for content and clarity.

An Update on the People
Michelle Canavan Ward: By way of background, could we take a step back and discuss the real return team that you lead and that a lot of your funds fall under. Maybe you could walk us through the growth and evolution of the real return team since you took over in 2007, with regard to both the investment professionals and the various strategies that have been launched since you joined the team.

Mihir Worah: On the portfolio management side, we've progressed in two distinct directions. In the real return space at PIMCO, while we cover a lot of different liquid real assets, the two cornerstones are inflation-linked bonds and commodities. In terms of personnel on the inflation-linked bond side, we've been increasing our global coverage--enhancing focus on the U.S. but also increasing global coverage. Jeremie Banet joined us about two years ago and is a very experienced TIPS (Treasury Inflation-Protected Securities) market maker in the United States.

Rahul Seksaria, who was on the Treasury desk at PIMCO, also joined a couple of years ago. Rahul also focuses on U.S. TIPS but tends to have more of a global relative-value perspective. In Munich, Michael Althof covers the European markets and emerging markets. He works closely with Mike Gomez and PIMCO's emerging-markets team to execute and analyze emerging-markets inflation-linked bonds. The most striking thing on the inflation-linked bond side has been our increased focus on emerging-markets inflation-linked bonds. We've always been doing TIPS, we've always been doing Europe, U.K., and Australia. Clearly we added expertise there in recent years, but the biggest changes are our focus on emerging markets and the decision that emerging-markets inflation-linked bonds would be traded off my desk. We collaborate extensively with Mike Gomez's team, but the main execution analysis happens off the real return desk.

In parallel, on the commodity side, the growth has been in some ways more striking. In TIPS and in inflation-linked bonds, we've always been active investors. In commodities, over the last five years, we've gone from being smart passive [investors] or enhanced-index investors to full-blown active investors, with the addition of a lot of the key personnel.

Start with Nicholas Johnson, who has been working with me on commodities since 2008. He has his own mutual fund, the  PIMCO CommoditiesPLUS Strategy (PCLIX), but he is a very strong commodity relative-value investor. To complement Nic and myself, we've added four people on the commodity side. And again, the additions on the commodity side have been somewhat more than on the linker [inflation-linked] side, because while I need people like Jeremie Banet and Rahul Seksaria and Michael Gomez, who are linker specialists and focus on the linker markets, there is a lot of fixed-income research and macroeconomic thinking that we can lever, and we do lever, off the rest of PIMCO. While in commodities, it's us.

We guide PIMCO's thinking on commodities from A to Z, so we needed to get more resources in commodities. So, two key senior-level additions in commodities. One is Greg Sharenow, who joined about two years ago and focuses on energy, that being the most important macro commodity and one where we see a lot of opportunity to add alpha for our clients. A second addition--this is brand new, just started a month ago--is Gillian Rutherford. She is a grain specialist, an agricultural commodity specialist. She's a great addition and just a wonderful resource.

Once we have the energy sector covered, the two other major sectors in commodities are metals and grains. I was actually searching for a metals specialist initially because again that fits into PIMCO's style, because metals have macroeconomic importance. So a metals specialist would add alpha to my commodity funds, but would also be able to guide PIMCO's thinking on what's happening in the emerging markets or what metal copper prices are doing, for example.

But through the course of my search, what I found was that there weren't that many alpha opportunities in the metals markets, and all of the traders and portfolio managers I was speaking to in metals, I didn't feel they had the right skill set. Meanwhile, we've been very successfully adding a lot of alpha in grains. After energy, our second biggest active source of alpha in the commodity complex has been the agricultural sector. So we started searching for an agricultural commodity specialist and ended up hiring Gillian Rutherford about a month ago.

Those are the two senior hires. We also have two junior additions on the commodity side. Andrew DeWitt and Yi Chian Chang help us with analysis and trade execution, and I hope to develop the junior people. I hope in a couple of years they'll be strong PIMCO-caliber portfolio managers, too.

 

The Team's Offerings
Worah: The most noticeable product development has been the launch of the GLADI [a suite of indexes that concentrates on a country's GDP rather than its market capitalization], or Global Advantage Inflation-Linked Bond Index and suite of products. We have the PIMCO Global Advantage Inflation-Linked Bond exchange-traded fund in the U.S., and the PIMCO GIS Global Advantage Real Return UCITS Fund. But with real interest rates in the United States and the developed markets artificially repressed and expected to stay low, we thought long-term inflation hedging--by long-term investors who are looking for bond-market inflation hedges--would be well served by having a strategic exposure to emerging-markets inflation-linked bonds, and so we launched the Global Advantage suite of products last year. (Click here for a table of sample strategies offered by PIMCO's real return team.)

In commodities, we launched the PIMCO CommoditiesPLUS Strategy as a complement to our commodity flagship, PIMCO Commodity Real Return Strategy, to offer our clients two things. The same ideas back both funds, but CommoditiesPlus is much more active in commodity management, with a larger tracking error and larger concentration. It also offers the possibility of having more pure commodity exposure; that is, commodities plus enhanced cash as opposed to the commodities plus TIPS combination of Commodity Real Return. Often the TIPS performance significantly adds to or detracts from the commodity performance, and you don't get that pure commodity exposure. So we launched the CommoditiesPLUS Fund. 

Then the final thing, which you know we did almost two years ago now, is the PIMCO Inflation Response Multi-Asset Fund, which to us was a response to client requests for basically a one-stop real-return product where they would not have to decide. They were looking for long-term positive real returns, but they didn't want to make the choice between TIPS, commodities, REITs, and so on. Given PIMCO's developing asset-allocation capabilities, we thought--and we've been right so far--that we could add value by giving clients a one-stop inflation-hedging solution, and that's been getting a lot of traction both from defined-contribution plans as well as from institutional defined-benefit plans. So our three big product initiatives have been the Global Advantage suite of inflation-linked bond [funds], which includes emerging markets; more active management in commodities; and then finally the multi-asset real return solution. 

Outlook on Inflation Expectations and TIPS Market Valuations
Canavan Ward: Broadly speaking about the various real-return funds you manage, what expectations about inflation are you currently incorporating into your investment process, both near term and long term?

Worah: Our near-term inflation expectations are fairly muted. We think inflation over the next nine to 12 months in the United States, for example, is going to be below 2.0%, and the market is pricing that one-year break-even in the TIPS market at about 1.8%. So we're kind of in agreement with that. Just like the near-term inflation outlook, our near-term currency outlook is that the dollar is going to remain strong. (Click here for an exhibit of the historical break-even inflation rate.)

Meanwhile, we're worried about long-term inflation risk. Longer term, we worry about the dollar versus other real assets and versus some of the faster-growing economies of the developing world. When we talk about the TIPS market, yes, the Fed has indicated that it's going to taper its asset budgets somewhat sooner than what the market expected. But it's still going to be left with a $4 trillion balance sheet, and what happens to that? Where does that go as the economy heals and banks start lending again? So we're worried about the long-term inflationary impacts coming from this unprecedented central bank experiment. It's hard to pin a number on it. But longer-term, we're worried about inflation being higher than what people have been used to. Meanwhile, near term, our inflation outlook is for modest 2%, sub-2% inflation.

Canavan Ward: In the few months leading into July, we've seen a significant increase in bond-market volatility, and TIPS in particular faced a pretty steep sell-off. Could you discuss some of the dynamics that led to such poor returns in the asset class over the past couple of months?

Worah: Sure, let's separate that into two major factors. One is fundamental and one is technical. On the fundamental side, some of the TIPS underperformance is warranted, unfortunately. Basically, TIPS, by their name, are real-return bonds. They react to changes in real interest rates, and basically to the extent that the central bank or the Fed, where it wants to ease financial conditions or tighten financial conditions, is really targeting real interest rates. TIPS are a financial instrument that is more sensitive to Fed actions or perceived Fed actions.

So, when the Fed is dovish or perceived as dovish on rising rates, TIPS will lead a rally, and when the Fed is hawkish or perceived as hawkish, TIPS will lead a sell-off, and that's the fundamental that happened over the last month. The Fed is going to come out, even probably this week [in early July], [qualifying] the tapering or the pace of asset purchases with the fact that they're not going to raise interest rates for a very long time. All of that said, the fact that this tapering was somewhat earlier than the market expected means the Fed was somewhat more hawkish than what the market expected, and this negatively affected TIPS as it should. Like I said, if the Fed is hawkish or perceived as hawkish, TIPS should get hurt. 

 

So that's the fundamentals. Should TIPS have gotten as badly hurt as they did? I don't think so. I think TIPS are attractive today and that leads us to the technicals. Why did TIPS underperform so much? There are three technical factors that resulted in this TIPS underperformance.

The first factor that started it, and probably the most important one, was selling from the risk-parity funds, which started even before the perceptions of the Fed changed. The risk-parity funds are large owners of TIPS, and they own them basically as a diversifier against the equity holdings. When correlations of TIPS with other asset classes go up or change from what they were, when the volatility of TIPS goes up, then this leads to mechanical selling from these risk-parity funds, because they have a target volatility and they have a target correlation. And it doesn't matter if real interest rates are attractive or not, it doesn't matter if break-even [rates] are attractive or not. As volatilities change and as correlations change, these funds have to sell TIPS. Because risk-parity funds are somewhat price-insensitive sellers, and because they're large owners of TIPS, that's been a big part of the TIPS underperformance.

The second factor is that TIPS mutual funds, including mine, have been seeing outflows for a large part of this year. I actively manage my funds, so, for example, if I get an outflow today and if I think TIPS are attractive, I don't need to sell TIPS. I'll manage the outflow by selling something else, raising cash by selling something else. A large portion of TIPS are owned by passive funds, whether it's a passive ETF or a passive mutual fund, and when these funds see redemptions, they have to sell TIPS. So even when valuations get attractive, you've got a couple of price-insensitive sellers.

The third price-insensitive seller in the TIPS market is the U.S. Treasury. The U.S. Treasury likes to be very predictable; we are in talks with them. Other governments' treasuries may reduce the size of their auctions or even cancel them if market conditions don't warrant new issuance; the U.S. Treasury doesn't do that. On the margin, it may change the size of an auction by $1 billion or so, but it won't significantly change the size of its announced issuance. So even as technicals have been poor in the TIPS market over the last couple of months, as volatility has been high and technicals have been poor with many more sellers and buyers, the U.S. Treasury doesn't reduce its issuance. There are other governments' treasuries that might say: If I can borrow at zero percent real for 10 years, I'll issue a lot, and if I have to pay 0.5% or 1.0% real, I won't issue anything. But the U.S. Treasury just keeps issuing no matter what the level is.

That's kind of the perfect storm that the TIPS market got caught in. Poor technicals from mutual fund outflows and risk parity selling, combined with a little bit of a fundamental push from the Fed, where people were completely taken unawares that the Fed would indicate it would taper even as current inflation expectations were stable, and, in fact, current inflation was quite low. So that was the fundamental that hit the TIPS market, and then with the addition of the technicals, it got hit pretty heavily.

Canavan Ward: Given that, where do you think we are now with respect to valuations?

Worah: Today, I think we're at quite attractive levels and the most attractive levels we've had in a while. So the five-year, five-year forward real interest rate--or the market's expectation of what inflation will be over five years, five years from today--is around 1.5%. The 10-year real interest rate, which six months ago was about negative 1%, today is positive 0.5%. What these real interest rates suggest--even the forward real interest rates--is that TIPS, which are an insurance policy against a central bank error or inflation getting out of control, are now paying you.

So you've got this insurance policy that's paying you a positive real return while you own it. So at 1.5% five-year, five-year forward real rates, and at 1.5% third-year real rates, TIPS are starting to look attractive, and I'm actually starting to see some money come into the TIPS market, not only from mutual fund investors but also from large official institutions. The sovereign wealth funds and the central banks are starting to buy TIPS again after having been quiet over the last quarter or so. TIPS sold off enough that they're starting to attract attention again from both domestic and overseas investors.

Please check back tomorrow for Part Two of our Q&A with Worah, where he discusses portfolio positioning, recent performance for inflation-linked securities, and provides additional insight into the commodities market.