Peering Under the Hood of PIMCO's Real Return Team: Q&A with Mihir Worah, Part 2

Yesterday's Fund Spy featured Part One of an in-depth interview we conducted with Mihir Worah, head of the real return portfolio management team at PIMCO. Under his leadership since 2007, the team has grown both in investment professionals and in real return product offerings, including Morningstar medalists  PIMCO Real Return (PRRIX),  PIMCO Commodity Real Return (PCRIX), and  PIMCO Inflation Response MultiAsst (PIRMX). Part one of the interview focused on Worah's team, its offerings, and its outlook on inflation expectations. What follows below is Part Two of the interview, in which Worah discusses how he's positioned his funds in the current environment, recent performance for inflation-linked securities, and his thoughts on the commodities market and whether commodities should play a role in an investor's portfolio. All observations were current as of July 9, 2013, and market conditions may have changed before this commentary was published. The interview was edited for content and clarity.

Translating Views on Inflation Into Portfolio Positioning
Michelle Canavan Ward: Earlier in our interview we touched on your outlook for inflation expectations; now let's switch gears to one of your funds, PIMCO Real Return. Unlike some inflation-protected bond category peers, you can invest up to 20% of assets outside of TIPS. Could you discuss some of the inputs that go into allocation decisions? Given the sell-off over the past few months, have you adjusted the TIPS allocation in the portfolio as a result?

Mihir Worah: We can actively manage not just the TIPS portion, but if we see value outside the TIPS universe, whether inflation-linked bonds or not, we will try and seek that value. This is a real return product, and we’re trying to offer our clients an after-inflation rate of return.

So, the main question we consider is, are these off-index assets that I’m buying safe? That is, given the fact that they’re not U.S. TIPS, which are the risk-free asset, is the reward justified given a slightly higher degree of risk relative to TIPS? And the reward is always calculated in terms of real or after-inflation returns. Do I expect a positive or higher after-inflation return in these alternative assets compared with TIPS? And if I expect positive, a small amount of the fund will be invested in non-TIPS assets.

For example, early in the year I had large allocations to U.K. inflation-linked bonds, Italian inflation-linked bonds, and Mexican inflation-linked bonds. All of which did extremely well, and I sold them into TIPS over the last couple of months. So, like I said, today TIPS are extremely attractive, so I don’t need to go away from the TIPS market to look for value. I have much of the fund in TIPS, and the largest off-index allocation is probably 3%–4% in Brazilian interest rate swaps and Brazilian inflation-linked bonds.

A new development as part of this recent market volatility, and the underperformance of Brazil and emerging markets in general, is that Brazil lifted this investment tax or this IOF tax they had on overseas investors. As a result, I can invest in Brazilian inflation-linked bonds without paying a tax to the Brazilian government. I'm cognizant of the technicals in that market, which are almost as bad, or worse, than the TIPS market. So, it's not a big holding but it was increased over the last couple of months just like my TIPS holding was increased over the last couple of months. And today I find the most value in TIPS and to some extent in Brazilian inflation-linked bonds.

Canavan Ward: Within the TIPS allocation of the fund, one strategy that you've used in the past to add value is through different maturity allocations. Could you discuss where along the TIPS curve you've been finding the best opportunities and whether that positioning has changed much during this year?

Worah: Early in the year, in December 2012 and January of this year, I had a fairly large concentration in the front end of the TIPS curve. Often that’s a quantitative, seasonal pattern of front-end TIPS performing early in the year. So, I had that in December and January. But other than that, for most of the year, I have been significantly underweight short maturity and five-year TIPS, and that’s helped the fund in this downdraft. Overall, the fund has actually underperformed modestly for the year through June, and we can talk about the reasons for that. But the curve positioning in TIPS actually helped. Like I said when I talked about how when the Fed is dovish, TIPS lead a rally, and when the Fed is hawkish, TIPS lead a sell-off, within the TIPS sector itself the five-year sector of the front end will have the highest beta or the highest sensitivity to Fed action. So, in this recent sell-off, actually the five-year sector has been hit the hardest, and the fact that I’ve had a big underweight in that five-year sector has helped the fund not be hit as hard as it would otherwise. So, that’s worked.

Given the sell-off in the five-year sector and given what we expect the Fed to do in clearly separating the pace of asset purchases with the timing of the first interest-rate hike, we think the front end of yield curves, whether we are looking at a TIPS curve or the nominal curve, have overreacted. Both are pricing in interest-rate hikes much earlier than we actually are going to get them. So now the five-year sector is starting to look attractive again. I’ve been underweight the front end and the five-year sector of the TIPS curve for most of the year, and recently I started buying it again. So, I’m selling longer-maturity TIPS into five-year TIPS.

Canavan Ward: Why is it that the front end reacts more quickly than the rest of the curve based on the Fed actions?

Worah: The simplest way to see it is, that’s the part of the yield curve that the Fed can affect the most. The Fed can lower and control long-term real interest rates, but generally whether the Fed is hiking, cutting, or on hold is really affecting short-term interest rates most directly. So, those are the interest rates that react the most to Fed action or perceived Fed action.

For example, in January 2012 the Fed first came out with its inflation target of 2% and said they’d also tolerate inflation above target as long as unemployment was still high. At that point, the Fed was very dovish and perceived as dovish and the five-year sector led the rally in the TIPS market. Now more recently when the Fed is perceived as hawkish, the five-year sector has led the sell-off in the TIPS market. So, our underweight there helped, but clearly we had other things that didn’t work in the fund over the last couple of months.

Insights into Recent Performance
Canavan Ward: This may be a good segue to discuss some of the things that did go wrong so far this year, given the PIMCO Real Return fund's slight underperformance versus its Barclays U.S. TIPS index benchmark.

Worah: Basically, year-to-date I’m underperforming the benchmark by about 50 basis points; most of that has been in the last couple of months and there have been two factors, already touched upon. Once this underperformance started in the TIPS market and in the emerging markets, it accounted for roughly the first half or two thirds of the underperformance. At that point in late May, early June, I thought both TIPS and high-quality emerging markets like Brazil were very attractively priced and I increased my allocation to both TIPS and Brazilian interest rates. Unfortunately both areas underperformed quite a lot in June and heading into July, leading to about 50 basis points underperformance in the fund. So, the things that didn’t work were the TIPS overweight in duration terms and the emerging market off-index exposure. Those are the two things that detracted from the fund's performance. (Editor's note: As of Aug. 31, the fund's year-to-date negative 9.0% return trailed the benchmark by 0.9 percentage points)

Canavan Ward: And after adding in late May or early June amid the sell-off, did you add more at that point?

Worah: I have not added and I have not reduced. In an indirect way I might have added a little bit, because, even though we are still seeing modest outflows, I wouldn’t sell TIPS. If I get an outflow and I don’t sell TIPS, that’s indirectly adding a little bit. But I haven’t actually been buying in the market.

Canavan Ward: There has also been some volatility in the commodities market the past couple of months, and also this past year it’s been a difficult environment for most commodities funds. You also manage PIMCO Commodity Real Return Strategy, which has exposure to both TIPS and the commodities market. Could you discuss how the commodities market has performed this year, if there are certain areas of the market that have been bright spots or particularly challenged?

Worah: I'll talk about how commodities have done through the year, but focus for a little while on this latest bout of volatility over these last couple of months, where the fixed income markets have been very volatile. It's often the same factors that drive TIPS and drive gold prices. The commodities other than precious metals have been somewhat immune. They have been reacting to their own micro supply and demand factors, whether it’s grains, energy, or investment metals--those areas have been less susceptible to this big sell-off and this Fed tapering, except for gold. Given what happened to TIPS, you would expect a correction in gold, because gold is very sensitive to the level of real interest rates.

I’d say the bright spot in commodities has been the energy sector for three reasons. One is that there is a big glut of natural gas in the United States coming from the shale gas technology, leading to a big correction in natural gas prices over the last couple of years. This year natural gas prices found their floor and have actually rallied off the bottom and are stable and doing well. Demand has picked up, so we got a lot of supply, and as a result, prices sold off. Meanwhile, demand picked up because prices got cheap enough that for power generation you could switch coal for natural gas, so that’s one source of demand. A second source of longer-term demand has been the approval of future LNG [liquefied natural gas] export terminals. So, natural gas won’t be isolated in the United States. If we’ve got too much of it, we can export it. Finally, there has been some growth in storage capacity in natural gas as well. So, natural gas prices have been doing quite well.

Also, crude oil prices have been doing quite well. The story there is, U.S. crude oil was artificially suppressed. Relative WTI crude oil prices were trading at a discount to global crude oil prices for reasons somewhat similar to natural gas. U.S. crude oil is benchmarked and delivered into Cushing, Oklahoma, which is landlocked. There's a lot of oil coming in, nowhere to get it out. And now, not only is there less oil coming in, but the pipelines are being built to get it out. So pipelines have been built to get oil out of Cushing, Oklahoma. Also, other U.S. domestic oil sources that were feeding into Cushing, Oklahoma, have also had pipelines built that now take the oil away to other places. So we've got a nice rebound in U.S. crude oil prices. (Click here for a table of the year-to-date returns of the various commodity subsectors.)

The dark spot in commodities has been precious metals, because it's going through the same cycle, central bank, real interest rates, et cetera. Industrial metal prices have been weak this year, basically responding to the slowdown relative to expectations of Chinese and emerging-market growth. Industrial metals are the most sensitive to Chinese growth, and to the extent that Chinese growth is slower than people expected, metals aren't doing that well. Grains respond to weather and planting and generally tend to be the most mean-reverting of commodities. If you get poor weather, you get high prices, then with high prices farmers plant more, so the next year the prices correct. We are seeing some of that cycle in grains. The one bright spot in agricultural commodities that we really like and we think could explode to the upside is cotton. You're getting two continuous years of drought and taxes. Crops are off and we think cotton prices could explode. But other than cotton, the other grains like corn and soybeans, we think their prices are stable or, in fact, could even correct lower from current levels, because the crops are coming along quite well.

Are Commodities Still Relevant for Fighting Inflation?
Canavan Ward: More of a general question then, since a lot of the commodities have been responding to their own kinds of microevents. Can commodities still be a valuable part of an investor's portfolio from an inflation-protection standpoint?

Worah: That's a great point, and actually there's one very important development in commodities coming from shale oil that really helps commodity investors. So the first thing is, with commodities as a hedge against inflation surprises, commodities as a diversifier, you may have oil prices going up, stock prices going down, and grain prices going up because of weather issues independent of what stock and bond prices are doing. So, as a hedge against inflation surprises and as a diversifier, commodities still warrant a place in an investment portfolio.

What’s changed and what's positive for investors is roll yield. For long-term investors, particularly--and I hope many of the investors in PIMCO's commodity funds are long-term investors--the biggest driver of returns is the roll yield. On a two-month horizon and even on a one-year horizon, it’s spot price returns that will dictate what commodity investors’ returns are. But on a five-year holding horizon, it's the roll yield that's going to dictate what your returns are. (Editor's note: roll yield is the profit realized from “rolling over” from expiring futures contracts to those with longer future delivery dates--when the market is in backwardation. Backwardation occurs when a commodity's futures curve is inverted and contracts for delivery further in the future are less expensive than nearer-term contracts.)

This is a fundamental change in commodity markets. Especially in energy, especially in oil, we think the oil markets are going to stay in fundamental backwardation for a long time, which means roll yields in oil are positive and roll yields on average in the commodity index are flat to slightly positive as opposed to the last five years, the 2006-12 era, where commodity roll yields were negative, so investors needed constant appreciation in prices to break even. (Click here to see the oil futures curve.) 

Now, roll yields are positive, and so even if prices go nowhere, you're actually getting paid to own the commodities. While you wait for that inflation spike or that war in the Middle East or the poor weather or the hurricane, you're actually getting paid to own commodities, and that's a big fundamental change in commodities. The big reason—it might get a little technical—is shale oil. Shale gas gets a lot of press, but the fact that we've had this big oil discovery in the United States is anchoring long-term crude oil prices at around $90 a barrel. Meanwhile, constant geopolitical risk, constant weather outages, constant pipeline damage has spot crude oil price trading closer to $100 a barrel. So spot crude oil trades at around $100, long-term deferred crude oil is around $90, the market is backwardated, and you get this positive roll yield. If you buy crude oil futures and you roll them, at the end of the year even if prices do nothing, you’ve made about 5% or 6%. So, that's the big fundamental change in commodity index investment, that roll yield is now in your favor as opposed to being against you. That's a big piece to me. As opposed to over the last five years, you're actually getting paid to hold your commodity index investment. Plus, especially with real yields and the TIPS collateral also being as positive as they are, you’re literally getting paid to own this.