PIMCO Total Return's High-Yield Play

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Does a recent prospectus change signal a junkier portfolio for PIMCO Total Return? Joining me on the phone to discuss that question is Eric Jacobson, he's a senior analyst covering fixed-income research at Morningstar.

Eric, thank you so much for being here.

Eric Jacobson: Glad to be with you, Christine. Good to talk to you.

Benz: So Eric, PIMCO Total Return recently got permission to invest up to 20% of its assets in below-investment-grade bonds. That's up from its previous prospectus limit of 10%. Why did PIMCO initiate this change?

Jacobson: Well, I think there are a few reasons. One, the main one that they are pointing to, is that they do sort of an annual review of how funds' rules are set up versus competitors and that they felt that this would put them more in line with other funds. And that they--combined with the idea that they want to be able to be opportunistic as things pop up that look like a good idea for the fund--they want to have the freedom to do it. The other thing that I think contributes to some of it is that nonagency mortgage securities that were beat up so badly during the financial crisis and which have become more interesting and popular over the last several years, they contributed a lot to the success of PIMCO Income run by Dan Ivascyn, effectively their CIO now. Those kinds of securities have made their way into the Total Return strategy as well. But because they carry what they might call legacy junk ratings from right after the crisis, even though the assets themselves are healthier and more appealing now, that brings them under that old 10% cap. So it was competing with space in their investment choice selection with high yield and making it harder to hold much of either of them in any magnitude.

Benz: Eric, you also made the observation that since the fund has gotten smaller that perhaps it's a little better positioned to capitalize on the high-yield space. Let's talk about that idea.

Jacobson: I don't think that's the way that PIMCO would put it, but it sure seems pretty likely to me. I mean, they have spoken a little bit about the possibility that credit can take a more important role in the portfolio going forward. I think in a more general way kind of tipping a hat to the fact that now that Bill Gross has left, Mark Kiesel is one of the three main managers on the portfolio. He's got a credit background, obviously, and that may seem more appealing. I'm sort of adding on to the fact that now that the fund is so much smaller than it was, it's still a very large fund, but the smaller it gets the more that credit selection will have a potentially bigger impact on returns and make it a more useful tool. So whether or not they are saying that explicitly, it's certainly some flexibility I think that they might be able to use better going forward.

Benz: One question is whether you expect that PIMCO will begin to capitalize on this opportunity to stash more in high yield straight away. Do you have any sense that they really have spotted a lot of opportunities in the high-yield space, or is this just something that they are trying to give themselves a little more leeway for the future?

Jacobson: My guess is it's probably somewhere in between, in the sense that I don't think they are probably planning on jumping on anything right now. Few funds would ever want to do that in this situation because they like very much to downplay the importance of it right at the get-go. And I think in most cases that's actually a pretty fair thing to say here. But we've had very volatile markets and high yield and credit in particular have been knocked around quite a bit, going from what people thought was very rich to very cheap for a while and then back to rich again. So I think that I would leave open the possibility that should an opportunity arise they might try to do something like that. But nothing is clearly on the horizon right now.

Benz: How about PIMCO's resources in the high-yield space. Do you think of it as being particularly well-equipped firm to navigate the high-yield space in the research individual high-yield credits?

Jacobson: They definitely have a lot of firepower. They have a very large staff of credit analysts. They've got a really broad level of expertise and it stretches to include folks like Mark Kiesel, even though he mostly runs investment-grade money on his own. And it's very, very difficult to handicap the high-yield research sometimes because of the way that money is allocated across different accounts, and for example the high-yield fund at PIMCO is actually run by a different gentleman than Mark Kiesel, who is on the Total Return fund. Ultimately the same research still generates the same ideas and so forth. But if you have problems in one fund it doesn't necessarily mean they are going to be reflected somewhere else. But in general I would say that they are very large staff, very effective staff and I think it's not a bad story here to think about them investing more in high yield.

Benz: Final question for you, Eric, is for people who are shareholders of PIMCO Total Return: Should this affect their view of the fund, should they expect it to be riskier going forward? What should they have in mind as they kind of set their expectations for future performance?

Jacobson: I think it would be folly to say nobody should ever worry about it. Because once you have that freedom and it certainly can get used, anything can change. I think that in the grand scheme of all the various risk factors that people may be thinking about, looking at, I don't expect that this is really going to dramatically change the profile of the fund. Like I said as it gets smaller, getss more freedom, certainly could wind up seeing higher allocations to credit. But they really haven't had that much of it over the years with this portfolio. It's much more about sector rotation and so forth. Again it's the kind of thing where you want to check in on it, watch it every now and then, sort of as you regularly check on your funds. But by and large I don't think it's going to be a major strategic shift for the portfolio.

Benz: OK. Eric, thank you so much for being here to share your insights.

Jacobson: Glad to be with you, Christine. Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.