Is PIMCO Income the New Total Return?

Eric Jacobson co-wrote this article. Eric owns shares of PIMCO Total Return.

By the time Bill Gross left PIMCO in September 2014, the formerly $2 trillion bond firm had already been in net outflows for a couple of years. That was especially the case for its flagship

Outflows from the strategy then accelerated dramatically in the quarters immediately following Gross’ 2014 departure. Meanwhile, many of the firm’s other strategies experienced net outflows through 2015 as well. Group CIO Dan Ivascyn’s

PIMCO’s business is on much firmer ground today. In the second half of 2016, net flows turned positive for the firm for the first time since the second quarter of 2013. The flagship PIMCO Total Return strategy has continued to shrink—to $155 billion as of September 2017 from $377 billion at the time of Gross’ departure—but its outflows have slowed to a trickle.

Meanwhile, the PIMCO Income strategy has rapidly ballooned to become the firm’s largest at nearly $177 billion across vehicles, more than tripling its size from three years ago. The level of assets in that strategy, across vehicles, surpassed PIMCO Total Return’s during the third quarter of 2017, marking a symbolic, if belated, torch-passing from the firm’s old CIO to its new.

The New Flagship? PIMCO Income's hallmark has been the delivery of a consistent level of income over several years, but the fund's real calling card has been a string of stellar performances that has helped it to long-term trailing returns that place at or near the top of the U.S. multisector bond Morningstar Category; versions of the fund offered in other markets have performed similarly well in their respective peer groups.

Its dominance has other roots as well, but the fund’s winning bet on nonagency residential mortgages in the wake of the financial crisis, in particular, has been a crucial contributor. The firm managed its way through the mortgage crisis well thanks to prescient research, and its large mortgage credit team helped this fund navigate the market’s rebound. PIMCO, and this fund in particular, gathered exposure to assets that had been so badly beaten down that they remain compelling investments even today.

But despite the headline troubles of Gross’ departure and a few bouts of weakness since, PIMCO Total Return has also been a remarkably strong performer relative to its peers over the ensuing three years. The U.S. fund’s 3.2% annualized return for the three years through September 2017 topped more than 80% of its U.S. intermediate-term bond category peers. Smaller shares of the portfolio, nonagency residential mortgages and the team’s calls on corporate bonds, have both been helpful contributors to the fund’s overall success under its post-Gross management trio.

Overall, though, PIMCO Income has outshined its PIMCO Total Return cousin in popularity and performance, nearly doubling PIMCO Total Return’s returns over the past three years. We know anecdotally that some of the investors who redeemed from PIMCO Total Return turned around and invested in PIMCO Income instead. But while there have been differences in the success of the two funds’ various bets, the big-picture roots of that performance mismatch deserve to be a crucial factor in investors’ decisions to purchase one fund or the other.

Apples and Oranges For starters, the funds are in two very different categories. PIMCO Total Return is a stalwart of the U.S. intermediate-term bond category, home to funds that generally take their cues from the Bloomberg Barclays U.S. Aggregate Bond Index, a broad representation of the high-quality U.S. bond market. Numerous members of the group, including PIMCO Total Return, employ so-called core-plus strategies that give them some flexibility to hold out-of-index sectors such as high yield and emerging markets. Their inclusion in the category, though, is dependent on enforcing limitations on those forays. Generally speaking, for example, funds that typically hold more than one third of their portfolios in below-investment-grade exposure will no longer qualify for the group.

Bond funds with a diverse sector mix and more than one third in below-investment-grade fare are typically classified in the multisector bond category, which is where PIMCO Income resides. That classification befits PIMCO Income’s benchmark-agnostic, income-focused mandate, which gives it the freedom to take more risk than PIMCO Total Return across a range of dimensions, including credit, sector, interest-rate, and currency exposures. And in some of those areas, PIMCO Income does in fact carry significantly more exposure to risk than PIMCO Total Return. They include higher exposures to high yield and both non-U.S. developed and emerging-markets debt.

The largest portfolio difference, meanwhile, has been in the nonagency mortgage sector. PIMCO Total Return has taken advantage of that sector’s unusual profile—maddeningly cheap after the financial crisis while generating fat income streams and recovery-led appreciation—to good effect. PIMCO had already invested significant resources in mortgage research, and while a handful of competitors had similar skillsets, the landscape of investors willing and able to spend the time to carefully analyze the sector’s risks shrank dramatically in the early years after the crisis. Given its mandate as a core fund, though, it wouldn’t have been prudent for PIMCO Total Return to take on notably large positions in that sector. By contrast, PIMCO Income carried roughly 15 percentage points of additional nonagency mortgage exposure as of mid-2017 compared with PIMCO Total Return, and held even more at various points since the crisis.

The Right Place at the Right Time That's an especially important distinction when comparing historical performance between the two funds. The sector became so cheap after the crisis that even mortgage pool tranches with the most collateral support underneath them—and thus very little likelihood of major permanent losses—were priced at double-digit discounts to par. The bonds' prices had declined in part because of the sector's perceived risks, but also because its investor base had shrunk so dramatically—not least because it had become labeled as a "toxic" asset class.

Those low prices made the nonagency mortgage sector a very yield-rich locale, though, while removing a tremendous amount of downside risk from the equation. PIMCO and its competitors in the space recognized that even given potentially severe losses as many underlying loans defaulted and homes were sold, their recovery values would likely be significantly greater than the mortgage bonds’ market prices implied. In practical terms, that meant the sector had very few places to go other than up. Supportive economic factors—a recovering economy and housing market, tremendous stabilizing influence from government programs, and banking reform—served as an added tailwind.

As time has passed, the sector has slowly recovered, and demand has increased, nonagency mortgage prices have made a steady climb closer to more reasonable estimates of underlying value. Meanwhile, as mortgages have either been refinanced, defaulted, or amortized out of existence—while no new similarly priced pools have been brought to market—the sector has been shrinking dramatically. The end result has been a nearly unheard of trifecta of still-generous yields, rising prices, and almost unthinkably low volatility.

So while PIMCO Income has taken advantage of numerous other well-conceived market plays, and more successfully dodged problems that other funds—including PIMCO Total Return—felt in periods such as the 2013 taper tantrum and the 2011 Europe crisis, its nonagency mortgage stake has been a terrific anchor of steady performance. The likelihood of finding a similarly compelling opportunity in the future, though, is extremely low. It’s not an exaggeration to say that the circumstance may easily have been a once-in-a-career opportunity. So while we expect PIMCO Income to remain a very attractive option, the level of its past success is likely to be almost impossible to replicate.

That caveat could become even more meaningful if the fund continues to grow anywhere near its recent pace. If Gross showed anything with the PIMCO Total Return strategy, it was that despite the challenges, it is possible to successfully manage a very large bond portfolio into the hundreds of billions of dollars. But even he had to change his ways as that strategy grew. Despite his reputation as a macro-focused seer, Gross started as a bond-picker and had to grow into that macro mold as bond-by-bond management became less relevant in such a large mandate. Ivascyn and PIMCO Income have the advantage of that example as a guide, and if any firm has the necessities to manage the kind of growth the latter is experiencing, it’s PIMCO. At this stage, the fund’s size hasn’t yet become a worry, but it’s growth remains torrid. The risk isn’t so much that PIMCO Income will become unmanageable, but that it could eventually become more difficult to exploit opportunities among mispriced sectors in the scale necessary to move its performance needle.

Meanwhile, there’s no reason to expect that PIMCO Total Return will fade into obscurity anytime soon. In general, predictions that rising yields would inflict widespread damage on investors’ portfolios have failed to materialize, while core bond strategies have remained effective diversifiers in equity-heavy allocations. We’re also confident that the fund’s new Scott Mather-led management team, plus the legion of analysts and managers backing it, have what it takes to extend the strategy’s successful track record under Gross. As of September 2017, for instance, the fund was on the path to having its strongest year versus its benchmark and peer group since 2012.