Lessons From the Worst Bond Market Ever

On this episode of The Long View, Sonali Pier, managing director and portfolio manager at Pimco, joins us to discuss 2022′s bond market, Pimco’s 2024 outlook, current market dynamics, and more.

Here are a few excerpts from Pier’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz:

2022′s Worst Bond Market Ever

Dan Lefkovitz: 2022 was termed by some as the worst bond market ever. We had double-digit losses for core bond indexes, and some advisors and investors concluded that the best way to own bonds is to skip bond funds and purchase individual credits and hold them to maturity instead. What should people know if they go that route? What do you think they missed by not owning a fund?

Sonali Pier: I can see the temptation, but really diversification is so important for investors, especially as volatility increases or you hit pockets of stress. When we look at a multisector credit strategy, for example, we’re looking to diversify across risk factors and find alpha from asset allocation, regional selection, industry selection, security selection. There’s a lot of ways the market’s dynamic from which to not just generate alpha, but also have the most efficient expression. The strategy you’re describing, that passive ladder approach, can work well in a low-vol environment, but it gets very difficult when there’s stress in the market. Imagine you own 10 bonds in that scenario and one or two have an adverse outcome, that would be worse than the high-yield default rate that we see currently in the market, for example. And as we look ahead, we see stress potential in the credit markets from things like liability management exercise, creditor-on-creditor violence, that again, it really depends on the specific bond you hold and the holding period as well. So, I think of this as the market’s dynamic and that ladder approach is static.

So, when we look at what you miss from it, I would say you’re not really going to capture the trends of the market and the evolution. So, an example would be, if we look at the high-yield market today, 35% of high yield is secured. It’s only a few years ago in 2020, it had about 20% in secured bonds. So, another way to put it is over the last five years in this asset class, the benchmark has had close to 50% turnover. So, it is an evolution, and you don’t capture that evolution by buying the single bonds and holding them to maturity.

Lessons From 2022

Christine Benz: I wanted to ask about 2022 specifically—Dan just did—but it must have been a tough time to be a fixed-income fund manager. Can you talk about some of your key takeaways or lessons from that experience, and also whether there was anything that surprised you during that period?

Pier: 2022 was a tough year for all investors across both fixed income and equities. We had the fastest rate-hiking cycle we’ve seen in decades and correlations dramatically increased across asset classes with rates rising and credit spreads widening. And essentially one of the takeaways is you need to be nimble and pivot quickly to respond to a new environment. So having that liquidity and flexibility in a portfolio is very important.

But today the situation is quite different. Rates have reset higher; the opportunity set looks attractive for bonds. And we’re trying to take advantage of that opportunity but still cognizant of scenario analysis, not just modeling for the base case, but really how would our portfolio perform across “fatter tails”? At Pimco, we value the behavioral economic aspect throughout our investment process. And we try to limit our confirmation bias or appreciate the probability of those tails that I was mentioning when we’re looking at opportunities in the market.

Is the Inverted Yield Curve Predictive?

Lefkovitz: Getting back to current market dynamics, we have an inverted yield curve. It’s been inverted for some time now; I think since late 2022. It’s often cited as an indicator of recession. Do you see it as predictive? What do you make of it?

Pier: It’s interesting. Because often people will say, well, if it’s inverted yield curve, we could have a recession. But the reality is every time we’ve had an inverted yield curve has not necessarily meant a recession. However, recessions are typically preceded by a yield curve that’s inverted. Inversion at this point, we are still seeing relatively low unemployment, inflation overall coming down. So, I think there is a path for the Fed to see a soft landing, especially as I shared earlier, our outlook is for rate cuts in the second half of the year. The market had been pricing more cuts than our outlook. And we believe the Fed will stand firm on restrictive rates until inflation is a bit more consistently low. And at this point, the market seems to be pricing in a bit more in terms of cuts than our base case. But we see it as a second-half event. And when we look at the probability before June, it just seems the economic data has been quite strong.

And so, if we were to evaluate what happens if rates were to remain elevated, I guess that’s the other side of it, I would be concerned about some of these low margin, low multiple businesses that have low free cash flow and also some areas of the floating rate market, like some parts of the bank loan market and some parts of the commercial mortgage market where there is a bit of stress already. But again, it’s case by case, meaning you have to be selective within each of these asset classes.

The Corporate Credit Market, Vibesession, and Rolling Recession Concept

Benz: We wanted to delve into the health of the economy a little more deeply. As you mentioned, there have been some mixed indicators. The job market is strong overall, but there have been a lot of layoffs, especially in I think the technology sector. We’ve heard about the vibecession and there’s also the rolling recession concept. I’m wondering with your perspective, looking at the corporate credit market, what do you make of the rolling recession concept and what are the investment implications of it?

Pier: It’s interesting. So, the rolling recession concept is essentially that you don’t have an instantaneous or ubiquitous negative shock. So very different from what we experienced during the great financial crisis. Instead, it’s like pockets of weakness or stress that can impact one sector at a time or one geography at a time. In terms of what we’re seeing in some of our areas of concern within the corporate credit segment, again, this goes back to that high capex, low free cash flow theme, and the sector that that’s affecting, we’re seeing it already in telecom, media and cable. And then even outside of corporate credit in some segments of real estate, for example, within office commercial mortgage space. Office CMBS has repriced meaningfully, although it has started to see some green shoots in certain spots. The key is essentially to stay diversified and be selective with such exposure and have that active lens on it.