Sumit Desai: Hi, I'm Sumit Desai, fixed-income analyst at Morningstar's manager research group. Joining me today is Mark Kiesel. Mark is chief investment officer of global credit and head of global credit portfolio management for PIMCO. He's the lead portfolio manager for PIMCO Investment-Grade Corporate Bond Fund (PBDAX) and the Long-Term Credit Fund (PLCPX) and a co-portfolio manager in the PIMCO Total Return Fund (PTRRX). Mark, thanks for joining me today.
Mark Kiesel: Thank you.
Desai: So, Mark, it's obviously been quite a roller coaster for PIMCO, its employees, and its investors following the announcement of Bill Gross leaving the firm. Can you talk a little bit, briefly, about how morale is within the company and how the overall firm has been managing this transition phase?
Kiesel: Sure. So, morale is very good. As you know, PIMCO has 2,400 employees in 13 offices in 12 countries all over the world. And basically, we have a team of 240 portfolio managers and 61 analysts. We have a new management structure in place led by Dan Ivascyn. We have six CIOs who are leading these groups, and the company is actually doing quite well in terms of handling liquidity and generating performance. So overall, even though we're sad to see Bill leave, the depth and breadth of PIMCO is significant, and we are quite confident in our future.
Desai: How have outflows changed the way the portfolios are managed?
Kiesel: There have really been no changes in how we've been managing the fund. We were actually very fortunate in that in September when we had to handle some of these outflows, we had significant cash. That portfolio, Total Return fund, as you know, is a third Treasuries, a third mortgages, and a third corporates. We also were sitting on a significant amount of cash, because in the prior spring and summer, we ended up raising a lot of cash when spreads had tightened. So, these outflows did happen, a lot of it happened in the first five or six days, but then they've subsequently tapered off. We've been able to rebalance the fund, and the overall portfolio structure has actually been able to be maintained with performance being decent. So, we're quite happy with how we've been able to handle some of the outflows.
Desai: With the management changes in the Total Return fund. How has the portfolio changed?
Kiesel: So, our views have not changed. The investment committee continues to set the targets and ranges for all of the major risk factors at PIMCO. One of our highest-conviction ideas remains currency; we have a large dollar overweight versus, particularly, yen and euro right now. We think that the Japanese economy is struggling and Europe is struggling, although the U.S. is starting to decouple a little bit with stronger growth. We are now starting to see [quantitative easing] in a taper in the United States, whereas in Europe we think we are going to see an expansion of the balance sheet.
In Japan, the Bank of Japan is going from 59% of GDP to 73% a year from now. So, currency remains a big theme in the fund, as does duration in Mexico, some in Brazil, non-agency mortgages, and then also the credit selection favoring those companies with high barriers to entry, pricing power, and superior growth. So, all that remains in place.
Desai: How will your background as a credit-oriented manager change the way that the Total Return fund approaches credit risk?
Kiesel: So, it doesn't mean that we'll be taking more credit risk. In fact, nothing about our process, again, will change. We still have the investment committee set targets and ranges for all the major risk factors. What it does mean is that now you've got as one of the three managers someone who's been predominantly in credit their entire life--18-plus years at PIMCO. What it means is that perhaps we can optimize that credit bucket.
We spoke earlier about the attractiveness of bank loans. Owning more bank loans in our credit bucket, we think, makes sense now. We're getting 4.5% or 5%; we're investing at the senior part of the capital structure of firms. Those are floating-rate instruments--which means that if rates eventually rise, the coupons will get reset higher. You've got four to five times asset coverage in these companies. The fundamentals are improving. So, as we were talking about earlier, owning more bank loans in the credit part of the bucket, there, makes some sense.
Desai: Many investors have cited the complexity of PIMCO's portfolios. Can you talk about how PIMCO uses derivatives and what the risks and benefits are?
Kiesel: So, PIMCO uses derivatives in an unlevered way. And we use derivatives when they are cheap substitutes for underlying cash bonds. So, for example, PIMCO has been using derivatives for almost 30 years when the original futures contracts came out on Treasury bonds. Futures traded cheap, and so PIMCO bought futures because they were cheap substitutes for the cash bonds. The other great thing about some derivatives is they tend to be significantly more liquid than the underlying cash market.
We were talking earlier about CDX and how the bid-offer spread is so narrow, quarter basis points, that you can transact billions a day with very little bid-offer spread. So, in many ways, these derivatives, if used prudently in an unlevered way, can actually get clients the beta exposure to the market in a much more cost-effective way. That's how PIMCO is using derivatives.
Desai: What about the risks of derivatives versus cash bonds?
Kiesel: So, with derivatives, basically you need to be able to monitor that you are actually aggregating up the risks of that contract, whether it's an interest-rate contract or a credit-spread contract, that the manager is properly accounting for the actual risks. In PIMCO's case, all those risk measures--the interest-rate risk of the derivative contract, the credit risk--all get aggregated up into the portfolio level. So, again, we are not using derivatives to lever the fund. We're actually using them as a cheap substitute. That's what's important to monitor when you are using those.
Desai: Where are you finding opportunities today and what are you avoiding?
Kiesel: We find significant opportunities today all over the world. It's primarily in companies that have a couple of features. Number one, high barriers to entry. Number two, superior pricing power. And number three, strong cyclical and secular growth.
Airlines fit that criteria because of the great pricing power. Lodging, where RevPAR [revenue per available room] growth is 8% to 12%. Gaming, where you've got significant growth in Asia. As well as in building-materials companies, where people are starting to remodel their houses. And also in midstream energy. Even though oil prices are coming down, Marcellus has boomed in terms of gas supply. All that gas has to go somewhere; firms have to gather process fractionate. MarkWest Energy (MWE) benefits from that.
What we are avoiding are exactly the opposite of what we are owning. We're avoiding companies with poor pricing power, poor growth, and low barriers to entry. So, this would be retailers; this would be certain technology companies. The commodity sector we've tried to avoid entirely--coal, iron ore, steel. That sector is under significant disinflationary pressure as you've seen supply increases and also China rebalance its economy. So, fortunately, PIMCO has done a good job this year of picking the winners and also trying to avoid some of those losers.
Desai: Mark, thank you for sharing your insights with us today.
Kiesel: Thank you very much for having us. We appreciate it.