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Preserving Capital in a Central-Bank-Dominated World

Eric Jacobson

Eric Jacobson: Hi, this is Eric Jacobson. I'm here from Morningstar with Jerome Schneider--he is Morningstar's Fixed-Income Fund Manager of the Year. We're going to talk to him a little bit today about the short-term funds that he runs, including PIMCO Short-Term Bond Fund (PTSHX), which is the main product that he operates.

Jerome, thank you so much for coming and meeting with us today.

Jerome Schneider: Thanks very much, Eric. It's honor to be here, and we appreciate the honor that you've bestowed upon us this year.

Jacobson: Congratulations.

Schneider: Thank you.

Jacobson: So, tell us a little bit, just for starters, about what makes the way that PIMCO runs short-term money a little bit different from the more plain-vanilla options that we are familiar with out there.

Schneider: Absolutely. First of all, cash management is at the forefront of most people's mind, especially with all the volatility in the broader markets these days. The way we really think about it--starting with the macro and the macroeconomic themes--it's very important now, more than ever, to be really encapsulating in your investment thesis what's going on with differentiating global central-bank policies. Long story short: In the past, front-end people used to just simply focus on what the Fed was doing; but ever since the global financial crisis, we've really had to think about the global effects of things like quantitative easing--not just from the Fed but other central banks globally.

As we entered 2014 and on to 2015, it became increasingly apparent that global central-bank policies were going to become very divergent, and we had to think about that in two prospects. One, what does that mean in terms of protecting one's capital? And two, specifically for U.S. investors who are already facing a near-zero-rate environment, how do we help protect capital and produce some return?

So, for us at PIMCO, we're always focused on those macroeconomic conditions. For us on the front end--specifically the short-term franchise--we need to be specifically focused on it to understand what the Fed's going to do and take advantage of those opportunities as they percolate globally. For us, that's really the focal point, which differentiates us. We've had a short-term franchise for many, many years--decades, in fact. The short-term fund's been around for almost three decades. And that's one pillar of what we do in the front-end franchise. But more importantly, focusing on capital preservation isn't simply about earning zero or earning a small amount of nominal return. It's about having degrees of freedom, diversifying your risk, diversifying your sources of liquidity, and ultimately hopefully producing some positive returns both in a nominal sense and also in inflation-adjusted terms for your clients.

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Jacobson: So, you mentioned a few interesting themes that are kind of important. Let me cycle back for a second. You mentioned the front end--obviously, the short-term, short-maturity part of the market effectively. You also mentioned the Fed. And we're at a point right now where there's a lot of discussion about whether or not the Fed was a little hasty in raising rates in December, even though that was something that seemed inevitable for the course year. And ever since then, we're at this point where now we're even talking about whether or not they made a mistake. Are they even going to want to raise again later? Give us a little thumbnail, if you would, about what PIMCO's thinking is in terms of how that might play out.

Schneider: So, we have to take ourselves, once again, back to what we've seen over the past few years. Central-bank policies have been very stimulative. What we knew beginning in late 2014 is that that process of exiting, specifically in the U.S., was going to be emerging--it was going to be on people's minds. And what we saw in December of 2015 was really that culmination. The Fed hiked; they started that process. But what the Fed also did was give us very specific prescriptions, saying that we're going to be data-dependent, that we're really going to focus on what the economy in the U.S. is doing, and it's going to be a very deliberate and prolonged sequencing of hikes that potentially goes on.

So, for us as investors, we also know that that reaction function hasn't really been tested. So, as a portfolio manager, what I want to do is give my clients the smoothest ride possible--preserve capital and income but not necessarily induce a lot of volatility in the portfolio. And when I need to do that and think about portfolio construction, I'm basically articulating and emphasizing those areas that are good value with low sources volatility and de-emphasize those sources of risk that are going to produce higher volatility.

So, for myself, what we saw in 2015 was looking at interest-rate exposure--"duration," as we call it--as being an underaccentuated part of that portfolio composition. And I really think that's the main takeaway as we move from 2015 into 2016. While the Fed may be on a course to hike gradually over the next year or two years, for the investor, it's really going to be focused on the discussion of volatility, and that volatility really emanates from central-bank policies and, specifically, the Fed in the short-term businesses.

So, for an investor in the short-term, we really don't want to be focusing on the very digital outcomes of where the Fed goes or doesn't go. We want to be focusing on other sources of value and creating that diversified-portfolio approach to capital preservation.

Jacobson: That's a really good segue, because you talked about the different kinds of risks. I think that for the average person who is not all that familiar with the space that you are in or the fund, if they look at the portfolio, they are going to see things in there at the headline level and they are going to wonder, "How does this fit into a short-term portfolio?" Obviously, I'm talking about some allocations to things like emerging markets and so forth. Help us understand why that belongs in the portfolio and why people shouldn't be that worried about seeing that in there?

Schneider: First of all, what we do at PIMCO is we have very much a team-based approach, and part of that is, of course, learning and understanding the plumbing in the front-end--understanding repo markets, understanding how T-bills trade, those integral parts of the money markets. But that's not the only story. There are other ways to manage liquidity and capital other than simply owning T-bills, and the story that we're showing this past year and what you all have articulated in the award is that there are ways to manage short-term risk, short-term liquidity without simply being invested at near-zero yields in money market funds.

For investors, we have to create a diversified approach and, sure, you don't want to be overly concentrated in emerging markets or high yield or even credit for that matter. But having small allocations to that does two things: It obviously produces income above what a T-bill can do, but it also produces diversification in terms of risk and, more importantly, generally very short-dated, self-liquidating type of assets that continually cash flow and produce cash for the portfolio. And that's one of the many things that folks are missing. So, as we think about liquidity-management tools at PIMCO--not just for the short-term fund, but throughout our portfolio--whether it's an ETF or a mutual fund or even a separately managed account, our clients are benefiting from that expertise in managing liquidity, our being able to capture liquidity premiums at significant discounts within the portfolio over the past year.

And so having emerging markets, having credit, having structured products--in addition to having high-quality Treasuries and agencies and non-U.S. agency types of products--creates a very nice blended approach to risk and income and, at the same time, allows for multiple outlets for liquidity-management purposes. And all those things together really help to differentiate us from a traditional pure money market type of strategy.

Jacobson: You mentioned some of the different vehicles that your group runs, and I know that there are some shadings between the PIMCO Short-Term Fund, the relatively new ETF, and some other options. And I know that they also have slightly different mandates and different levels of risk. Help us understand what that spectrum is like and who you are targeting there.

Schneider: What we really need to do is, again, dial it back up to what the macro level is. What we like to do is understand the world and then prescribe various ways of risk that we think are best articulated for the world that we see. And so we're going to do that through our investment committee process, through our short-term team, and globally through our credit analysts worldwide to find those stores of value. Now, what's really interesting about the short-term space is that everyone's prescription in terms of how they think about managing liquidity and capital preservation is entirely different. You, myself, everybody in the retail sector, individuals, and corporations have a different paradigm of how they think about liquidity. And from that perspective, it's very challenging to create one tool, one panacea, to satisfy that request. And so what we've done basically is create different avenues of risk.

One that looks globally for different opportunities, such as the PIMCO Short-term Fund; ETFs are another way--some retail and institutional investors look to our short-term franchise. We have the largest actively managed ETF--[PIMCO Enhanced Short Maturity Active ETF (MINT)]--in the fixed-income space. And then we have, obviously, separately managed accounts. And all these things distill the risks to what individual investors--retail or institutional--see fit in their portfolio and how they want to manage their liquidity. Because again, there is no one cure-all in terms of how somebody should think about their liquidity. It's a very personal choice--probably one of the more personal investment choices out there.

Jacobson: Well, I want to wish you congratulations again. Thank you very much for coming in, and we hope that you have a good year with it.

Schneider: Thank you very much, Eric. It's an honor, and thank you on behalf of the team.

Jacobson: For Morningstar, this is Eric Jacobson. Thanks for joining us.