As governments and central banks transition from crisis management to maintaining easy conditions and significant financial support for industries, investors can be forgiven for thinking that capitalism has been disrupted.
Robert Mead of fixed income giant PIMCO says right now, monetary and fiscal policies are providing support to most market participants and everyone is more or less “winning”. But that will only be temporary. As we move through the cycle and support levels wind down, the differentiation between winners and losers will become more apparent.
But the bond market may not necessarily see it that way - potentially throwing babies out with the bathwater, leaving spreads across the credit spectrum in a distressed state. And that's the opportunity that PIMCO has been preparing for over the last several years.
In this Q&A, Rob expands more on this opportunity, the part of the government bond market he likes and the impact of fiscal and monetary policies from the perspective of a fixed income manager.
What message is the bond market sending the economy right now?
What’s interesting and important is that we're in unprecedented territory in terms of non-economic players being involved in market pricing. Central banks all over the world have interpreted their mandates in different ways and had very large impacts on the level of bond yields. So, first of all, through direct targeting, the RBA for instance is anchoring the 3-year bond yield to 25 basis points. That's the same as the cash rate essentially and a very powerful force.
Then in every other jurisdiction, the central banks are doing similar things. So whether it be anchoring curves, whether it be flattening curves, whether it be just ensuring that the cost of funding to the broader economy is kept lower for even longer, that sets a really important backdrop. That's something that probably lives with us for at least another 2-3 years. As investors, we acknowledge those forces very clearly and don't try to fight them.
From your process as a manager, what's that experience been like having these non-core participants stepping into your investment universe?
When you look back to March and the level of dysfunction that the bond market was experiencing, it's fortunate that we do have some policy support. So again, we're all in unprecedented times navigating a pandemic. We've all become health experts, to the extent we can read as much research as we possibly can hoping to get an edge. But the reality is, it's a bunch of investors that are more focused on financial issues than health issues, and navigating that as best we can.
The impact of central banks, the impact of fiscal policy; without those, the depth of the recession we're currently experiencing would be quantums worse.
Even with the policy support – the very intense, fiscal and monetary stimulus - we still think it's going to be 2022, maybe 2023, until we get back to the same level of GDP that we were at in 2019. So, that's a pretty deep hole to climb out of even with tremendous support.
As investors, you always invest in the world that you know is happening around you, rather than the one that you would wish was happening. I think that's the most important takeaway and not thinking about a world where central banks weren't as active as they are.
Could you summarise PIMCO’s key views on the world and how that's feeding into the opportunities that you’re identifying?
For context, we made a very careful decision from almost back during the financial crisis times to construct an advisory board. When you look at PIMCO's advisory board, it's dominated by prime ministers, central bank governors etc. That was a reflection of our view from really a decade ago, that understanding policy response was going to be the most important driver of markets going forward. We're really thinking about what are these big policy drivers and how they will impact markets and economies. We've always been leveraging off that type of insight and that's become even more important over the past 6-12 months.
Then over the past, really 3-5 years, we've been spending a lot of effort in building resourcing within areas like distressed credit. That's because up until early this year, spreads were exceptionally tight. We thought that at some point there would be a re-pricing. We wanted to be ready for that in advance, and now we're starting to see those opportunities become much more significant. We now have the ability to deploy some of our more permanent capital into those opportunities. So, that'd probably be the area where the resource base at PIMCO has changed the most over the past three-plus years.
Is distressed credit the biggest opportunity you’re seeing in bond markets?
One of them – absolutely. We'd split the credit market into two in some ways.
- High-quality issuers – The very large end of town in the high-quality structured credit or in the investment-grade universe, we think the opportunity to invest in that sector is right now. Those companies have been very conservative. We know there have been record amounts of issuance in corporate bonds in the US, so they've done that very effectively. They've been given a support structure from various central banks that identify investment grade as a threshold for central bank support, which is very powerful. We've also seen some bottom-up decisions to cut dividends, to raise equity, to be very conservative in terms of balance sheet management. So all of those things mean that there's an opportunity right now within the very high-quality end of the credit spectrum.
- Distressed credit - Further down the credit curve, we think there are some opportunities materialising now and some of them will be coming up over the next 1-3 years. So, we're being a bit more patient in deploying that capital as opportunities arise.
You’ve also highlighted an opportunity in government debt maturing in 5-7 years. Why this end of the curve, and what about duration and inflation risk?
One of the concepts in bond investing that I'm sure many of the viewers and listeners have heard about but don't think about on a daily basis is rolling down a yield curve. That's one of the most powerful, absolute return generating opportunities that the financial markets offer investors. That just means buying a security at a high yield and then watching it roll down a curve and end up being priced at a lower yield. As we know, the inverse relationship between yield and price means the price of those bonds go up.
When you've got an anchoring that we do, say in Australia with the RBA at 25 basis points, if you can buy a slightly longer-dated instrument and roll down to that anchored point, then you generate real return and you generate absolute return.
So you're right, that if you go further out the yield curve, you do expose yourself to more duration risk. But given the fact that unemployment rates, again, they're being sticky in terms of staying quite low, but the reality behind the numbers is that unemployment rates will be double digits.
We know that retail sales and the traditional bricks and mortar retailers are struggling in terms of their own pricing power. We know we've had an energy shock in terms of oil prices coming down, and then gradually going back up. All those things are not conducive to generating inflation that's even close to the RBA or the other central bank's targets, it's likely to be weaker for an extended period.
As I mentioned, we don't think that the absolute growth level gets back to where it started for 2-3 years. All those things suggest that inflation may become a risk down the track, but it's one that we should get plenty of insight and guidance and early evidence of before we need to worry about it in an investment sense in the near term.
What's the role of bonds in a portfolio now? And do they retain their traditional defensive attributes given the yields that are on offer?
I think the very clear answer from our perspective is yes. The reason we say that is bonds are there to provide some form of diversification. So if you had 100% insight into the future, that you knew exactly what was going to happen, then you could put all your eggs in one basket. But nobody has that crystal ball, so you need to then think about alternative states of the world, like the one we're in.
Again, bonds were excellent diversifiers in Q1 when equities were well down. Bond prices were up. So anytime there's uncertainty, you need to have diversification. Diversification is, in my view, the only free lunch in investing, because otherwise, there are no free lunches. To be able to improve your risk-adjusted return is a very important concept.
Bonds also do provide other benefits. They provide a much more certain distribution of income than dividends. As we've seen very recently across a whole range of different companies in Australia, the dividend outlook is changing. Dividends are either being cut or they're being regulated to be lower. So some of those income streams that investors rely upon, that they've relied upon historically are now under threat. So, bonds can provide some of those substitutes in terms of income.
I would also say that within the universe of bonds, it's not just a matter of buying the lowest yielding, the lowest risk instrument as the solution. We do think there's plenty of scope for actively deciding where across that opportunity's there to invest. At the moment, as I mentioned, we'd say we're taking a little bit more risk, buying some of the higher quality credit instruments, providing in some cases multiples of what's available in the risk-free alternative, but with still a very high degree of both underlying cash flow generation, plus some very robust policy support.
Could you give us a bit more colour around those comments and some examples of the long-term versus temporary winners that you're referring to?
I think that's probably the most important thing for investors to, not just bond investors, but all investors, to think about going forward. When you're in a crisis, which we were in March, so markets in free fall, liquidity and dysfunction, the rapid response from authorities is to use a very blunt instrument to ensure that there's not a domino effect. That's what we've seen so far.
So we've seen fiscal policy, which meant in Australian terms packages like JobSeeker and JobKeeper, and they were very blunt in terms of their application. So to that extent, some people probably got a pay rise, because it had to be rapid, it had to be blunt, the authorities did the right thing. As we move forward and we have some time to retool the policies, they become much more targeted. That's what we're seeing now in a fiscal sense, and we think that's what we'll see in a financial market sense.
So companies that would otherwise have not survived over the coming quarters or years, even in a decent economic growth environment, those companies will be allowed to fail.
We do think that the larger companies that have more dominant roles in their industry will be the beneficiaries. We do also acknowledge that certain sectors have been clear beneficiaries already and will likely continue to be beneficiaries, while other sectors will suffer. So, it's both within sectors and across sectors.
So we think further down the credit curve, where historically, and again until recently, bondholder protection was very weak, the forms of security provided to bondholders were largely nonexistent.
Some of those historical vintage issuances are probably vulnerable, and the new production where bondholders now reassert their position of strength in terms of security, in terms of subordination, in terms of covenants, we think will actually represent a fantastic opportunity. But that one's coming over the next several quarters and years, and we're being a bit cautious on some of the older production further down the credit curve.
So just on that point, you're expecting there to be a shift in the balance of power between providers of credit and seekers of credit?
Yes and we've already seen that. So as you know, we were very cautious on credit as an investor into Q1. Not expecting a pandemic at all, but just acknowledging that spreads were exceptionally tight and bondholder supports were relatively weak.
What we've seen since then is obviously credit spreads are a lot wider, not as wide as they were in March, but still relatively attractive in our view. Then also the bondholder protections in terms of new transactions that are coming to market are much more robust. So, absolutely correct that we're seeing a shift in that balance of power which makes us excited as a manager.
Livewire Income Series 2020
Rob also contributed to the Livewire Income Series 2020, an educational series designed to help investors understand the outlook for traditional income-generating assets and discover new asset classes and the role they play in an investment portfolio. View Rob's submission on corporate bonds here.
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