Bonds are Back: Making the Most of Today’s Market

Text on screen: PIMCO

Footer Overlay: PIMCO provides services only to qualified institutions, financial intermediaries and institutional investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.

Text on screen: PIMCO EDUCATION –Title – Bond are Back: Making the Most of Today’s Market with John Nersesian and Tony Cresenczi (8 minutes)

Text on screen: TITLE – Learning objectives:, BULLETS – Yield peaks and future performance: the repricing of yields has created attractive opportunities, Active investing in fixed income: considering the benefits, Key consideration for investors: volatility, liquidity, and market timing, Key consideration for investors: behavioral science and its impact on investment decisions  

Text on screen: John Nersesian, Head of Advisor Education

John Nersesian: Hi, everybody. I'm John Nersesian and I'm so pleased to be joined by my friend and my colleague, Tony Crescenzi. Tony is a member of the PIMCO investment committee. And Tony is the author of The Strategic Bond Investor.

So we all know of course that 2022 was a tough year

FULL PAGE GRAPHIC – TITLE -- 2022 Fed Hiking Cycle; Subheader: “2 year Treasury Yield and Federal Funds rate have rapidly surpassed their highs from the prior hiking cycle.” This chart shows the rise of the 2-year Treasury Yield, Federal Funds Rate, and the Crane Money Fund Average 30-day yield, over the period spanning from December 2021 to December 2022. It displays the 2-year treasury yield and the federal funds rate rising from approximately 0.9% and 0.3%, respectively, in December 2021, to both sharing a similar rate of around 4.5% in December 2022, with the Federal Funds Rate slightly higher than the 2-year treasury. The chart also shows the Crane Money Fund Average rising from 0% to 3.5% over the same period.

Notably, the federal funds rate, after remaining below the 2-year treasury yield from December 2021 to September 2022, recently surpassed the 2-year treasury for the first time in the period shown, around November/December 2022.

for the bond market. Lots of volatility. Saw a significant spike in rates.

You've made the case recently though that this is an appropriate opportunity to think about allocation to fixed income. You want to expand on that a little bit?

Text on screen: Tony Crescenzi, Portfolio Manager, Market Strategist

Tony Crescenzi: Well it's fairly simple in a sense. Despite the anxiety from last year, the repricing of yields has created attractive opportunities for investors. Because yields today look very attractive on three fronts.

Text on screen: TITLE – Today’s yields look attractive on three fronts:, BULLETS – Versus inflation, Relative to volatility, Diversifying in times of stress

Number one versus future inflation. Markets are priced for the inflation rate to drop somewhere into the low twos. This is based on inflation protected securities and other gauges.

So low twos, but yields today, according to the Bloomberg Aggregate, which is sort of like the S&P 500 of bonds, that's in the low fours. And we think yields returns could be achieved around 5 percent plus when you mix that Bloomberg Aggregate with investment grade securities that we like. So yields above 5 percent relative to that 2 percent expected inflation is very attractive.

Secondly, yields look very attractive relative to volatility. Of course I'm not talking about 2022-like volatility, but historical volatility.

Bonds tends to move perhaps around 5 percent per year. So thinking about a 5 percent-ish yield versus a 5 percent long term volatility is a very good so-called sharp ratio. It's pretty good. And certainly very good relative to more volatile assets such as equities, which tend to have volatility in the mid-teens and certainly a lot higher. And so on those fronts it looks very good.

And finally, when we think about yields, and we have to put them in the context of the diversifying characteristics of bonds, they tend to be a diversifier in times of stress. And that time of stress, who knows, could be around the corner if there's ever a recession. So we have to be thinking about that aspect, not just the yield in itself.

John Nersesian: I love those references.

FULL PAGE GRAPHIC: TITLE – Today’s yields are at a much stronger starting point. The bar chart shows yield to worst (YTW) for various fixed income asset classes. YTM is the estimated lowest potential yield that can be received on a bond without the issuer defaulting. The solid-colored bars show YTW as of December 31, 2022 at much higher starting points compared to December 31, 2021 across fixed income asset classes, namely core bonds, investment grade credit, high yield credit, emerging market bonds, municipal bonds, and high yield municipal bonds. The yields for most fixed income asset classes more than doubled in 2022 from 2021 levels.

So starting yields are a lot higher today, right? And of course starting yields are a very key determinant in the total return that we might receive when we allocate money to fixed income. Let's talk a little bit more specifically about this active and passive decision that investors face. I know that in the equity markets, passive investing has really taken on a life of its own. What about in the fixed income market? What are the opportunities for active managers specifically to add value in the fixed income markets?

Tony Crescenzi: John, one of the first things that's coming to mind is something I read in a famous book from Frank Fabozzi, The Handbook of Fixed Income. There's a chapter in there written by our own Chris Dialynas, a member of the investment committee, on the importance of index consciousness. What does that mean?

Well you have to be thinking about the index that the investments you have is judged against and what's in it. So for example,

Text on screen: TITLE – Convexity:, BULLETS – Definition: Convexity is the price measure of how much a bond's price/yield curve deviates from a straight line (measure of the degree of curve of the price/yield relationship). Implication: This number, used with modified duration, shows how the duration of a bond changes as the interest rate changes.

convexity. In the Bloomberg Aggregate, it includes lots of mortgage securities. And that matters because there's more convexity in that than there is in a corporate bond index. Meaning if yields decline, we know that homeowners would decide to perhaps sell their homes and buy other ones. Or perhaps refinance their mortgages.

The point is that the mortgages that are in the pool of the securities that investors hold will go away. And suddenly the duration, in other words declines, and that's not what you want when yields are falling. So you got to be thinking about the convexity. You have to have some degree of index consciousness.

One other point to make on index consciousness in this day and age, Uncle Sam has been issuing lots of bonds, and making up an increasing part of this market weighted — these market weighted indices. And that — does an investor want to be investing more and more into US Treasuries which have lower yields and can be offered on other high quality bonds where the chances of default we think are rather low in certain ones that we buy of course.

No. And so an investor should be thinking about what's in these indices when they're making decisions. And lots of decisions to be made today with these yields.

John Nersesian:I love that point. I know that when I buy the index on the equity market, the S&P 500, I kind of know what I'm investing in and what kinds of attributes I'm going to receive. When it comes to the fixed income market however, the ag, I'm curious how many investors actually understand what is in the ag and what they ultimately own from a decision to allocate to that. Investors —

Tony Crescenzi: And John, it's constantly changing too.

John Nersesian: Absolutely. Constantly evolving. Look at all the new issuance in the fixed income market, which you don't necessarily have in the equity market. Which makes that index replication, the replication of the return in the index, that high tracking error that we see in the fixed income market very different than what an investor might receive when they index to the equity market.

Tony Crescenzi: Absolutely right. And so it's not only a matter of looking at the yield on these things, but thinking about what's in the mutual funds perhaps that investor's in. And more importantly speaking, John, investor's today with the repricing of yields face an important decision point. And some of the decisions they have to make are personal and really up to the individual investor and advisors.

Text on screen: TITLE – Key considerations for investors in the fixed income market:, BULLETS – How much volatility to expect?, How much liquidity is needed, Market timing

There are three major parts of this decision point. Number one, how much volatility does the investor expect. PIMCO would suggest that volatility this year, 2023, will be a lot lower than last year. Secondly, an investor has to just these yields against the amount of dry powder that they want. PIMCO itself is looking to have more dry powder. That could be in the form of cash of simply flexibility within a portfolio to maneuver from one asset to another. So in other words, be thinking about liquidity.

Finally in this decision point for investors after the repricing of yields, investor has to think how long do I want to continue to market time this diversification benefit that bonds tend to have.

Because many investors are deciding well interest rates might rise more, so perhaps I'll take a break from bonds and simply buy them later. It's an idea we would suggest avoiding generally when seeking to diversify, especially if there's a recession around the corner. Because bonds tend to have higher — high excess returns as they're called. They tend to fare well relative to equities and risky assets in those times of stress.

John Nersesian: Yeah. I love that. And I love your reference to the individual investor and the challenges that they're facing. Tony, I have a suspicion that the decision making process of the individual investor today is governed by the experiences that they had last year. It's recency bias.

Text on screen: TITLE – Recency bias:, BULLETS – Definition: When an investor looks at recent market returns when making important financial decisions. Implications: Clients may choose an investment based on recent returns or some news that was recently heard rather than perform a thorough analysis. May cause clients to chase performance – buying high and selling low

Wait a minute, I had a negative experience last year, is that likely to replicate itself again this year.

Text on screen: TITLE – Loss aversion:, BULLETS – Investors typically feel the pain of loss more profoundly than the joy of an equivalent gain. Implications: May prevent clients from unloading unprofitable investments. Causes investors to take on additional risk to avoid pain from losses

Loss aversion. I hate losing money. I saw a loss in my fixed income portfolio last year. Maybe that's something I'll avoid this year.

These are the kinds of issues that many investors are facing, in addition to anchoring. I'm accustomed to a particular return or a particular data point. I kind of hold on to that and I make future decisions based on that.

These are the kinds of challenges that the individual investor faces, which is why they're so often seeking the benefit of an active manager who can help them navigate the complexity of the fixed income market, and the personal attention and guidance that they receive from a financial advisor.

Tony, I want to thank you for the time today. And I want to encourage all of our viewers who have enjoyed this conversation to continue it, to continue to access the expertise that PIMCO can bring to the fixed income market by contacting your local PIMCO account manager. Thanks so much for your time today.

Text on screen: Visit pimco.com to discover how PIMCO fixed income can lead to better outcomes

Text on screen: PIMCO

Disclosure

Past performance is not a guarantee or a reliable indicator of future results.

Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds is exempt from U.S. federal income tax and may be subject to state and local taxes and at times the alternative minimum tax. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision. Outlook and strategies are subject to change without notice.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. It is not possible to invest directly in an unmanaged index. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

PIMCO as a general matter provides services to qualified institutions, financial intermediaries and institutional investors. Individual investors should contact their own financial professional to determine the most appropriate investment options for their financial situation. This is not an offer to any person in any jurisdiction where unlawful or unauthorized. | Pacific Investment Management Company LLC, 650 Newport Center Drive, Newport Beach, CA 92660 is regulated by the United States Securities and Exchange Commission. | PIMCO Europe Ltd (Company No. 2604517, 11 Baker Street, London W1U 3AH, United Kingdom) is authorised and regulated by the Financial Conduct Authority (FCA) (12 Endeavour Square, London E20 1JN) in the UK. The services provided by PIMCO Europe Ltd are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Europe GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany), PIMCO Europe GmbH Italian Branch (Company No. 10005170963, Corso Vittorio Emanuele II, 37/Piano 5, 20122 Milano, Italy), PIMCO Europe GmbH Irish Branch (Company No. 909462, 57B Harcourt Street Dublin D02 F721, Ireland), PIMCO Europe GmbH UK Branch (Company No. FC037712, 11 Baker Street, London W1U 3AH, UK), PIMCO Europe GmbH Spanish Branch (N.I.F. W2765338E, Paseo de la Castellana 43, Oficina 05-111, 28046 Madrid, Spain) and PIMCO Europe GmbH French Branch (Company No. 918745621 R.C.S. Paris, 50–52 Boulevard Haussmann, 75009 Paris, France) are authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 15 of the German Securities Institutions Act (WpIG). The Italian Branch, Irish Branch, UK Branch, Spanish Branch and French Branch are additionally supervised by: (1) Italian Branch: the Commissione Nazionale per le Società e la Borsa (CONSOB) (Giovanni Battista Martini, 3 - 00198 Rome) in accordance with Article 27 of the Italian Consolidated Financial Act; (2) Irish Branch: the Central Bank of Ireland (New Wapping Street, North Wall Quay, Dublin 1 D01 F7X3) in accordance with Regulation 43 of the European Union (Markets in Financial Instruments) Regulations 2017, as amended; (3) UK Branch: the Financial Conduct Authority (FCA) (12 Endeavour Square, London E20 1JN); (4) Spanish Branch: the Comisión Nacional del Mercado de Valores (CNMV) (Edison, 4, 28006 Madrid) in accordance with obligations stipulated in articles 168 and  203  to 224, as well as obligations contained in Tile V, Section I of the Law on the Securities Market (LSM) and in articles 111, 114 and 117 of Royal Decree 217/2008, respectively and (5) French Branch: ACPR/Banque de France (4 Place de Budapest, CS 92459, 75436 Paris Cedex 09) in accordance with Art. 35 of Directive 2014/65/EU on markets in financial instruments and under the surveillance of ACPR and AMF. The services provided by PIMCO Europe GmbH are available only to professional clients as defined in Section 67 para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2, Brandschenkestrasse 41 Zurich 8002, Switzerland). The services provided by PIMCO (Schweiz) GmbH are not available to retail investors, who should not rely on this communication but contact their financial adviser. | PIMCO Asia Pte Ltd (Registration No. 199804652K) is regulated by the Monetary Authority of Singapore as a holder of a capital markets services licence and an exempt financial adviser. The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Asia Limited is licensed by the Securities and Futures Commission for Types 1, 4 and 9 regulated activities under the Securities and Futures Ordinance. PIMCO Asia Limited is registered as a cross-border discretionary investment manager with the Financial Supervisory Commission of Korea (Registration No. 08-02-307). The asset management services and investment products are not available to persons where provision of such services and products is unauthorised. | PIMCO Investment Management (Shanghai) Limited Unit 3638-39, Phase II Shanghai IFC, 8 Century Avenue, Pilot Free Trade Zone, Shanghai, 200120, China (Unified social credit code: 91310115MA1K41MU72) is registered with Asset Management Association of China as Private Fund Manager (Registration No. P1071502, Type: Other) | PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246862. This publication has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision, investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. | PIMCO Japan Ltd, Financial Instruments Business Registration Number is Director of Kanto Local Finance Bureau (Financial Instruments Firm) No. 382. PIMCO Japan Ltd is a member of Japan Investment Advisers Association, The Investment Trusts Association, Japan and Type II Financial Instruments Firms Association. All investments contain risk. There is no guarantee that the principal amount of the investment will be preserved, or that a certain return will be realized; the investment could suffer a loss. All profits and losses incur to the investor. The amounts, maximum amounts and calculation methodologies of each type of fee and expense and their total amounts will vary depending on the investment strategy, the status of investment performance, period of management and outstanding balance of assets and thus such fees and expenses cannot be set forth herein. | PIMCO Taiwan Limited is an independently operated and managed company. The reference number of business license of the company approved by the competent authority is (110) Jin Guan Tou Gu Xin Zi No. 020 . The registered address of the company is 40F., No.68, Sec. 5, Zhongxiao East Rd., Xinyi District, Taipei City 110, Taiwan (R.O.C.), and the telephone number is +886 2 8729-5500. | PIMCO Canada Corp. (199 Bay Street, Suite 2050, Commerce Court Station, P.O. Box 363, Toronto, ON, M5L 1G2) services and products may only be available in certain provinces or territories of Canada and only through dealers authorized for that purpose. | PIMCO Latin America Av. Brigadeiro Faria Lima 3477, Torre A, 5° andar São Paulo, Brazil 04538-133. | No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2023, PIMCO.

CMR2023-0207-2725725