The following is excerpted from the latest edition of Litman Gregory's "No-Load Fund Analyst" newsletter. Littman Gregory's research team interviewed Saumil Parikh, a portfolio manager for Pimco's Total Return Fund and a member of the firm's investment committee.
Due to the ongoing threat of weak and slowing global growth, PIMCO expects little movement in the Treasury yield curve up to the five- to seven-year point over the next several years. Beyond the effects of near-zero Fed funds and quantitative easing, rates are further suppressed by the lack of credit creation from the private sector. Regardless of political posturing, PIMCO assesses the risk of an abrupt post-election change in Fed policy as “trivial” since an unassisted deleveraging would be painful to the true creditors of the nation, which are corporations and higher-income households. “So the demand/supply dynamics for duration risk in the market are very heavily skewed toward low interest rates remaining low for an extended period,” (Saumil) Parikh says. The longer end of the yield curve (beyond 10 years) is much more susceptible to inflation expectations, which he says will be driven not only by monetary actions but also by realized inflation. Over the cyclical horizon, he sees the demand/supply imbalance moving to the favor of supply, and therefore “price inflation is actually on the down trend.” To Parikh, this means the possibility of a currency or externally driven event is the most likely source of a major shift in inflation expectations during the next few years.
Over the past 15 months, (Bill) Gross shifted the fund's net exposure to U.S. government securities (including futures and other interest-rate derivatives) from approximately 0% as of June 30, 2011, to a peak of 41% on January 31, 2012, and back down to 21% at the end of August. During the latter half of 2011, he increased the fund's stake in high-quality (mostly Fannie Mae) mortgage-backed securities from 21% to 50% of the fund and has maintained the allocation around this level throughout 2012. This decision has boosted the fund's year-to-date performance, as mortgage-backed securities have significantly outperformed Treasurys in 2012. Most recently, the Fed's latest announcement of bond purchases includes an open-ended plan to directly target the mortgage market, committing to buy at least $40 billion of mortgage-backed securities monthly in addition to the reinvestment of proceeds from maturing holdings. In the third quarter, Gross substantially reduced the fund's weighting in nominal U.S. Treasurys while maintaining its allocation to U.S. Treasury Inflation-Protected Securities (TIPS).
Parikh explains that TIPS are an efficient vehicle through which to express PIMCO's conviction that the “rickety bridges” of monetary policy are far more likely to produce inflationary outcomes than to restore strong, self-sustaining economic growth, “discerning between the composition of nominal growth [being tilted] more toward inflation and less toward real growth.” Over the next three to five years, PIMCO expects to earn nominal returns of 3%–3.5% from the TIPS they hold today, primarily longer-duration issues. Parikh says this comes “from the inflation carry as well as from the roll-down in the real interest rates of the TIPS curve,” which is very steep at present. He likens this to a strategy PIMCO has used in the past with intermediate-term nominal Treasurys: buying a bond with a seven-year maturity, for example, and clipping its relatively higher interest coupons for several years before selling it closer to maturity, then reinvesting the proceeds in another seven-year bond. Parikh says this is a significant mispricing, calling it “a gift to get the same roll-down characteristics in the real yield curve as in the nominal yield curve . . . because in the real yield curve you get the additional upside convexity of inflation surprises, which in the nominal curve you get punished for.” Taking a long-term perspective, PIMCO expects inflation to surprise on the upside rather than the downside.
Parikh says they are finding similarly steep roll-down characteristics in certain emerging markets, such as Brazil and Mexico. While Mexico's economy is tightly linked to the U.S. economy and the country faces political uncertainties such as the drug war, PIMCO believes Mexican bonds represent a more attractive form of duration because their higher real interest rates offer fair compensation for these uncertainties and price volatility. In general, Parikh says they view emerging-market central banks as more likely to cut rates than to raise them over a cyclical time horizon as growth slows down. PIMCO believes the secular trend of outperformance by emerging-markets currencies will remain intact, but Parikh cautions, “As the rest of the world adjusts to the reality of lower growth rates and lower [currency yields], we would expect volatility and [downward adjustments to] the valuation of emerging-markets currencies.” For the time being, this has led Gross to hedge most of the currency risk of positions in emerging-markets bonds which are not denominated in U.S. dollars.
