Investors are seeing losses in their bond portfolio. Given how low interest rates are today, mistakes in your bond portfolio are more costly than ever.
PIMCO’s David Braun helps us understand what’s going on in the bond market.
Listen now and learn:
- What’s going on in the bond market today
- The outlook for interest rates and inflation
- Why indexing in bonds is different than indexing in stocks
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Show Notes
Investors opening their statements for 2021 are likely seeing losses from their bond portfolio. As a reminder to our listeners, when interest rates rise, bond prices fall. My personal philosophy with fixed income is that it’s primary role is to reduce overall volatility for the overall portfolio.
That doesn’t mean bonds can’t lose money, but given how low starting interest rates are today, mistakes are even more costly, so I think it’s more important than ever to understand what’s going on so that you avoid those costly mistakes.
That’s why I invited David Braun from PIMCO to join me. David has been with PIMCO for 13 years and is a U.S. generalist fixed income portfolio manager in the New York office. He has 28 years of investment, risk management (including chief risk officer of a large investment company) and actuarial experience.
Here are a few things I jotted down during our conversation.
What’s happening in the bond market recently? [1:18]
Nobody likes losses. We are investing in a fast moving cycle. The Covid recession was one of the sharpest, most violent in history.
We quickly moved from an early-cycle recovery to a mid-cycle recovery and now we’re well into a late-cycle recovery. Rising rates in the late part of a recovery is very consistent. The Fed explaining to the market that they are tightening policy in response to inflationary environment that no longer seems transitory – both by hiking rates and quantitative tightening.
The bond market, especially the front end of the yield curve, has repriced itself for that path of Fed tightening.
The bulk of that repricing is behind us.
August 2020, 10-yr closed at 0.51% and now we are at about 1.80% and 1.90% — so the pain of that rate move is mostly behind us.
The beautiful thing about bonds is when you take that initial pain of rates rising and the value of your bonds fall, you have a much better forward-looking yield and you can usually grind out a higher return over time.
For long-term investors whose time horizon is longer than the duration of their portfolio, they actually benefit from rising rates.
Interest Rate Outlook [3:43]
The market is waking up to not just the change in the Fed’s policy direction, but ECB and other major central bankers are taking a more hawkish tone. With the latest high inflation numbers and the economy nearing full employment, monetary policymakers have cover to tighten policy.
Fed funds rate of 0.00% is an emergency policy rate. A $8.7 trillion balance sheet that is still growing is an emergency tactic to get us out of the Covid recession.
We’ve had a big snapback. We are 18 months beyond the end of the recession and near full employment. Stock market established new highs 70 times 2021 – it’s like the recession never happened. It makes sense to remove the emergency level accommodation and get back to more normal rates.
Expecting Fed Funds Rate to get to 2.00% or 2.25%. Again, the bulk of the rate move up is priced into the market. Going forward, we are entering a highly uncertain path for interest rates.
One of PIMCO’s highest conviction views is that uncertainty and volatility are likely here to stay as the economy transitions from a fiscal and monetary led recovery to one drive by aggregate household demand and corporate spending.
Plus, markets must deal with the question of whether or not we’ve entered a new regime for inflation.
Inflation Outlook [7:05]
Base case for inflation is that Core CPI peaks in the next month or two, and then pulls down below 3% by year end, with Fed-like levels of inflation by 2023.
PIMCO doesn’t think they’ve entered into a period of structurally higher inflation, but it is a risk that could affect the yield curve.
Drivers That Could Lead to Structurally Higher Inflation:
- As money from fiscal and monetary policy gets put out into the economy, the velocity of money picks up and leads to an increase in inflation.
- Deglobalizing supply chains pulls jobs and production to higher cost inputs.
- Brown to Green Energy Movement: pulling more of the goods that you need for other goods to make strides in green energy
Drivers That Could Lead to Lower Inflation:
- Productivity gains from lots of technology We just spent a whole bunch on CAPEX on technology to help workers do more with less during Covid lockdown/WFH.
- Digitalization of how we consume as a society. That is disinflationary as it leads to higher productivity.
- As an economy, we have added debt and we are higher leveraged than before.
- There is currently some wage inflation, but once we get past the shifting in the labor market and jobs, we could get back to the prior year conditions where unemployment and inflation was low
The Case for Core Bonds in Broader Portfolio Construction [9:45]
With starting rates so low, mistakes are more costly.
Risk assets are priced to perfection and not acknowledging that uncertainty. Uncertainty and volatility mean you ought to get paid more to take risk – but that’s not happening right now.
You want to own core bonds when the outlook is uncertain. Core bonds provide income and help reduce the volatility stocks create within a portfolio.
When the yield curve steepens
The Case For Active Bonds [13:45]
Indexing in bonds is fundamentally different than indexing in stocks.
See More: Bonds Are Different (PIMCO)
Stocks are exchange-traded with incredible transparency about transaction costs. Meanwhile, the bulk of the fixed income market is still over-the-counter traded where an active manager can hopefully garner an execution or information edge to exploit some of that market’s inefficiencies.
The number of securities. The Bloomberg Barclays U.S. Aggregate Bond Index has roughly 12,000 securities. Unlike a company in the S&P 500 that has one set of common stock, that same company might have dozens of issues in the bond index. It’s not as simple to replicate.
Turnover is very different. S&P 500 has about 4% a year, so it’s easy to replicate. The Bloomberg Barclays U.S. Aggregate Bond Index turns over about 40% a year, plus it’s less liquid and more opaque – all making it less reasonable to replicate.
Philosophically, indexing corporate bonds, by definition it’s debt-cap weighted, meaning you loan more of your money to the most indebted issuers.
Think about running a bank that only loans money to people with a lot of debt but turns away borrowers without much or any debt – it’s the reverse of how you would think it should operate.
There is a tremendous halo on bonds deemed index eligible by ratings agency, which means those bonds are financed at a lower spread and less opportunity for improving risk-adjusted returns.
As soon as something isn’t index eligible, it drops in price and the index is forced to sell it when its price is low. Similarly, when something comes back into the index, it’s price spikes and indexes must buy at the higher price.
Where PIMCO Sees Opportunities Across Core Fixed Income Markets [18:00]
Housing: Price appreciation plus household balance sheet strength. Fundamentals for housing are strong.
Banks over Non-Banks: Since the Great Financial Crisis, banks have been forced to hold more capital and liquidity, while also taking less risk. Meanwhile, non-financial world has had a debt frenzy.
Taxable Municipals: Balance sheets look very strong and the space is less trampled over.
Explicit Covid Service Re-Open Themes: Prices are lower and safety of margin is higher.
TIPS and Inflation Protection [22:15]
The big inflation event already happened. TIPS do well when there is unexpected inflation.
PIMCO relatively neutral on TIPS valuations, would have been great if you had gotten into it 18 months ago, but looks fairly valued.
Core bond shouldn’t be the inflation protection. It can be positioned for reflation – the economy is going to grow eventually, labor market is going to come back, asset prices rise, etc
You can do that in four ways:
- Underweight duration
- Curve steepener
- Overweight credit risk
- TIPS
What Does It Mean To You To Be A Long-Term Investor? [25:12]
If you didn’t have some sort of beacon to anchor yourself to, you can get caught up in euphoria or panic. We are human. You need that longer term view to hold you back. We feel more confident about long-term trends than short-term moves.
Resources
- Why Bonds Are Different (PIMCO)
- Submit your question for the show through my “Ask Me Anything” form
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Long term investing made simple. Most people enter the markets without understanding how to grow their wealth over the long term or clearly hit their financial goals. The Long Term Investor shows you how to proactively minimize taxes, hedge against rising inflation, and ride the waves of volatility with confidence.
Hosted by the advisor, Chief Investment Officer of Plancorp, and author of “Making Money Simple,” Peter Lazaroff shares practical advice on how to make smart investment decisions your future self with thank you for. A go-to source for top media outlets like CNBC, the Wall Street Journal, and CNN Money, Peter unpacks the clear, strategic, and calculated approach he uses to decisively manage over 5.5 billion in investments for clients at Plancorp.
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