Q: What is the history of the fund?
Mutual fund investors have typically had a limited opportunity set in mortgages, as most traditional mortgage funds are focused almost entirely on Agency mortgage-backed securities, either Fannie Mae, Freddie Mac and Ginnie Mae MBS or just Ginnie Mae MBS.
We felt there was a gap in the opportunity set. PIMCO had a longstanding record of investing across the mortgage market, both in interest rate sensitive and credit sensitive MBS, backed by residential and commercial mortgages and spanning the globe. We thought a best-ideas portfolio in real estate-related investments made sense, one that held our best credit or government-guaranteed ideas. This set us apart—it was the first of its kind in terms of a best-ideas portfolio for real estate credit, spanning the entire securitized mortgage market.
In addition, interest rates were historically low, and people were concerned they might rise. So we designed the fund with flexible guidelines to navigate a variety of interest rates and to give us the flexibility to trade from both long and short sides. We can take a negative position in interest rate duration, and if we thought interest rates would rise, we could position the fund defensively. We can also take defensive, short positions in many of the main sectors of the mortgage market.
Our competitors at the time were more segmented. You would have to buy one, two, or three different strategies to gain similar exposure, and even then you were typically tethered to a benchmark in a long-only type portfolio, whereas we did not tie this fund to a traditional benchmark.
Q: How would you describe your investment philosophy?
We want to be compensated for the risk we take, so when assets become expensive, without sufficient compensation, we can reduce our position, step away when there is no opportunity, or take a short position. That is the beauty of a broad mandate.
The global mortgage market is a very diverse market, and we go where the opportunity is, maintaining sufficient risk factor exposure. The global mortgage market is massive in size and combines interest rate risk, credit risk, commercial mortgages and residential mortgages, as well as U.S. and European assets. Agency mortgages are a very large, liquid market, making it possible to short a position rather than invest in an asset class that does not boast an attractive valuation. We can also take short positions in certain credit sectors to the extent they become rich.
Our main goal is to generate consistent absolute return across full market cycles, taking advantage of the broad opportunity set. We won’t bet the fund on a specific trade. Instead, we want to build a diversified portfolio. This typically results in lower correlations to traditional sources of fixed income risk.
Q: What is your investment strategy and process?
We have a unique investment process. We integrate the insights from our cyclical forums, which look ahead at the coming economic trends over a six- to 12-month period, plus a secular forum that projects trends over three to five years.
This is how we first came up with the new normal, and that changed to the new neutral, that growth will be slower than traditionally, and when the rate-hike cycle comes, it will be shallower than historic rate-hiking cycles. That top-down view, coming from our investment committee and cyclical and secular forums, is complemented by our bottom-up perspective, from the specialists and our roughly 60 portfolio managers dedicated to bottom-up, bond-by-bond analysis.
With a macro view on interest rates, it’s important to determine what is driving the current market. We use inverses, a structured bond backed by government-guaranteed mortgages. These function in the opposite way floating rate securities do, hence the name. Inverses start with a very high coupon that declines as the short-term rates increase. If the Fed does not raise interest rates, the coupon remains high for a longer period of time, whereas a floating-rate bond’s coupon doesn’t rise until and unless the Fed raises rates.
The use of inverses links our top-down process of the new neutral with our bottom-up estimate of prepayment fees, and we found attractive securities to reflect this opinion.
Inverses comprise a broad market, but not all bonds are equal. Our specialists find bonds to best express that view with the largest margin of safety in the event we’re wrong. Bond-by-bond analysis is not only used to implement our views but also to provide a cushion. We want to find ways to implement our ideas where they are not fully priced into the market.
Q: Can you provide an example to illustrate your process?
In today’s market we believe U.S. interest rates are lower than they otherwise would be if based solely on U.S. growth, because of tremendous overseas purchases. There are over $10 trillion in negative yielding assets around the globe, so the U.S. stands out as having relatively attractive yields. Lower interest rates are supportive of U.S. real estate.
We look at the benefactors, what things have caused dislocations in markets over the last six to nine months. Energy is one, as although it’s a concern for energy companies, it certainly benefits consumers. It does not negatively impact U.S. housing beyond a few pockets in Texas or North Dakota.
Issuance has weighed on markets over the last six to nine months. The corporate bond market had half a trillion net issuance last year and if there aren’t enough buyers, wider spreads result. The non-government-guaranteed mortgage market has negative net issuance, so for investors to maintain the same exposure next month, they must buy bonds and they make zero.
Supply, which may have caused some dislocations over the last nine months, was not an issue in the non-government guaranteed market, but we saw spreads or bond prices cheapen commensurate with other spread assets. That was an opportunity for us to add. We endeavor to identify the drivers of overall market conditions—are we moving in sympathy? Is it a buying opportunity? We reassess daily the risks we currently own and those we should be taking in the portfolio, such as whether we should be adding new positions or reducing existing positions.
Q: How do you conduct research and where do you look for opportunities?
We come up with return forecasts for broader segments, such as how we expect government-guaranteed mortgages to perform across a variety of economic environments. Our forecast could, for example, be slow growth, slow growth, base case, and then an upside surprise to growth. We do that across the headline asset classes to identify the best sectors to allocate to. We forecast how we think non-government-guaranteed mortgages will likely perform, commercial mortgages, and so on.
We work with our analytics team to look at the historic returns on asset classes, what we call academic guardrails. Such an academic approach illustrates how a portfolio should be positioned given today’s starting outlook. We rely upon our portfolio management and analytics teams to input assumptions on how markets will move based on our economic outlook.
We look for investment opportunities with a cushion. As there is always a degree of uncertainty, we want securities where even if we are wrong we won’t get hurt that badly. Buying cheap securities helps provide that cushion.
Scaling is more of an art, one that defines the best managers over time. At the extreme, both rich and cheap assets stand out, but extremes do not happen that often. We scale in order to find a way to generate returns in the middle. We think about how many units of risk we want for a given valuation. As valuations change, we reduce or increase the position along the way. Scaling positions is essentially a risk management tool.
Q: How do you select securities?
Each security or trade is subject to a two-prong test, the first being whether we like it on a stand-alone basis and the second being how it works with the overall portfolio. When we find opportunities that diversify the overall risk of the portfolio but have an expected positive return, we scale those positions larger.
We spend extensive time on the portfolio’s different components and how we expect them to interact with one another, such as pairing interest rate risk with credit risk, or marrying our top-down economic forecasts with our bottom-up security selection.
That way, if housing does well, for example, we have assets that will perform well; but if housing stalls, we have some Treasury duration or government-guaranteed mortgages to offset that. We have securities that will do well if the Fed stays on hold. Again, the goal is to deliver strong absolute returns across full market cycles via a diversified portfolio.
We have an optimistic view on housing and believe that housing fundamentals remain strong. So by reducing our spread exposure there, we can increase our spread exposure elsewhere to maintain the same overall spread.
Q: Is there a sector that is particularly attractive right now?
We are very active in trading government-guaranteed mortgages. It is a large market, roughly $6 trillion in size, and you can trade it actively from both the long and short sides of the portfolio. We like the government guarantee and the excess spread they offer above U.S. Treasuries.
Q: What is your portfolio construction process?
Our curve exposure is a key element in our ability to generate returns for clients, taking positions on various points of the yield curve. Regarding credit exposure, each bond in this portfolio has been individually rated by a PIMCO portfolio manager—we do not rely on rating agencies.
In fact, having a different view on the credit relative to that of the rating agencies can present real opportunity. Within non-agencies, the downgrade stemming from the housing crisis resulted in about $900 billion in AAA securities being downgraded to CCC, where the number of people who can own such securities is much smaller. A significant amount of forced selling brought prices down below where we gauged fair valuation to be. So, we individually value those CUSIPS and assign our own internal rating to them.
We also consider duration, which can be a positive expected return risk factor when yields are high. If we think yields might go lower, that provides both capital appreciation and the opportunity to earn the coupon. It also provides a diversification benefit. Typically what we see is when credit underperforms, interest rates move lower and there are diversification benefits.
How liquid the bond is also matters to us. Government-guaranteed mortgages are liquid and can generate excess return. The agency mortgage portion of the portfolio is also a low-beta strategy relative to benchmark. The returns on mortgage spreads—mortgages versus swaps, mortgages versus U.S. Treasuries, one mortgage coupon versus another—are independent of interest rates movement, whereas returns in a traditional bond fund are driven either by credit spreads or interest rate risk.
The benchmark is LIBOR, the London Interbank Offered Rate, which is consistent with most in this sector. We try to view our returns on an absolute basis while limiting the volatility of the overall fund. So we are looking for high-quality risk-adjusted returns. We want to deliver an above-LIBOR return while exhibiting lower volatility. While interest rates have been a tailwind, now we’re starting with lower levels of yield so we no longer have that tailwind.
Q: How do you define and manage risk?
Risk is ultimately not delivering to expectations, whether it be not delivering sufficient returns or, during downturns, not being positioned defensively enough to protect capital. We focus on curve, credit, duration, and ultimately liquidity of the fund so we can take advantage of opportunities as they arise.
Our risk management team sits on our trading floor. Together we perform scenario analyses on how the portfolio would weather historic events, such as the LTCM (Long-Term Capital Management L.P.) and U.S. financial crises.
We also do forward-looking scenarios, our best estimate of global uncertainties, such as a Brexit, or if China’s growth is slower than expected. These estimates highlight risk areas, potential holes in the portfolio, so we can take steps to protect against such scenarios at a low cost—not giving up too much return, reducing downsides, etc.
When markets move, they rarely move without zigzags along the way, so even when you’re wrong you have a few chances to buy and sell to cushion the blow.
