Q: What is the history of the fund and what distinguishes it from its competitors?
The PIMCO Corporate Bond Fund was designed back in 2000 to expose our clients to the investment grade corporate bond market and it currently has $6.5 billion in assets. I’ve been with PIMCO since 1996 and took over management of the fund two years after it opened.
My team’s size is considerable. It consists of 60 analysts from around the world and 40 portfolio managers and traders. That alone sets us apart, but the fund stands out primarily because we have delivered 6% to 7% returns over the last 5–10 years, outperforming the Barclay’s U.S. Credit Index, after fees, by 1% to 2%. Our tracking error is consistently low and information ratio is nearly 1, significantly higher than our competitors.
Q: How would you describe your investment philosophy and core beliefs?
We focus on the “big picture” and “where the puck is going to be” and we are true value investors. We don’t focus on next week, next month, or even the next quarter. We look to the next 3 to 5 years. What guides us is the long-term view, the forest, not the trees, and strong principles that have stood the test of time.
All thing being equal, we favor a few key themes in the portfolio. Number one is barriers to entry. We seek companies that feature unmatched intellectual property, unique assets, patents, or real estate location.
Second, we want superior growth, businesses that are growing significantly faster than the overall economy, because companies that grow quickly and have strong sales and profit growth boast the strongest financial flexibility. They throw off the most free cash flow and can organically de-lever the balance sheet quickly, which leads to tighter credit spreads and bond outperformance. Buying great growth businesses is not just good when you’re picking stocks; it’s good for bonds as well.
The third characteristic we seek is strong pricing power, as that tells you that demand is stronger than supply and that inventories are typically being drawn down. We focus on where inventories are going and the intersection of supply and demand on the ground.
We focus more than most managers on downside risk protection. We look at asset quality and stress-test companies for risk: commodity risks, cyclical risk, emerging market risk, and political risks. We also have a philosophical bias toward companies that act in bondholder interest vs. equity interest. You can only do that by being on the ground. That’s why we have 60 analysts around the world on our team.
Q: Do you believe in meeting management as part of your investment process?
One of my first jobs at PIMCO was credit analyst. Today, 20 years later, I still regularly get on the road and meet face to face with CEOs and CFOs all over the world to make onsite qualitative judgments of management teams, and I’ve logged about three and a half million air miles doing it. Not many chief investment officers are willing to get on a plane and travel, consistently throughout the year, every year, for 20 years. The combination of the on-the-ground research, long-term relationship and experience gives us an edge in the global credit markets.
Q: What constitutes your investment strategy and process?
Again, we are long-term value investors because we believe success lies in getting the big picture right.
PIMCO has a top-down process, a secular view on markets over a period of three to five years, which enables us to see both opportunities and risks. As PIMCO’s Global Credit CIO, I’ve written roughly 50 quarterly papers on the global credit markets. As early as 2006, I wrote one on the housing crisis, which we saw coming well before others did. We not only saw it coming, but we shorted it. That’s why, in 2008, the fund delivered positive returns when our competitors were down 10% to 15%.
We saw the risk of housing before other people not just because of our knowledge of the mortgage market but also our on-the-ground research. With 4.7 million homes in inventory, I was meeting with homebuilders in 2006 who didn’t know who they were selling their homes to.
In fact, my on-the-ground research in 2006 spurred me to sell my house and move into a rental apartment, where I waited six years before buying another house. I would never have made that decision had I not been on the ground traveling the country, meeting with homebuilders and banks and grasping just how huge this housing crisis was going to be.
Q: How does your research process work? How do you search for opportunities?
We have a simple three-step formula: top down, bottom up, and relative value plus risk management. With top down, we seek superior growth countries as well as industries. Step two, the bottom up, is gauging which companies in those industries and countries have the desired barriers to entry, pricing power, asset quality and liquidity, and management teams that act in bondholder interest. Here, and in step two, is where our on-the-ground research, where we get out and actually meet with CEOs and senior management, makes such a difference.
Step three is determining relative value in the capital structure. With all the shareholder activism going on, many companies have begun focusing on rewarding shareholders, but we need to ensure that within the capital structure of a company, it’s the bondholders who come first. And that’s the case currently in the banking sector, and in the specialty finance companies being forced by regulators to hold more capital. It’s only because we had on-the-ground intelligence and the foresight to see the big picture that we could calculate how this regulatory change would lead to bank and financial sector outperformance within the corporate bond market.
There are still many areas today where bondholders benefit in the capital structure. For example, two of North America’s largest pipeline companies, Kinder Morgan and Plains All American Pipeline LP, have recently cut dividends and issued secondary equity or other subordinated securities to defend their balance sheets. While most see this as an equity-negative event, this kind of transfer of value in the capital structure can be decidedly bondholder-friendly. Companies have to do that for a variety of reasons, in this case because of necessity in the energy market, or, for example, regulation in the banking sector.
Q: Can you provide some specific examples as to how your research process has paid off?
Back in 2014, I was meeting with companies in Brazil and found myself growing more and more concerned with the political situation there. I thought it might lead over time to something bondholder-unfriendly and that the economy was heading toward a recession. I was also influenced by the book Why Nations Fail.
By February 2015, my team and I began a significant cleansing of Brazil credit risk, getting out of a lot of emerging market risk. Brazil ended up significantly underperforming last year, so we were very pleased with the call we’d made in reducing emerging market credit risk and in recognizing how China’s softer growth model could negatively impact some emerging market credits.
Q: Have there been any instances where your strategy wasn’t quite so effective?
Of course. I’m not saying that we get everything right all the time. All portfolio managers make mistakes. One of my biggest fears in managing hundreds of billions of dollars for clients all over the world is disappointing them. When I feel like I might be about to make a mistake, I find myself waking up at 1:00 A.M. and I can’t rest until I get on a plane to meet again with the companies and do more research.
Many of our buy and sell decisions stem from these research trips and on-the-ground involvements. One recent mistake I made was underestimating the anticorruption campaign in China and its impact on Macau, which is basically a gambling market in China. We have exposure to some companies there. I was back and forth to Macau a lot. We decided to keep the position, but in that time Macau has come under even more pressure. Looking back over the last year or two, we should have reduced our Macau exposure.
While we recognize that we make mistakes like everyone else, we are proud that, overall, our winners tend to significantly outweigh the losers, so even with the occasional mistake, at the end of the year our clients have made 1% to 2% of alpha, or outperformance, vs. the benchmark.
Q: Can you provide specifics on how you outperform your benchmark?
Well, last year we outperformed the market by 1.5% because we foresaw China slowing down before they did. We felt that the slowdown, the new president’s anticorruption campaign coupled with China changing its growth model from investment spending toward consumption, would have severe negative spillover effects on commodity export countries like Australia and Brazil, on commodities in general, on emerging markets. So we went negative and underweight in emerging markets, commodities, and energy. That played a large role in our outperformance last year.
We outperformed last year by playing defense. If you want to win the Super Bowl, to win championships, you have to play both offense and defense well. In 2006 and 2007, we played defense by avoiding the housing market, before shifting to offense in 2008 and 2009. And last year we played defense in the energy sector, in emerging markets and in the metals and mining sector.
Whether we can continue to outperform going forward comes down to whether we can time the bottom of the commodity markets. We have a good track record when it comes to predicting when to buy and sell assets classes—when to buy equities and sell equities, when to buy and sell credit, when to buy and sell interest rates—and that has given us an edge.
Q: What is your portfolio construction process?
Generally, we have about 120 issuers in this portfolio, which may seem like a lot, but just like the S&P 500 has 500 stocks, our index is relatively diversified with a lot of issuers. That said, we’re not afraid to deviate from the benchmark in a significant way.
For example, banks and financials make up about 30% of the investment grade corporate bond market index. There have been times when we have been between 40% and 10% overweight. Pipelines in 2011 and 2012 were about only 4% or 5% of the index, while we were running 12% or 13%.
At times when we have extremely high conviction, we will deviate significantly from the index. While it’s diversified in terms of having about 120 issuers, we generate outperformance because of our chosen overweights and underweights, which is more of a top-down decision. We screen what industries to favor based on growth, barriers to entry, and, from a bottom-up perspective, whether we are picking the right names.
Q: Do you maintain positional limits at any level?
On a sector level, we’re not significantly overweight right now in anything. The most we’ve ever been overweight was about 10% a couple of years ago, in banks and financials, but that’s come down somewhat since. We are still overweight banks and financials and in U.S. consumer sectors like healthcare, pharmaceuticals, and medical device companies, and housing and building materials. We tend to focus on the domestic U.S. consumer. Coming out of 2011 and 2012 we were significantly overweight in pipelines, and recently we went from a significant underweight in energy to a slight overweight.
I see being more than 1% overweight in an individual name vs. the benchmark as a big position, and so in my history of running this fund, I rarely have more than 10 names overweighted more than 1% vs. the benchmark.
To do that, I have to have a lot of confidence and it has to pass our three tests, the ones I mentioned earlier: (1) Is this a country you want to be in and do you believe in the growth of the industry? (2) Do you believe in the company, in the barriers to entry, the pricing power, the asset quality, the liquidity, and the downside risk protection? (3) Is the relative value of the bond position so compelling and is the company acting in the bondholder interest so that, within the capital structure, this is just a screaming buy from an evaluation perspective?
It has to meet our top-down macro thesis, our bottom-up barrier to entry, growth, pricing power, asset quality, and liquidity screens, and meet our relative value screens as a great risk/reward investment. Only when it passes all three of those tests does it become a really large position. Even then, since I began managing the fund 14 years ago, it rarely gets above 1% overweight vs. the index.
Q: How do you define and manage risk?
The Sharpe ratio says everything about whether a manager is talented—it’s basically your outperformance vs. that of your competition in the market, relative to the amount of risk you take, relative to the competition’s, and relative to the market. As I said earlier, information ratios of 1 are all but impossible to achieve—almost no manager has them. We’re very close to having an information ratio of 1 on this fund, which I’m proud of. That tells you a lot about our risk management and the depth of talent on this 100-member team.
Our commitment to our clients is such that we arrive at the office most days by 3:00 A.M. every weekday. Not too many people in the investment community are willing to get up at 2:00 A.M. every day! But securities are priced in real time. We hold video calls with Asia and Europe as well as North and South America several times a week, getting real time information on spreads and security pricing and equity prices to ensure we’re making the right investment calls.
I pass out the portfolio every Wednesday and then we meet every Friday to discuss it and decide if we’re on the right track or not. In addition to getting market information on how we rate against the benchmark, our 60 analysts review every security in the portfolio to determine whether more on-the-ground research is needed. What are the hotspots? Do we need to be getting on airplanes and going to Houston? To New York or London or Asia, for example?
Q: Can you give an example of a portfolio change you’ve made based on a risk assessment?
In just the last couple of weeks we’ve shifted from the significant underweight in energy I mentioned to being slightly overweight in pipelines and higher-quality exploration and production companies, and we’re looking to increase that to a more modest or significant overweight, because we think oil prices are close to bottoming here at $30.
Now as a hedge against that, we have currency positions. We are long dollars and short in the Asia currency basket. That’s our hedge for basically a sharp slowdown in China. If you were to ask me where I perceive the biggest risks will lie in 2016, I’d answer that they’re going to be commodity prices and China.
If China slows more than people expect, it’s our belief they’ll let the currency go. And if the currency goes, having our Asia currency basket short will pay considerable dividends. So, as a risk management tool diversifier in the portfolio, we are essentially long credit risk. So one way to hedge against that is to have long dollar exposure vs. the Chinese renminbi and Asia as a whole.
