Words on Navigating the Bond Market Sell-Off

 

In this episode of Words on Wealth, Head of Investment Strategy Max Casey is joined by Esteban Burbano, Managing Director at PIMCO, to unpack the drivers behind the bond market sell-off and what the shift in Fed expectations could mean for investors. They explore what previous periods of bond market volatility can tell us about the outlook from here, and why current yield levels may be presenting a compelling opportunity across fixed income. Esteban also shares where PIMCO sees the most attractive opportunities in the market today. Tune in to find out more.

This episode is also available on Apple Podcast. 

Max Casey (00:16)
Hi all and welcome to another Evans and Partners webinar. this week there is no shortage of of topics to discuss. And so what we thought it would be good to do was to get a fixed income specialist on to chat through recent developments in in bond markets, in in credit markets. and so joining me today I have Esteban Burbano from Pimco.

Esteban Barbano is a managing director at PIMCO, and he’s gonna join us today for a candid discussion on what’s going on in bond yields, key drivers of the sell-off in bond markets, and potentially some opportunities that we’re seeing amidst the volatility. so just a couple of housekeeping housekeeping issues before we do get into the conversation.

just a reminder that everything discussed on today’s call is general advice in nature. and if you do wish to seek personal advice, please get in contact with your investment advisor. I’d also like to flag that there is an an option to submit questions and we will do our best to get those through to Esteban and and get them answered either on the call or post the call as well.

so with that, I’m happy to kick off the conversation today. introduce Esteban and get the conversation going. So so Esteban, obviously no shortage of topics to to kick into. do you just wanna talk through, you know, what is happening in bond markets, what you’re seeing across your client base at the moment.

But then p potentially just unpack, you know, what are some of the key drivers in terms of the sell off that we’re seeing in bond markets at the moment as well?

Esteban Burbano (02:08)
Yes. thanks, Max, and thanks everybody for for being here and allowing us to sort of talk to you today. A lot happening in the markets today. so let me just try to unpack some of the key factors. of course, in the US, we’ve had a significant increase in interest rates over the the last nine months. You know, if if you measure, for example, how quickly the

The 10-year has moved about 80 basis points. there’s been a couple of factors that we think are are driving these moves. number one has been a pretty significant shift in expectations for what the Fed is going to do. You know, we went into 2026 with an expectation that the Fed was going to cut rates, and very quickly that has turned into an expectation where the Fed is going to hike rates. So we’ve gone from two cuts to four hikes.

Or five hikes. That’s about 150 basis points move. the main driver for that has been the conflict that we’re seeing in the Middle East, and the effect that that has had to energy prices, oil prices, gas prices, and the expectation that that will that would create pressure for inflation over the short term. And so as a result, markets have factor in more sticky inflation.

In the US, and therefore a Fed that was going to be either on hold and then eventually hiking. That’s factor number one. The second factor that has perhaps contributed to the increasing interest rates has been a changing guard on the Federal Reserve. You know, a new chairman that is not only adamant that the that the Fed

That inflation needs to get to 2% target, but also that the economy needs to get to 2% target quickly. So it’s not just about the level, it’s also about the speed. And that also changes the expectation, has has influenced markets’ expectations for the Fed to be more aggressive. And then lastly, of course, all in tying together with this has been a more resilient US economy. The US economy is still growing quite healthy.

You know, it’s obviously slowed down since the periods post-COVID, given the the significant amount of fiscal stimulus. But you know, but if you look at growth for the US economy as of the the the second and third quarter, you know, it is expected to be somewhere in the order of two and a half percent real GDP growth. Right? Our expectations is that this growth will could will will continue to slow down, but remain quite resilient.

So we expect the US economy to grow at around one and a half to two percent. And so a health, and this is being led by, you know, perhaps higher than expected, higher payroll numbers, 155k payroll numbers in the last August report, versus an average of 55 over the last five months. an employment rate, obviously, that has been also very sticky, very low. And so all of these factors, if you if you will.

have created this notion that inflation will be sticky, that the Fed is going to be more aggressive in trying to bring it down, and therefore the rates have to move higher.

Max Casey (05:33)
into like you you’re obviously based in New York and and a lot’s been made around the strength of the US economy and we saw some some data even overnight that that you know reemphasise that. H how is well how are conditions on the ground in the US? what are the kind of key drivers of s of some of that growth and and where are potentially some some vulnerabilities in the US economy as well?

where you could start to see, you know, a slowdown in inflation effectively helping the Fed.

Esteban Burbano (06:08)
Correct. so yes, as I mentioned and and Max, I think as we turn also into investment strategy, it’s also important to keep in mind that a lot of this is a lot of these sort of resiliency and potential inflation pressures are already priced in to yield levels. And so what matters is not so much whether or not inflation is going to be sorry, interest rates are going to go up, they’re already expected to go up if you look at forward curves.

What matters is whether or not they go up by more, what’s already priced in. I like to make the analogy that when you’re buying a stock, equities, right, what matters is not whether or not the company makes money or not, but whether or not company beats earnings expectations. Right. So similar thing here, already embedded in market prices is an expectation of where rates are going to go. And if you look at, for example, front-end yields like Fed funds rate.

Which is a four, the Fed just went from 375 to 4 last week. markets are anticipating one more hike in December and two to three more hikes next year. So a fed function rate that is going to be somewhere around a four point seven percent by the summer of next year. So it’s not so much that you know, whether or not we think rates are going up, they’ve already priced in to go up.

you know, one year, two year rates are expected to touch five percent. so what matters is really like what can change in the global in the economy, as you mentioned, to perhaps, you know, change the expectations and how should we position ourselves for that. And so in terms of growth, your question is what’s driving it, what could be the key the the sort of the key factors changing the picture going forward and changing expectations?

Well remember I mentioned the US economy has been growing quite strong.

A big portion of that, I would say the vast majority of that growth has been this Capex cycle that we’re seeing on not just AI investments in data centers, but also energy, infrastructure, defense spending globally. Right. So this is what’s, you know, if you think about it, you know, the US economy being a consumer economy, you have these components. You have the consumer, you have investments, you have government, you have net imports and exports.

You know, that investment component is quite strong, given that you know, companies are building up infrastructure. And so what can change the picture? Well, a couple of factors that you that we need to be aware of. Number one is, and you some of you who might be aware of the political environment in the US might might have read that more recently there’s been some increased opposition to more data centers by by people in their, you know.

They don’t want this huge infrastructure projects in their neighborhoods. You know, they’re using water resources, using energy resources, they can be noisy, et cetera. And so a few states have proposed moratoriums. a few localities have already imposed moratoriums, basically saying, you know, let’s let’s pause, let’s wait, let’s give it a year, let’s see what happens before we agree to any new projects.

And so, you know, you could you could see an environment where this one of the engines of growth, which has been capitalist expanding, slows down, you know, and that could have an effect of slowing down the overall economy. That’s that’s more sort of specific to the current sort of big driver of growth. Then you can also see other sort of more traditional sources of of challenges for the US economy.

Right, as as many of you know, you you know, the US economy is a consumer economy. 80% of the economy is driven by consumption. The US consumer has three sources of funding. The first one would be their their salaries, the second will be their savings, and the third will be credit. And when you look at salaries, I mean, wage growth has been quite quite robust, but if inflation

Over the short term were to were to stay higher, so headlight inflation is at 3.5%, 3.3%, it’s basically in line with income growth. And so, but if it were to be sticky and income growth slows down, then you could see a situation where, I mean, you know after inflation, things get more expensive for the US consumer. And then obviously, related to rates, interest rates, as rates go up, it’s harder for people to get credit. You know, so much of the US economy is finance.

through credit, credit card, credit cards, auto loans, student loans, mortgages, you know, all of these things are getting more expensive. And so if the US consumer has less disposable income because prices at the pump, gas prices are higher, and all of a sudden also their interest rate payments, their credit card payments are getting higher because rates are higher, that also has an effect on slowing down the economy. And so that’s one of the main reasons why when you put these two

Things together. Number one, that already a lot is being priced into in terms of increases in interest rates. And number two, that is putting more and more pressure on the US economy. We are buyers of interest rates. We’re buyer, we use this term duration, which is just signaling like the amount of interest rate exposure that we have in our strategies. We’re at the highest level that we’ve ever been, at least since the global financial crisis in many of our portfolios.

And that it has to do more with the confluence of A, you have very attractive levels today. It’s a very good buying opportunity. And B, a lot is getting priced in in terms of, you know, the the more dire scenario for inflation and not enough in terms of the dire scenario for growth, which could drive rates down.

Max Casey (12:18)
And just just building on that a little bit, you know, what do you think the role of of governments has been in terms of this sell off? So we’ve obviously seen a lot of bond issuance coming from, you know, most of the developed world, particularly over in the US. And a lot of that is is being done to fund f physical stimulus packages. Like that is a reversal from what we’ve had over the past

decade or so. Is that something that you expect to pers to persist or or do you think there is, you know, a moment in time coming where, you know, governments are going to have to be aware that the more debt that they issue, the the higher yields can effectively go?

Esteban Burbano (13:00)
Yeah. That’s a very good question, Max. And and and one way that I hear this question often is are we worried about debt sustainability? How sustainable is this debt issuance, not just in the US but around the world? the short answer is we are concerned, you know, as bond managers, as buyers or of debt, it’s never good when the issuer keeps issuing more debt. Right? That’s not a good scenario.

So we do watch it very closely in terms of like what is the fiscal picture. but on the other hand, as investors, we also have to think about what is the alternative. Right? You know, we want to allocate assets. What is that core holding, that that risk off holding that is going to protect our portfolios in an event of a of of a market sell off? What is that risk-free asset, if you will?

And when you look around the world, the reality is that even though the US and other countries are issuing debt, the US is probably in one of the best positions vis-a-vis other G7 countries. And two numbers I’ll give you is, you know, number one, you know, when you look at tax revenues as a percentage of GDP, basically ta average tax rates for the US are hovering around 30%.

You know, compare that with like places like France, who you know, are running tax rates of 50%, over 50%. Right. So many of the G seven countries are actually the US is the one of the lowest, right? And and the US, as we mentioned, is also one of the one of the most robust in terms of growth and one of the countries at the vanguard, if you will, of this AI boom. And so, yes, we are concerned about the level of debt getting issued.

But when we compare alternatives in terms of what is that risk-free asset, we still think there is room. We’re not saying on a base case that there’s going to be more, you know, fiscal tighten there’s going to be fiscal tightening through more taxes, but at least there is room in the US vis-a-vis other countries, and there is higher growth. You know, the EU is growing at one percent, the US is growing at two and a half percent. And so there’s more ability to generate revenue through taxing some of that growth.

even if you kept the same tax rates. And so bottom line is yes, we are concerned, but but we think the US that still is sustainable. And there will be some fiscal consolidation, you know, in the future. Hard to say exactly when, but there is room, especially if the US, you know, continues to grow at a healthy pace.

Now you mentioned like how much of the this the the pressure on yields is due to this debt sustainability. You know, it’s hard to pinpoint exactly how much, but I would argue that the majority of the increase in the 10 year yields is not because of debt sustainability. It’s because of changes in expectations at the front end because of the conflict in Iran and the pressure in in in energy. That’s probably accounting for the majority of the move.

And then the other factors affecting it is you mentioned issues of debt. It’s not just governments. I just mentioned the capex spending as well, this capex cycle that we’re going through. So it’s corporates and governments issuing more debt. And so there’s competition for capital, and investors are demanding a higher risk premium, right? And so those are those would be two factors that I would point out. The third one would be also you know, the the the

The Fed has said that they’re going to provide less forward guidance. And so there’s going to be less certainty as to sort of the path of interest rates. And that perhaps also increases the risk premia, you know, in the intermediate and lone end of the yield curve. And so again, not to say that that debt sustainability is not an issue and it’s not affecting. There is probably some effect there, but it’s not what’s driving. That’s not the principal component one, if you will, of the movement in rates.

it’s it’s it’s the changes in expectations on inflation over the short term that has driven the changes in expectations from the Fed reaction function that has you know created more pressure on the intermediate side of the yield curve. Last point I’ll make is it the you know the inflation pressures are short term. If you look at long data long term inflation expectations are still very much anchored. Ten year break evens, you know, using using futures market, sorry, using tips markets.

show that break you know the markets are expecting inflation to be somewhere around 2.1 2.2 over the next 10 years. So you’re not seeing you know this this concern that inflation is getting out of control, that that therefore there has to be a higher interest rate levels at the 10 year none of that. This is more to do with basically short dated expectations.

Max Casey (18:03)
Thanks. And you know, you you touched on it briefly there, but but one one dynamic that we’ve seen, you know, over the last twelve to eighteen months has been this surge in corporate issuance alongside government issuance. I just wanted to unpack that a little bit more for everyone, you know, on the line in terms of who these corporate issuers are, why we’ve seen a surge in corporate issuance over, you know, the last twelve or so months.

And then, you know, do you and does PIMCO expect that to persist for the next twelve, twenty four, thirty, six months?

Esteban Burbano (18:41)
Yes, there’s been a so so as I mentioned, there’s we’re going through a transition period in the bond markets where we’re transitioning from a world where there has been

very very little issuance of bonds. what I mean by that is just to give you a a sense of you know historical trends, you know, after COVID rates went down aggressively, right? So many companies use that opportunity of having lower interest rates to refinance their and and and heal their balance sheets. Right. So as rates went up in 2022, you know, companies stopped issuing or or

issued less debt, right? Because now yields were higher and therefore there was less issuance. As investors, that wasn’t a great environment because you’re basically having less fewer bonds to go and buy, and you know the same demand for yield. And so therefore more competition for fewer bonds. We’re transitioning now to a world where there’s been more issuance now, not just on the government side, but more importantly on the corporate side.

Where is that coming from? Well, there is, you know, and I would I was I would put it in the cara in three categories. One, obviously AI infrastructure, energy related, so data centers, energy projects, if general infrastructure, and then defense. You know, not as prominent today, but you know, last year, you know, you may recall, especially in Europe, there were a few significant fiscal packages that were passed.

As Europe got more concerned that the US was going to pull away from NATO. And so, you know, Germany, for example, passing, you know, hundreds of billions of dollars of of of new legislation to build up, you know, what’s basically their their defense spending. And so that’s that’s also part of the equation here. Now we expect this to continue.

especially on the AI infrastructure side, what are these? These would be infrastructure projects, for example, data centers. Anything from you know, a data center of CHIPs, CPUs, GPUs, as well as the underlying infrastructure that needs to build around it, you know, water supplies, energy supplies to be able to power these data centers.

And then the infrastructure to get those products, you know, across the states. And so that’s that’s there’s been a significant boom. You know, so far these years, we’ve seen a couple hundred billion dollars invested so far. and we think this is going to continue. Now we see this as an opportunity. Again, because for us as investors, this means that there’s going to be more opportunities for us to look at deals. Not everything is going to be good. In fact, there’s going to be some very very good deals.

And then there’s gonna be some very, you know, not so good deals. and so this is where so having having the the the ability to discern like which ones are good, which ones are bad is gonna be very important. which is which is what we’re doing right today. We’re working on a couple dozen deals live at this moment.

Max Casey (22:11)
And then thinking about you know, h historical precedents. So so instances where we’ve had this level of bond market volatility, where we’ve had, you know, significant drawdowns in government bonds and long duration assets. Like, is there a particular period you would compare this to in the past? And and if so, how how have assets typically performed? What’s been the catalyst?

for a reversal and you know, if so, like when could we see that reversal occurring?

Esteban Burbano (22:46)
Yeah, no, this is this is perhaps Max, this is perhaps the the most important question is have we seen this happen before? And what can we learn from those episodes today? You know, the 10 year just hit 5%. And I know that’s creating a lot of anxiety for for our clients and for in for bond investors who are concerned about how high can these interest rates go.

Just a qu as a quick reminder, the last time the 10-year hit 5% was in October of 2023, three years ago. back then, you know, the concern was we were coming from a time where the Fed has done had done some aggressive aggressive hiking. You know, that they they had taken the the Fed funds rate basically from zero to five percent, you know, over twenty twenty two.

And the markets were reacting to the and the markets were expecting eventually the Fed to turn around and cut rates. and in October 2023, there were some data suggesting that that that the Fed was going to be on hold and therefore higher for longer. And that caused a sell off on interest rates. Now, you know, to to put things into perspective, that was a world also where inflation was much higher.

You know, we we were coming in from a period in 2022 where inflation was at nine percent. Today, inflation is at 2.4 core CPI. You know, headline CPI is higher, of course, because energy prices are higher, so 3.3. So yes, we do have stickier inflation, but inflation is coming down. And we’re not seeing this sort of structural dynam supply and demand issues. This is more to do with a localized event given the conflict in the Middle East.

But going back to your question, Max, what did we learn from the episode in 2023? Well, if you had, you know, something like our you know multi-sector strategy, you know, which has about a 7% yield today, 7.5% yield. Back then, it also had a 7.5% yield. If you had bought bonds at that point in time, you know, you would have had a three-year return today of about eight percent annualized in dollars.

Also, something that people don’t forget is back then when yields went to five in October 2023, they ended the year. So two months later, the 10-year was at 4.2, 80 basis points lower. Right? And so why? What happened then? you know, some data just came back weaker. And the Fed came back saying, you know what, like we need to we need to look at growth. And so

It’s just a quick reminder that I know today when we’re looking at economic data and we’re looking at the conflict in the Middle East and the Fed just did the hike, it just seems like this this could be a runaway train. But the reality is that just as quickly as expectations have gone from Fed cuts to Fed hikes, you could see a reversal of that. And you don’t need the Fed to cut. As I mentioned, there is already three to four hikes priced in. Our base case, by the way, I didn’t mention this, but at PINCO.

We think the Fed is likely to do a hike in December and then be on hold for the rest of 2027. You know, there’s a chance that it won one more in 2027, but our base case still is basically one more hike from here. So that’s why we like duration. That’s why we think you are getting an opportunity to buy yields at five, you know, the 10 years at 5.11 right now, but you’re buying a multi-sector portfolio that is probably yielding you somewhere between seven to eight percent.

And remember, that starting yield is going to be very highly correlated to your total return over that you know a three year, five year horizon. So if you’re buying at seven and a half percent, you’re likely to get at a seven and a half percent. By the way, we look into you know our portfolios are running very, you know, very elevated inflation. As I mentioned, they’re running about seven years of of duration. Sorry. and we looked at like how high would 10 year need to go for for.

that to to erode away the yield that the portfolio is generating on top of what’s priced in the 10 year would need to go to about 6.3%. Right? So, you know, I I like to think about it in terms of what asset class do you have today that you have this bell curve of distributions of outcomes where the median is centered at 7.5%. And if rates were to go to say six and a half, you’re basically flat for the year.

And if rates were to go to four, you’re up 14%. You’re up 15%. Right. So, you know, that’s that’s why we like bonds so much right now. The base case is so attractive. You so much is priced in in terms of these fears of inflation that it none of that materializes. Or if you get a surprise on weak growth on or or less resilience or less sticky inflation, you could see easily you could see the 10 year goal 50 basis points lower.

And you know, and and your bond fund is up three percent, four percent. so anyway, that’s that’s why for us it’s a it’s it’s a very attractive buying opportunity right now, just like any other market that you see when they they dip a little bit, you see that there is there’s there’s buying opportunities.

Max Casey (28:13)
Yeah, and it I think that’s I think that’s a a good point and an important point to remember is that the starting yield that you know you enter at is is typically very closely correlated with the end return that you’ll get on an on an annualized basis. And that’s why, you know, across Evans and Partners, clients and allocations, we have been advocating to increase allocations to the fixed income, floating rate, fixed rate universe.

Given that the return outlook has improved so so significantly. Now obviously PIMCO invests across a broad suite of sub asset classes. You know, you’ve mentioned duration, which we typically classify as as government bonds. But kind of thinking about, you know, government bonds, credit, securitized, high yield credit as well. Where are you seeing the most interesting

opportunities at the moment and and potentially, you know, hopefully you can put some context around what you would think returns will look like for underlying investors that are in those asset classes as well.

Esteban Burbano (29:21)
Yes, yes, yes for sure. so you know, I I I would r reiterate what you just said. You know, we we do think that yields are very highly correlated to total returns. By the way, this is this isn’t just math, right? Essentially when you buy a bond, you’re getting a coupon and you praise and you pay a price for that for that bond. If you take the coupon divided by the price, you get a yield. and assuming that the fund doesn’t that the the bond doesn’t default, you’re most likely to get your coupon.

Right. So the the strategy here is how do you get to a portfolio that is giving you the highest yield possible while avoiding defaults? while avoiding credit risk, basically. And so that’s what we’ve been trying to do in our portfolios. Now, our main strategy is one that invests across the world. You know, we’re a global fixed income manager. We have over two trillion dollars in assets. our global multi-sector portfolio.

Can invest across regions, across markets. And so this this really would be the best representation of if you give PIMCO $100, how will we allocate it across the entire bond market today? there’s three key levers that you can pull at the portfolio level. You know, think about it as this as the three key risks in the portfolio. The first one would be interest rate markets, second one will be credit, and the third effects. We don’t do that much effects, but

Really, the portfolio is being driven by how much interest rate risk do you have and how much credit risk do you have. we run a portfolio on our global multi-sector strategy, our income strategy, with a target volatility of somewhere between five to seven percent. So that’s our risk budget. And historically, that’s been allocated two-thirds in credit, one third in rates. Today, we’re overweight duration, we’re overweight rates.

And so, okay, so that’s I’m just giving you sort of like the framework of how we think about allocating risk across the bond market, but in this kind of as esoteric terms, you know, duration, credit. But as we go into investments, like how do you actually put this portfolio to work? You can think about the bond markets really as having these two types of assets. You have the high quality bond markets. This will be things like sh you know, treasury markets, agency mortgages.

That asks as a risk-off hedge. You know, these are things that people buy when they want safety. They they’re worried about the economy breaking and they want something to protect them. And then you have your risk-on assets. You know, this will be your corporate credit, investment grade, high yield, emerging markets, bank loans. These are things that people go to when they want to increase the yield in their portfolio, right? And they think the economy is going to fine. Right? They’re getting compensated for this.

so when you when you take on these two types of assets today, we’re overweight the high quality assets. It’s not because we think there’s a recession coming, but because the sell-off in interest rates has been much more aggressive than in the credit markets. And therefore the value in rates is higher today. The number one sector that we like today would be the agency mortgage back security market.

So let me give you a little bit of a summary of what those are, because I I know, especially outside of the US, when people think mortgages, sometimes they say, Well, wait, what are you talking about here? What exactly are you talking about? Remember, the US has a very large bond market, it’s the second largest bond market in the world, really, after US Treasuries, about $8 trillion in size. What makes these bunk unique is that the bond is guaranteed by a federal agency, by a US federal agency, meaning the US investor.

Your principal and interest rate payments are guaranteed by a federal agency. The agency itself is backstop by the US Treasury. And so, you know, you as an investor really have the backstuff from the government in terms of your investment. Now, these bonds earn a spread over treasuries. They give you a little bit more yield than a Treasury government bond, because mortgages in the United States can be prepaid at any point in time. So it’s something that that

you know, most most homeowners enjoy in the US is the ability to to basically prepay back to the bank at any point in time without penalties. And so because of that, because of that dynamic, investors need to be compensated for the uncertainty of when they’re going to get their money back. And if I buy a 10 year treasury, I know exactly when I’m getting my money back in 10 years. If I buy a mortgage bond, I know I’m getting my money back, but the speed is going to change.

depending on how quickly people are prepaying their mortgages, right? Depending on the level of interest rates. If rates go up, fewer people prepay. If rates go down, more people refinance their mortgages and I’m getting more of my money back. And so typically because of that, you get about a half a percent more yield in a mortgage than in a treasury bond. But today you’re getting about a hundred basis points, one percent, double

What if you guess historically? And it used to be much higher, by the way, over the last two years. So that’s gonna be a our number one trade because A, you have a lot of liquidity in that market, it’s so big, it’s so liquid, it’s so high quality, the backstab from the government, and you’re getting a spread that is very attractive. That would be number one. Number two would be assets in the in the asset backed security family, asset backed security sector that are still trading at spread levels higher than corporate credit.

Than IG corporates. So by way of reference, IG corporates are trading at about 75 basis points or 0.75% of spread over treasuries on average. you can get asset back securities that have better credit quality. So instead of being single A rated at triple A rated at 110, 120. So you’re getting about a half a percent more in yield. We love those assets. I mean, why do they exist? Because, you know, out of the

financial crisis really, like many of the banks that that that provided this type of lending, like retrenched. And so it created more opportunities for investment managers like Pimco to provide that capital. And so you have you have A, you know, higher spreads, B a pool of assets. This will be things like student loans, car loans that people are prepaying, that is backing your investment. Typically

those pools will be overcollateralized, meaning that the value of these pools is higher than the amount of the principal on the bond. And then also, some of these bonds also have what’s called credit enhancements, meaning that, you know, there are other investors that take first losses. They get pay higher yields, but they take first losses. And so we we we see it higher in the capital structure where we have a more consistent set of cash flows. You know, somebody else is taking the first losses from defaults of this mortgage on these pools.

And we get paid basically first. And we’re still getting better spreads than IG corporates. And so that’s the thesis. It’s like you have something that is more higher quality, more resilient, and still better yield. You know, again, because this much this this this this market is a little bit more complicated than IG corporates. Therefore, we like that. So number one would be mortgages, number two would be asset back securities. And then number three, you know, we like

We do have corporates in our portfolio. When you look at our multi-sector strategy, you know, about 15% of it is in IG corporates. but what’s what’s the distinction that I would make is that instead of just buying, you know, indiscriminately in the secondary market, like corporate bonds, what we do at PIMCO is recognizing that there is this huge capital cycle, is negotiating directly with issuers.

To provide them with capital and get better concessions, not term in terms of yield and in terms of better protections. And so something that I do want to explain is you know, the way that the bond markets work is very different than the equity markets, for example. bonds expire, they mature, you know, they have set maturities. And most issuers, when those bonds mature, they come back to the market. They’re not paying down their debt, they’re rolling over their debt.

And so what that means is the bond market is constantly issuing new debt. And you know when those new issues are coming, because you know, let’s say company XYZ has a bond maturity next year, you know they’re coming to market anytime between now and next year to to roll over their debt. And so it’s it’s almost like a market that is where there’s constant IPOs, right? And at PIMCO, we benefit from the fact that because of our large asset base.

We can we look at the companies that we like, we we look at you know which bonds they have outstanding, when are those bonds expiring, and we can call them and say, hey, you have a billion dollars of debt expiring next year. You have two options. One, you go out and you hire an investment bank, you go out on a roadshow and you try to raise up the capital, or maybe we can negotiate a deal and we provide you that capital up front.

And here are the terms of the the here’s what we will require in terms of you know underwriting protections, legal protections in case something goes wrong, as well as concessions on the yield. We want slightly higher yield than your debt is trading in the secondary market. And oftentimes we’re able to negotiate directly with issuers and get better terms. And so that’s how we are accessing the corporate market, that’s how we’re accessing the high-yield market.

Even emerging markets, we can negotiate directly with countries. We’ve done that. We did that with Colombia and even a couple of the Middle East countries this year. again, not because we’re saying a blank statement on credit, but because there are deals to be made when you can buy wholesale, right? And negotiate directly with the issuers.

Max Casey (39:29)
And just kind of getting to a couple of the questions that we’ve had come through. we’ve just had a couple just on performance of some of the funds, predominantly the income fund. I think most most people on the call will be investors in in the income fund. We have had a a s a slight kind of negative impact on the on the asset value of the income fund recently. Do you just want to unpack

What’s what’s driven that? But then also where the portfolio sits today. You’ve spoken about, you know, sector positioning, but maybe just remind everyone where we sit in terms of a yield basis, an average credit quality basis, just so we have a a guide for what returns could look like going forward.

Esteban Burbano (40:14)
Right. So these mortgages are double A rated. a lot of the asset back securities are triple A rated, right? A lot of our corporates obviously will be investment grade. We have very little in lower quality credit markets, you know, less than fifteen percent. So seven you know, eighty percent of the portfolio is very high quality. as a result, the average credit quality of the fund is about of the portfolio is about double A minus. We’re sitting on a yield today of around eight percent.

We have a duration of six point eight years. You know, the the majority of that duration is in the in in the in the United States. Out of that six point eight, about five point two is in the US. out of that five point two in the US, the majority of it’s in the intermediate part of the yield curve. So when you hear Pemco, we’re adding duration. We’re not buying 30-year treasuries, we’re buying duration at the intermediate part of the yield curve. You know, that five to fifteen portion of the yield curve.

We have very little exposure at the very long end at the 30 year point. We we don’t really we’re more neutral there, so we don’t have a lot of exposure. So we like duration, six point eight years, most of it in the US, 5.2 of the 6.8 are in the US, the belly of the curve in the US. We also like some other interest rate markets, Australia, Canada, UK, where we are we’ve added slightly. So for example, in the UK, we have about 0.8 years. In Australia, we have about 0.4 years.

As a way to diversify our exposures, we recognize that countries have different growth speeds, different inflation dynamics, different central bank policies. The RBA, of course, has been more aggressive hiking rates this year. you know, and so there’s some value, same, same thesis in terms of rates are high because of inflation concerns. And economies, perhaps some other economies can be more vulnerable than the US.

And therefore, there could be more room for rates to stabilize and come down. And so adding a few exposures there outside of the US to diversify. you know, that’s been the sort of the the the main exposures in terms of interest rate markets. And as I mentioned, from a sector exposure perspective, about half of the portfolio would be in you know mortgages, a little bit of caps in the portfolio. So treasury inflation protected securities.

As a way to sort of capitalize on high real yields today. So that’s about 50% of the portfolio. About 30% would be in these corporates, asset backed securities, and also other sort of high quality credit. And about 15% would be in high yield, and bank loans. Those will be the three sort of weakest segments of the market where we have very little exposure across across our portfolios. you mentioned performance. So what has driven performance?

You know, it’s you know, the main factor of course has been a a reset on rate expectations. So the ten year has moved eighty basis points, and that has detracted, I would say about one and a half percent to returns of the funds. So, you know, depending on which share class you’re looking at, hedged, et cetera, fees, et cetera, you know, the portfolio is down about one percent on a year to day basis. And so the majority actually all of it has been

the moving interest rates. Right. So that has contributed negatively. And then on the positive side, the carry of the portfolio, right? The fact that we had that yield that is accruing to the fund, especially those spreads haven’t moved. And so we’ve been accruing positive returns from our exposure to those mortgages, asset backed securities, corporates. And so the the the negative move on on rates

has basically detracted about two points. And the carry on the spreads and other sectors have contributed one point. And so that’s how you get to negative one on a year to day basis. Now, it doesn’t feel great, I’ll be honest. Like obviously like we were hoping to capture the yield at this point of of of the year. But again, that has to do I I I I I do think that the environment that we are today has has enabled this very attractive entry point for us.

to sort of accrue positive returns at an even faster speed going forward, which is why we continue to be very, very bullish on bonds.

Max Casey (44:46)
That’s great. I’m I’m conscious that we’re pushing up against our against our allotted time. I I think there is plenty of things we could we could have unpacked even further. It does look like very dynamic but also very interesting you know, backdrop for fixed income returns kind of going forward. but you know, given we are up on time, I I will call it

quits there. I did just want to remind everyone on the call that if you did have any questions, p feel free to send them through to your advisor. We will do our best to get those answered either internally by the team or we can get comment from from Pimco as well. But I’d also like to thank everyone for joining on the call. But more importantly I’d like to thank Esther Barn for joining us.

Very insightful, very valued, and appreciated. So again, thank you, Esther Barn. and hopefully we can we can have a chat, you know, sometime in the future.

Esteban Burbano (45:49)
Thank you so much.