How 'BOND' Navigates Fixed Income Waves

David Braun is a portfolio manager at PIMCO, helping run the $2.2 billion PIMCO Active Bond ETF (BOND). Here, Braun shares his outlook for the fixed-income market as well as what he sees as the biggest risks facing bond investors today. He also tells us how PIMCO tilted BOND toward income, a shift that makes the ETF no longer merely a version of its PIMCO mutual fund counterpart.

ETF.com: What’s your outlook for fixed income?

David Braun: Our base case is pretty consistent with consensus. The global synchronized growth we've seen in 2017 is going to continue this year and perhaps accelerate, with a backdrop of low but rising inflation globally.

We're in consensus, but there are risks to that base view. As a bond investor, you need to be aware of these risks, especially in an environment where bond valuations and credit spreads are relatively tight and there's not a lot of room for error. Everything is almost priced to perfection for that consensus scenario.

One risk has to do with fiscal policy. The U.S. is in the ninth year of expansion, and we've got large fiscal stimulus coming in the way of government spending and tax cuts. You could argue that, at this stage in the expansion, the last thing you need is a fiscal stimulus package. The risk in that is that we're pulling forward future dry powder on the fiscal side. This is going to add about a $1 trillion-plus to the federal deficit over the next 10 years—money the government will presumably not have to spend should we trip up as an economy.

The second risk is that we could see an inflation overshoot. Inflation has been below central bank targets for the past eight years. But labor markets are at relatively tight levels. Commodity prices are recovering. On top of that, throw in fiscal stimulus, when the economy's growing at or above its potential already. It could be a recipe for both wage inflation and price inflation to pick up and potentially overshoot central bank targets.

The third risk is monetary policy overshoot. If you've got an economy growing faster than its potential, if you've got inflation overshooting you could see central banks go faster than the underlying economy could handle, overshooting on rate targets, leading to a cyclical rise in rates that goes above where they should typically be.

ETF.com: Would you argue that the relatively flat yield curve is the bond market telling us that near-term growth is all well and good, but there could be trouble in the horizon, longer term?

Braun: We don't believe the yield curve is going to invert. We believe it will actually be steeper. You've got an economy growing at or above potential, plus fiscal stimulus on top of that. You've got inflation on the rise. And you've got central bank monetary policy shifting from historic easing to a gradual tightening phase. All of those things should be a recipe for return of term premium, return of inflation expectations, which should cause the curve to steepen.

The Fed and other central banks realize that an inverted curve is not really healthy for anybody. The fact that the curve is relatively flat could be attributed to a lot of things, like the fact that the U.S. Treasury said a lot of its issuance for the next year will be frontloaded more in shorter-term Treasury bills rather than longer-term notes. There’s also the ongoing global quest for yield, and the fact that the longer part of the U.S. yield curve is still relatively attractive on a global landscape.

ETF.com: In the ETF space, replicating the Bloomberg Barclays Aggregate U.S. Bond Index is a very popular strategy. But duration in the Agg is near all-time highs, and yields near all-time lows. In a rising rate environment, are these passive investors going to be in trouble?

Braun: Yes, a lot of the passive money goes into ETFs tracking the Barclays Agg, but this is not your grandfather's Barclays Agg. It has significantly changed over the last decade. The biggest change is the duration.

Pre-crisis, the duration of the Agg was around 4.4 years. Now it's around 6 years. That’s a meaningful increase, because the borrowers that comprise the Agg—mainly U.S. Treasury, U.S. households with mortgages and U.S.-based corporations—have all pushed out the maturity structure of their debt given the low rates we've seen.

Sadly, on the other side of that, investors tracking that index are doing the opposite: They're lending their money at longer and longer maturities, and they're actually getting less and less yield.

Back when duration was 4.4 years, yield was nearly 5%. Now the yield's barely 2.7%, so you’ve expanded 1.6 years and you've lost 130 basis points of yield. At no point has the indexer stretched so far for so little yield.

The other thing is the corporate component in the Agg. It’s grown from around 21% to 25-26% now. Not scary as a headline, but if you drill in and see how much of that has shifted to lower-quality parts of the corporate universe, it’s alarming. A decade ago, 35% of that corporate universe in the Agg was BBB; now it’s almost 50%. The leverage has increased quite a bit.

ETF.com: How is the PIMCO Active Bond ETF (BOND) positioned for all this? In the past 12 months, BOND has outperformed the passive iShares Core U.S. Aggregate Bond ETF (AGG), the active SPDR DoubleLine Total Return Tactical ETF (TOTL) and the smart-beta Fidelity Total Bond ETF (FBND).

Chart courtesy of StockCharts.com

Braun: Last year, BOND, net of fees, returned 4.75% in an environment where rates largely didn't move. We’ve shifted BOND to be run more for income. About a year ago, we shifted the strategy to be less macro, less explicitly total return focused, and more focused on stability and robustness of income distribution. It's now out-yielding the Agg by about 100 basis points, at about 3.7%.

Our holdings in BOND look very different from the Agg. We're not slaves to the index.

For example, we have about 8% in high yield. High-yield spreads are relatively rich, but we have a bottom-up credit research approach that allows us to play offense with these credits. A lot of people ask me, “Are you constructive on high yield?” Not generically. We're constructive on our ability to identify high-yield diamonds in the rough.

Second, we have close to 15% of nonagency-securitized product, including nonagency mortgages. Housing fundamentals continue to improve. The nonagency mortgage universe is in net negative supply. There's a technical benefit there.

ETF.com: As a firm, PIMCO is product-agnostic. You have both a mutual fund and an ETF version (BOND) of a total-return strategy. Should we expect the mutual fund and ETF portfolios to be identical?

Braun: We are product- and vehicle-agnostic. Some investors prefer ETFs over ’40 Act mutual funds, and some don’t. Who are we to tell them what they should prefer? It just happens that, in the ETF space, our customers wanted the ETF to be more geared toward income delivery. If you think about who's using ETFs, it's largely people in their nontax-deferred accounts, whereas the mutual fund may be in a 401(k) or an IRA.

The ETF universe asked us for more income, so we pivoted away from being simply a clone of the total-return mutual fund to more of a stand-alone product, the emphasis being on income.

Also, if you look at BOND, it's trying to deliver our best ideas in a much simpler format; so, less use of derivatives, of nondollar securities and currency forwards in the quest for a more stable distribution yield because derivatives can add volatility. That's another difference on the income focus in the ETF wrapper versus the mutual fund. But at the end of the day, if one does well, the other should do well.

Contact Cinthia Murphy at [email protected]