“Tremendous Opportunities” Ahead for Fixed-Income Investors: Manager

Money to be Made on Mortgages

An investment in agency MBS securities offers about 175 basis points (one-hundredth of a percent) additional yield, versus investing in U.S. government treasury bonds. “Today, there are dramatically wider spread levels, compared to what you would typically receive. Investing in corporate credit spreads means you will get around 130 bps over treasuries. But you are getting wider spreads with agency MBS securities today, compared to investing in investment-grade credit,” says Murata, who has earned a PhD in engineering-economic systems and operations research at Stanford University, as well as a J.D. from Stanford Law School. “Typically, there is less spread with MBS instruments, compared to investing in corporate credit. That’s why we find that there are compelling opportunities in agency MBSs.”

Big Buyers Out of the Market Makes for Better Prices

Murata points out that there are differences in the so-called market technicals, in both the corporate credit space and agency-backed MBS market. “In the agency-backed MBS space, two of the largest buyers have essentially left the market. The Federal Reserve was buying very aggressively in 2020 and 2021. But with quantitative tightening, they have allowed their balance sheet to roll off. In effect, the Fed is not buying agency-backed MBS securities today. The banks were also buying agency-backed MBSs when they received a lot of additional deposits.” However, he notes, with the dramatic sell-off on rising interest rates in 2022, the banks have encountered severe unrealized losses on many of their previously purchased agency-backed MBS securities. The banks are also having deposit outflows, and they are not buying agency-backed MBS securities as well. “So, the larger buyers have left the market. Valuations are more attractive today. But we think that given the strong credit quality and strong liquidity, this is an asset class that can provide attractive returns over a long-term holding period.”

In contrast, in the corporate credit market, Murata points out that many companies found it attractive to borrow money when interest rates were low in 2020-2021. “But with the dramatic increase in interest rates, many companies have pared back their discretionary borrowing. They might still be borrowing money to pay maturing debt, for instance. But in general, many companies are not finding that this is a compelling time to borrow to invest in growth projects or buy back stock, given the level of interest rates. The market technicals are quite strong in the corporate credit space.”

While volatility is likely to remain in the market, Murata believes that investors can still withstand the volatility and earn attractive returns, based on the fact that yields have increased in the fixed-income space.

Year-to-date (November 27) PIMCO Monthly Income F has returned 4.12%, versus 3.15% for the Multi-Sector Fixed Income category. On a longer-term basis, the fund has been a top-quartile performer. Over five- and 10-year periods, it has returned an annualized 2.24% and 3.51%. In contrast, the category returned annualized 0.71% and 1.45%, respectively.

“It’s been a challenging year in the fixed income space. We have had quite a significant sell-off in interest rates, credit spreads and volatility. But given a significant increase in the yield-to-maturity in the portfolio, an elevated yield can protect the portfolio during the more challenging times in the marketplace,” argues Murata. “That’s why we think it’s very exciting to be investing in the fixed income space this year.”

The fund is somewhat defensive since it has a duration of 4.5 years, compared to 5.5 years for the benchmark Barclays Global Aggregate Bond Index C$. As of Oct. 31, the gross yield to maturity is 7.51%, before fees.

Higher Yields for Higher Risks

Still, some risks lurk in the market. “One of the largest risks that we face is a scenario where inflation turns out to be higher than anticipated, and the Federal Reserve and Bank of Canada look to raise rates,” says Murata. “You can see volatility in terms of interest rates selling off and credit spreads widening. That is a possible scenario that could occur and what we are most concerned about today. So an elevated yield in many fixed income portfolios can protect against this type of environment. But that is a risk [of higher-than-expected inflation] we continue to be concerned about.”

As a member of the team, Murata says they are not only concerned about return on capital but also return of capital. “What we want to do with the portfolio is to construct it in a way that it is well-protected across a wide variety of economic scenarios. This is likely to be a volatile regime in fixed income. Geo-political risks are elevated today. But there are also lots of attractive opportunities in the fixed income space. We want to take advantage of the flexibility within the mandate and our resources and be able to capitalize on them.”

From a strategic viewpoint, the managers look to generate attractive levels of income, while protecting the portfolio against downside risk. The key thing is having a balanced portfolio that is a mixture of higher-yielding assets that should do well when the economy is performing, as well as higher-quality assets, such as government bonds and MBS securities, that can perform well should the economy weaken. In addition, a portion is set aside in higher-yielding securities in the event the economy weakens. Murata calls these instruments “bend-but-don’t-break investments.”

“It would be ideal if we just invested in one bond and had a guaranteed and elevated return across all scenarios. But it’s very difficult to find those types of investments,” says Murata. “So, we have one portion devoted to dealing with a weaker growth environment and another portion devoted to higher-yielding assets that we believe will do well in a stronger growth environment. That being said, there could be volatility from a price perspective if economic conditions end up weaker than anticipated. What we are trying to do in the higher yielding part of the portfolio is hold positions that, although there may be volatility from a pricing perspective, we think that over time we will avoid a permanent impairment of capital. That’s what we call a bend-but-don’t-break investment.”

Get the Cash Flow and a Full Backing

A good example of that, Murata adds, is investing in non-agency-backed MBS securities. Although these are bonds that are backed by residential loans which do not have government guarantees supported by the U.S. government, investors depend on the cash flow from the loans. “In many cases, the property is worth far more than the loan on the property. So, the loan-to-value ratio may be less than 50%”

Using a blend of top-down and bottom-up analysis and backed by over 200 portfolio managers around the world, Murata and his colleagues have been shifting from higher-yielding assets to higher-quality assets mainly because of a significant increase in agency-backed MBS securities, which have increased in allocation for the past couple of years, combined with decreasing exposure to emerging markets and corporate high-yield bonds. As of Oct. 31, higher-quality assets, such as agency MBS and government treasuries, accounted for about 56% of the portfolio, while 26% is represented by higher-yielding assets such as non-agency MBS securities. The remaining 18% is in assets such as investment-grade credit and non-US asset-backed securities. In total, there are about 1,500 bond and MBS holdings.

Looking ahead, Murata reiterates that while volatility may be a permanent fixture in the marketplace, he expects a total return of mid-to-high single digits in the next nine to 12 months. “What we are trying to do with this strategy is generate enough income to pay out the distribution yield but also some capital appreciation on top of that,” says Murata, adding that in the past there have also been challenges and the yields in various portfolios have tended to increase. “Over time, the starting point in yields has been a good indicator of what compound returns might be over a five-year holding period. Returns may not be strong immediately. But over a long-term period, when there is a sell-off in rates and widening credit spreads, it’s an attractive time to be invested in fixed income.”