With the end of the European Central Bank’s asset purchases looming large, European fixed income investors are now facing many challenges. Besides domestically low yields, compressed valuations and the potential for a market correction, the cost of currency hedging on global bonds has increased significantly over the past year. Add the gradual tightening of monetary policy and global trade and political conflicts and many investors will need to navigate an increasingly uncertain environment ahead (see Figure 1).

We believe investors will likely consider three approaches:

1. Reduce risk and wait for better entry points. In this case, investors can consider short-term or low duration portfolios of high quality bonds. This approach helps to protect against higher market volatility, keeps liquidity high and maintains “dry powder” for capitalizing on opportunities down the line, although investors may sacrifice valuable returns.
2. Choose high quality duration from the major global bond markets given its historical role as a “safe-haven,” or hedge, during market selloffs. Even though sovereign bonds yield very little right now, high quality government bonds – or hard duration – offer important characteristics over the long run that may provide portfolios with the desired balance.
3. Take a more flexible approach to bond investing that is not tied to a benchmark, with the objective of actively navigating the changing fixed income environment and dynamically capturing available opportunities. With this approach, investors should determine whether their objective is to reach a certain income level or an absolute return target over a certain time.

The advantages of flexibility

Investors accustomed to, or who favor, a more traditional approach to fixed income investing may lean toward the first two options. In our view, however, a flexible approach to managing key fixed income risk factors such as duration, credit and currency risk can enable European investors to navigate through the current environment and achieve attractive yields — even when hedging back to euros. Furthermore, a globally oriented bond portfolio can potentially provide geographical diversification, greater alpha opportunities and higher downside cushion in an economic slowdown.

There are several approaches to global flexible investing, but we see two distinct strategies as viable options to play important roles in investment portfolios over the coming years: Investors need to determine whether their objective is 1) to focus on a dynamic strategy with an absolute return target over market cycles, or 2) to reach a consistent income level. The choice depends on the investor’s risk/return profile and objectives. Flexible strategies including the Dynamic Bond Strategy and the Income Strategy may be solutions for investors attempting to navigate the late stage economic cycle.

Investing for long-term return

The Dynamic Bond Strategy seeks attractive return over the long term, consistent with preservation of capital, and draws on the full spectrum of PIMCO’s expertise across global fixed income markets. Importantly, the strategy employs stringent risk management to aim for attractive risk-adjusted returns over a market cycle with volatility similar to that of core bonds. We have removed the typical focus on traditional bond benchmarks and instead diversify portfolio exposures across global interest rate, credit, volatility and currency markets, which allows us to implement PIMCO’s highest-conviction investment ideas.

The strategy has the ability to be very flexible. It can blend structural and tactical approaches, taking defensive positions today and then becoming more constructive when the market environment changes. Its dynamic nature, flexibility and wide duration range (-3 to +8 years) allow the strategy to exploit opportunities and hedge against risks through long and short positions that reflect our views on fundamental risk factors. The strategy can take short positions in credit, for example, when the macro environment is very unfavorable or valuations are so stretched that negative returns in credit seem likely. Currently, the strategy has a defensive tilt in duration with a focus on relative value, and it is selective in high quality credit. When more opportunities arise in credit, however, the strategy can re-engage quickly, while maintaining an overall investment grade portfolio quality.

Figure 2 shows how actively a dynamic strategy can steer tactical exposures to factors like interest rate risk (duration).

The strategy implements PIMCO’s high conviction ideas in a measured way and draws on a wide range of return sources, aiming for a smooth return profile and low correlations to other asset classes. The Dynamic Bond Strategy has the flexibility, the broad discretion and the risk management in place to complement core bond allocations and is designed to withstand even times of rising rates, as we have seen in the first half of this year.

Investing for income

Investors seeking a steady income stream while still protecting their capital should consider a different approach to flexible bond investing. The Income Strategy at PIMCO was designed exactly for this purpose: to generate current income while preserving capital, with capital appreciation as a secondary goal. It is a multisector approach that aims to meet its income objective in any market climate, while maintaining the overall high quality of the strategy.

The Income Strategy is divided into two broad components. The first consists of higher-yielding assets, such as non-agency mortgage-backed securities, which we expect to perform well if economic growth is stronger than predicted. The other component is invested in higher-quality assets that are likely to perform well if growth is lower than expected, thus acting as a strong diversifier and helping to protect against downside risk. In the current environment, we favor U.S. Treasury bonds for the higher-quality portion of the Income Strategy, given their higher yields and the Federal Reserve’s lead over other central banks in raising rates.

To reach high consistent income, we seek out the best income-generating ideas, depending on the environment, and target multiple sources of income from the global opportunity set. The strategy is structurally exposed to credit in meeting its objective: At the moment, we are opportunistic in corporate credit, favoring housing-related securities and financial companies and taking select positions in high quality emerging market debt to add yield. We also see occasional opportunities in what we refer to as “bend-but-not-break” assets that will likely perform well even in more challenging environments.

Bringing the two portfolio components together, the Income Strategy stays broadly diversified and avoids single positions (either in higher-yielding or higher-quality assets) dominating the return and volatility of the strategy. Figure 3 shows the strategy’s diversification and how it has adapted to different environments over the past several years.

Since its inception, the Income Strategy has achieved its goal of offering investors high consistent income with low volatility. Flexibility, liquidity and diversification were the essential drivers of past performance, and we are convinced that the underlying philosophy of the strategy is the right one to help clients achieve consistent high income without sacrificing liquidity or quality.

The bottom line

The current environment of low domestic yields, upward-trending global interest rates and recurring bouts of volatility is challenging many investors in Europe. The good news is there are strategies for today’s uncertain fixed income markets. While limiting interest rate risk or allocating to high quality bonds are viable options, we see a flexible investing approach as the smart way to navigate changing bond market conditions. PIMCO’s flexible bond strategies, including Dynamic Bond and Income, are designed specifically to meet many investors’ goals of long-term return and steady income.