Bouts of market volatility in the past year or so have led to a resurgence of interest in flexible or dynamic bond strategies. We believe strategic exposure to these types of benchmark-agnostic or opportunistic bond strategies, if well designed, can be a beneficial complement to a core bond portfolio in periods of higher volatility, a characteristic of the late-cycle environment we’re facing today. They can help capture fleeting investment opportunities while potentially sidestepping steep declines during periods of sudden volatility.

That said, not all benchmark-agnostic strategies are created equal, and it’s important to fully understand the scope of a given strategy, the investment processes by which it seeks to capitalize on shifting markets, and – critically – its approach to risk management.

Avoiding investment whiplash

Strategic allocations to benchmark-agnostic strategies are timely today, especially those with a focus on providing both flexibility and resilience – qualities that become more valuable in unsettled markets. By most measures, it appears the global economic cycle is in its later stages, and the resulting volatility and rapid shifts in both risk and opportunity can give investors in traditional benchmark-constrained portfolios a kind of investment whiplash.

Well-designed dynamic or opportunistic bond strategies, on the other hand, may benefit from greater investment flexibility to defend against scenarios that are challenging for traditional strategies, while potentially capitalizing on market shifts. For instance, a wider duration range or the ability to take long or short positions may help navigate a wider variety of market conditions relative to traditional strategies.

In particular, during periods of market volatility, flexible strategies may:

  • Make an overall portfolio more resilient by reducing directional risk, lowering beta exposure to duration and credit risk, and tilting toward relative value opportunities
  • Seize opportunities that arise in volatile periods, providing debt capital to liquidity-hungry issuers when they are most in need (i.e., when they are more willing to pay a premium to issue a bond)

Striking the right balance

The investment universe of flexible strategies encompasses a broad mix of approaches that span the global bond markets, from credit to mortgages, macro to rates. However, many suffer from a fundamental (and ironic) weakness: the very freedom that a flexible mandate provides. Without a limiting benchmark or framework in which to exercise that freedom, flexibility can result in unpredictability, with some approaches assuming too much directional risk or focusing too heavily on a single predominant driver of performance.

Credit-dominant approaches are one such example. They focus on credit risk and generally maintain low duration, which can pay off when rates rise. However, their single-minded overweight allocations to (usually higher-yielding, higher-risk) credit markets typically bring high correlations to equity markets, which can cause large drawdowns when equities sell off. We saw a glimpse of that in the fourth quarter of 2018, when most credit-oriented funds could not avoid drawdowns.

Strategies that fall prey to such directional drawbacks may not fulfill their strategic role of providing a flexible complement to a benchmark-dominated portfolio. To be successful, we believe flexible strategies must strike the right balance between defensive positioning in volatile markets and the opportunistic pursuit of alpha over the long-term – all within a well-understood investment framework.

Dynamic solutions in practice

PIMCO’s suite of more flexible, dynamic strategies have clear areas of opportunity in which to operate, including credit markets, interest rate markets, or other parts of the global bond market. But the key in each is its ability to harness the trade-offs between return-oriented trades and risk-mitigating allocations within each asset category – for instance, in the context of mortgages, between higher-yielding securitized credit and lower-risk agency mortgages; or in credit, between, say, securities rated above BB or below BB. 

In the case of our most flexible global multi-sector bond strategy, we seek to strike the right balance between strategic exposures across the major fixed income return drivers (beta) and more tactical, relative-value-oriented opportunities in rates, credit, and currency markets.

When determining exposure to broad fixed income risk factors, such as duration and credit risk, we look to our top-down macro investment process to guide the appropriate exposures given the current macro conditions. Rather than swinging for the fences and trying to time the markets, as many traditional benchmark-oriented managers may do, we determine a forward-looking target band and equilibrium point for these risks, within the broader parameters of the strategy (see Figure 2). We then scale exposures tactically in response to shorter-term fluctuations. When our assessment of interest rate and credit betas changes significantly, we adjust these targets accordingly.

Figure 2 shows a graph, marked by amount of credit on the Y-axis and duration on the X-axis, and three time periods represented by ovals or a circle. A horizontal oval on the bottom right represents the post-2013 taper tantrum, marked by a focus on higher duration and relatively less credit exposure. High up on the left, a vertically-oriented oval represents the period December 2015-January 2016, with lower duration and more credit exposure. In 2018, represented by a circle, credit exposure is lowered, and duration increased, and it’s situated between the two ovals representing the other time spans. Additional text below the graph gives more details for each time period.

The remainder of the portfolio seeks to capture bottom-up relative value and idiosyncratic opportunities across currencies, rates, and other sources of return. During environments when we believe market betas don’t offer value, the portfolio can tilt entirely toward relative value strategies.

This approach helps enable us to employ flexibility in a disciplined, range-bound, and risk-aware manner. 

Flexible, not unpredictable

Regardless of a flexible strategy’s investment focus, what’s critical, in our view, is that it maintains carefully constructed, market-determined (and thus time-varying) guard rails around a target range, all within the broader parameters of the strategy. Within this band is an equilibrium point between return-seeking and risk-mitigating factors. 

Such a framework allows a flexible strategy to adjust its relative pursuit of risk-mitigating or return-maximizing opportunities as market conditions inevitably shift. It allows investors to participate in risk-on markets when conditions warrant it and to mitigate risk when volatility spikes, although there is no guarantee that such an absolute return-oriented strategy will fully participate in or avoid market turns. The result is a strategy that seeks a balance of market participation and defense, with exposure to both return and risk varying within a targeted range over time.

Simply put, flexible strategies should not be unpredictable. Constructed appropriately, dynamic bond strategies can potentially provide an attractive long-term complement to core allocations across markets and over time.

The authors would like to thank Avi Sharon for his contributions to this article.

For insights into how we assess the key forces that will shape global economies and financial markets over the next three to five years, see PIMCO’s Secular Forum.

The Author

Berdibek Ahmedov

Product Strategist, Global and Real Return

Esteban Burbano

Fixed Income Strategist

Brian Koscielak

Fixed Income Strategist

Related

Related Strategies

Disclosures

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PIMCO Europe Ltd (Company No. 2604517) and PIMCO Europe Ltd - Italy (Company No. 07533910969) are authorised and regulated by the Financial Conduct Authority (25 The North Colonnade, Canary Wharf, London E14 5HS) in the UK. The Italy branch is additionally regulated by the CONSOB in accordance with Article 27 of the Italian Consolidated Financial Act. PIMCO Europe Ltd services and products are available only to professional clients as defined in the Financial Conduct Authority’s Handbook and are not available to individual investors, who should not rely on this communication. | PIMCO Deutschland GmbH (Company No. 192083, Seidlstr. 24-24a, 80335 Munich, Germany) and PIMCO Deutschland GmbH Swedish Branch (SCRO Reg. No. 516410-9190) are  authorised and regulated by the German Federal Financial Supervisory Authority (BaFin) (Marie- Curie-Str. 24-28, 60439 Frankfurt am Main) in Germany in accordance with Section 32 of the German Banking Act (KWG). The Swedish Branch is additionally supervised by the Swedish Financial Supervisory Authority (Finansinspektionen) in accordance with Chapter 25 Sections 12-14 of the Swedish Securities Markets Act. he services provided by PIMCO Deutschland GmbH are available only to professional clients as defined in Section 31a para. 2 German Securities Trading Act (WpHG). They are not available to individual investors, who should not rely on this communication. | PIMCO (Schweiz) GmbH (registered in Switzerland, Company No. CH-020.4.038.582-2), Brandschenkestrasse 41, 8002 Zurich, Switzerland, Tel: + 41 44 512 49 10. The services and products provided by PIMCO (Schweiz) GmbH are not available to individual investors, who should not rely on this communication but contact their financial adviser.

Past performance is not a guarantee or a reliable indicator of future results.

All investments contain risk and may lose value. Absolute return portfolios may not fully participate in strong positive market rallies. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The quality ratings of individual issues/issuers are provided to indicate the credit-worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P, Moody’s, and Fitch respectively.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2019, PIMCO.

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