The recent market turbulence highlighted how sensitive global markets can be. Before the volatility of May and June, investors had moved out the risk spectrum in search of yield, and even now disinflationary pressures remain substantial, unemployment – spare capacity in general – is on the rise, and strained political dynamics remain a key source of downside risk in the eurozone.

Andrew Bosomworth, managing director and head of German portfolio management in PIMCO’s Munich office, and Michael Story, product manager responsible for European and global fixed income strategies in PIMCO’s London office, discuss the current investment landscape and the importance of risk mitigation. They explain how PIMCO’s Euro Low Duration Strategy, which aims to preserve capital while generating attractive returns, has the versatility and durability to successfully navigate volatile market conditions.

Q: Given how volatile markets have been, what are some of the key risks faced by investors?
Bosomworth: The current investment landscape is one of the most challenging environments we’ve seen in quite some time. In addition to protracted economic risks, investors also must consider the political dynamics playing out across the eurozone as its 17 members struggle to agree on make-or-break institutional changes. Most daunting of all, investors face stretched valuations across all asset classes following the liquidity-driven rally over the past few years. The liquidity shock in May and June served as a stark reminder for investors of just how fragile markets are when supported by excess central-bank-created liquidity as opposed to underlying fundamentals.

Given these developments, how do we see the balance of risks? While none of the conditions are yet in place for a sustained increase in yields, such as inflationary pressure, or above-trend growth, we are concerned about stretched valuations in riskier asset classes. Central banks have so far been able to convince investors to stretch for returns beyond their natural risk tolerance as their policies have forced safe-haven yields down to punitive levels. We are concerned that this “liquidity cascade” could reverse. As the most stretched investors unwind positions in higher-yielding assets, as they did in May and June, prices decline and volatility increases, magnifying the pressure to unwind more positions in a self-reinforcing feedback loop.

Looking ahead, we expect a tenuous calm with potential for periodic bouts of volatility.

Q: How might investors respond to such persistent market uncertainty?
Story: For those investors who are underinvested, this may be a good time to build positions in riskier assets. Conversely, for those running at the higher end of their risk limits, now may be the time to lock in gains and begin building a reserve of so-called dry powder. There will be attractive entry points for riskier assets in the future; but they will be available only to those revitalized investors that have confidently navigated volatility today.

Given such market uncertainty, it is crucial to take greater care than usual to ensure maximum diversification. Geographic diversification should be particularly helpful given how de-synchronized the global business cycle appears to have become. Now is the time for increased flexibility – adding a global “alpha” (a focus on generating excess returns) to a domestic “beta” (simply earning market-based returns), for example, widens the opportunity set for uncovering assets with greater capital gains potential.

Q: What exactly is “dry powder”?
Story: Traditionally, cash would be considered “dry powder”. However, this is not the case in a financially repressed world. Economists define cash as a special class of assets that is “information-insensitive” – the price of cash does not fluctuate in response to news that does affect the price of non-cash assets. Most investors intuitively consider information-insensitivity and safety as the same thing – if an asset’s price does not respond to new news, it is considered safe. This is not the case today. Cash may remain information-insensitive and a trustworthy medium of exchange, but those who hold it are assured of forfeiting purchasing power, if not in nominal terms certainly in real terms – not a characteristic that is typically associated with safety. We talk of zero-, and in some cases, negative-yielding cash as “death by a thousand cuts” because, while losses are small and gradual, investors cannot preserve capital with such instruments.

For us, “dry powder” means a strategy that seeks to avoid “death by a thousand cuts” while also retaining as much information-insensitivity as possible. The PIMCO Euro Low Duration Strategy offers a respectable return (even after inflation) as well as capital preservation. The strategy is positioned just beyond where cash markets are most financially repressed, but before the point where asset markets become highly sensitive to uncertainty and the constant stream of new news.

Q: How does the PIMCO Euro Low Duration Strategy maintain such a balance between capital preservation and achieving respectable returns?
Bosomworth: Essentially, we look to optimize the following set of trade-offs: Target return, drawdown risk and required holding period.

First, we define capital preservation over a required holding period. The Euro Low Duration Strategy aims to preserve capital over a 12-month horizon regardless of market conditions, including the traditional bond bear market scenarios such as an aggressive central bank rate hike campaign, a surge of unexpected inflation, or a risk-aversion-led spike in credit spreads. Second, the strategy selects a beta which is most consistent with the capital preservation objective, harvesting as much market-based return as possible without compromising the capital preservation priority. The final step is to add a layer of flexibility that allows us to actively manage the strategy’s beta, dialing up or down the combination of risks, as well as uncovering mispriced idiosyncratic risks on individual instruments, to generate a complementary layer of alpha that tends to be weakly correlated with the beta.

In the end, the return target – both realistic and consistent with the capital preservation objective of the strategy – is cash plus 2% for the European market.

Q: Where does the PIMCO Euro Low Duration Strategy find opportunities to achieve this objective?
Bosomworth: The strategy is extremely diversified across risk factors, investing in a broad selection of government, government-related, corporate and collateralized instruments with short maturities, fluctuating primarily between the zero and four-year part of the yield curve, depending on market conditions. This is the part of the maturity spectrum that is least sensitive to new information in the market and includes corporate bond spreads which tend to be about a third as sensitive to market movements relative to longer-maturity corporate bond spreads.

Such targeted positioning allows the strategy to capture meaningful returns from credit risk as well as duration risk, with far less volatility.

Q: What role might the Euro Low Duration Strategy play in an investor’s portfolio?
Story: The strategy is PIMCO’s all-terrain vehicle, ideally suited for de-risking broader portfolios without sacrificing returns entirely, as one would do in cash. It is sufficiently versatile to seek out overcompensated risks and avoid underpriced risks.

Primarily, however, the strategy has the needed durability to withstand the unavoidable shocks that today’s markets might generate with little warning, preserving capital and delivering cash plus 2% along the way. The strategy may suit investors who seek to park their capital until stability returns to markets, generating a respectable return (avoiding “death by a thousand cuts”) while waiting to redeploy capital.

We often distinguish the destination from the journey when discussing market dynamics. The PIMCO Euro Low Duration Strategy is purposely designed for the tricky part of the journey when the road gets particularly bumpy and challenging to navigate. Today, we may be travelling on one of the bumpiest roads we have encountered in years.