Yes, Fixed-Income Investors… There Are “Alternatives”

During the past several years, many widely publicized “what to invest in next year” stories have featured one or more investment gurus forecasting the imminent end of the long-running bull market in bonds – only to be proven wrong because they underestimated the weakness in the global economy and the persistent appeal of the U.S. dollar and U.S. securities as a “safe haven” in a world often beset by bad news.  They also underestimated the lingering impact of the “ crash” and the “mortgage crisis crash” – which left the average investor with much lower 401(k) balances and feeling extremely jittery about any investment that included the word “stock” in it.

Therefore, as interest rates continued to fall to historically low levels during the past four years (the 10 year U.S. Treasury Note dipped below 1.50% for the first time since the 1940’s), investors kept pouring money into bond-related investments, as can be seen in the table below showing “net investment flows” into and out of U.S. mutual funds between 2006 and 2011 (data comes from the Investment Company Institute, ; note that the “Hybrid Fund” category is not included in this chart):

As you can see above, prior to the onset of the mortgage crisis, funds flows were heavily tilted toward equity funds – with stock funds capturing almost $.50 of each new dollar invested. Flows into bond funds reflected the allocation generally considered as part of the standard “balanced” portfolio of 60% stocks/40% bonds. However, following the height of the financial crisis (2008), there was a stampede out of equity funds, which accounted for more than100% of the net outflows from all mutual funds. Bonds actually saw a modest inflow during that year.

The fuller trend away from equities was seen during the following three years, through 2011.  During those years, 117.62% of all new assets into mutual funds found their way into bond funds, while equity funds (despite appreciating from the end of 2009 onward) experienced a cascading outflow of funds.

Given these trends, along with interest rates sitting at extraordinarily low levels, a growing number of investment experts converged upon consensus regarding one major point: investors had become so attached to (and over-weighted in) fixed income investments, and had become so lulled into complacency by the relatively steady performance of bonds, that they risked a serious shock when interest rates reverse course and start to climb.  These gurus consistently trumpeted the warning that investors needed to review their asset allocation and become open to making appropriate adjustments.

The most interesting of these warnings came in the form of a news report that UBS considered the danger lurking in complacent bond investors so significant that they were classifying bond-buyers as “aggressive investors” (most likely as much to limit UBS’ liability for disappointment as to alert customers to interest rate risk). Another illustrative warning came from TD Ameritrade, which distributed an article to its customers entitled: “Bonds Are Not Gravity Defying: Be Prepared”.

As we have alluded to in an earlier blog article about PIMCO’s huge Total Return Fund (PTTRX) and its steadily growing Total Return Fund ETF (BOND), manager Bill Gross is one of the world’s most widely recognized bond market experts.  As the asset class in which he specializes faces the bleak prospect of lower investment returns moving forward (Gross himself has forecast returns of only 2-3% per year over the next several years), watching net asset inflows into his funds could be indicative of investor trends. In fact, although PTTRX reported an average net monthly cash inflow during the first quarter of 2013 of $1 billion (an amount 99% of fund managers “would die for”) that was a full 33% lower than the prior year’s average inflow!! Even more telling is 2013 first quarter performance record of the widely watched Barclay’s U.S. Aggregate Bond Index – which fell by 12 basis points (-.12%). That was the first quarterly loss in the Barclay’s index in seven years! [1]

Given market conditions, Gross’ forecast, and inflow trends, one might think that morale at PIMCO might be trending downward a bit. However, anyone who thinks that would be wrong. In fact, as a whole, PIMCO’s overall inflow statistics during the first quarter were better than in 2012 – averaging $7.7 billion/month during Q1. That placed it second within the fund industry – with only Vanguard Group exceeding that level of asset inflow!

The key for PIMCO has been applying its recognized expertise in currencies and all types of fixed income instruments toward the development and enhancement of what is called “alternative fixed-income” funds – funds with flexibility to improve upon the returns possible from pure fixed income investments, while simultaneously controlling portfolio risk.

Financial experts are becoming increasingly interested in this growing asset class. For example, the chief investment officer at BKD Wealth Advisors LLC, Jeffrey Layman, in a recent interview with Investment News, said the following: “We are rethinking fixed income. The first stage was investing in satellite bond holdings like high-yield and emerging-markets debt, but those have been so bid up, they look like they will earn their coupons, at best.” Layman and many other experts believe it makes sense to follow PIMCO’s approach to diversification within the larger alternative fixed income space, which if successfully done will be less vulnerable to rising rates, thereby providing higher returns, while simultaneously maintaining the low volatility so highly prized by bond investors.

PIMCO is not venturing into the “alternatives” space without experience. In fact, it has two such funds with solid track records. The PIMCO Unconstrained Bond Fund (PUBAX) was started in 2008, when only eighteen “non traditional” bond funds existed (now there are 52). The same team that manages the famous PTTRX is also managing the PUBAX portfolio.  The prospectus indicates that this “non-traditional bond” fund invests “at least 80% of its assets in a diversified portfolio of Fixed Income Instruments of varying maturities, which may be represented by forwards or derivatives such as options, futures contracts, or swap agreements. It may invest in both investment-grade securities and high yield securities, subject to a maximum of 40% of its total assets.”

Expressed in simpler language, the difference between PTTRX and PUBAX is that the former is mandated to follow an index (average weighted duration plus or minus two years of the Barclays U.S. Aggregate Bond Index) while PUBAX is (as the name suggests) “unconstrained” – with great flexibility regarding portfolio investments (including shorting the bond market).

Below are two graphs of PUBAX performance (1 year and 5 years). Note that the dip in December 2012 was due to a large EOY dividend):

A second “alternative” fund from PIMCO is the PIMCO All Asset Fund (PASAX) – five years older than PUBAX. Unlike the focus of PUBAX (fixed income and its “alternatives”) PASAX is essentially an asset allocation fund that invests within other PIMCO funds from either the equity or fixed income spaces – providing PASAX managers with the flexibility to adjust its asset allocation as market conditions dictate. The advantage of such a fund vis-a-vis any pure fixed income or equity fund is the potential for smoother and steadier returns over longer time periods due to the synergy of non-correlated assets. The one and five year performance of PASAX is as follows:

Finally, PIMCO introduced a totally new alternative fund this year — PIMCO Worldwide Fundamental Advantage Absolute Return Strategy Fund (PWWAX) – with a focus upon an appropriate mix of stocks, short and intermediate term fixed income bonds, and derivatives that at any given time reflect the economies of at least three countries (which can include the U.S.). However, the fund is so new that it has no meaningful record, so a price graph would be meaningless.

The bottom line is that, for all fixed income investors who are open to the current plethora of warnings about the risks inherent in bonds at the bottom of an interest rate cycle, there are a number of “alternatives” to consider for their portfolio – whether from PIMCO or from other providers.

NOTES: None of the funds listed above are intended to serve as investment recommendations. Consult your own financial advisor to ascertain if any are appropriate for your financial goals and risk tolerance. The author was long BOND at the time the article was written, but does not own any of the others.

Fund performance graphs were created within by the author.

[1] For those unfamiliar with the Barclays U.S. Aggregate Bond Index, it is composed of over 8,000 bond issues, currently valued at almost $17 trillion, which compares favorably with the magnitude of the S&P 500 Index, valued at approximately $14 trillion!

Submitted by Thomas Petty

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