Features September 2018

Diversifying Portfolio With Bonds Reaps Benefits

Written By: Barzella Papa

Barzella Papa, president and CEO of the Community Foundation of North Central Florida, sat down with Anmol Sinha, senior vice president and strategist with Pacific Investment Management Co. (PIMCO) to discuss fixed income investments and adding bonds to
investment portfolios.

What is PIMCO’s history and how did it become a leader in fixed income investments?

PIMCO was founded in 1971 and helped pioneer the concept of “total return investing,” which is the philosophy that returns can be enhanced over time by buying and selling bonds, not just earning the coupon until maturity.

Over time, PIMCO’s investment philosophy and process – along with the depth and breadth of its resources – have enabled the firm to deliver strong track records across a variety of strategies spanning all manner of investment opportunities: public and private, U.S. and global, fixed-income and equities.

Today we manage $1.77 trillion in assets for clients across the globe from many backgrounds (individual investors, institutional, official institutions and so on). We have demonstrated a capability to generate consistent returns using an active approach that utilizes not just the insights of our investment process but also our portfolio managers’ abilities to uncover market dislocations and structural inefficiencies.

What makes bonds appealing as an allocation in an investor’s portfolio?

Bonds can play many different roles in portfolios, but one of the main roles has been as a diversifier.

Over time, a diversified portfolio consisting of equities and bonds may have meaningfully lower volatility without much reduction in return. Put another way, bonds may improve the efficiency of a portfolio as the potential for higher risk-adjusted returns improves, and the portfolio may exhibit more resiliency as drawdowns overall have the potential to be smaller.

If we are in a world of rising interest rates, should bonds be avoided so as not to experience negative returns?

A common misconception with fixed income is that rising interest rates are unequivocally bad. Yes, bond prices do fall as an immediate effect when rates rise. But, there are a few other considerations.

First, price impact does not equal permanent economic loss. Generally, while a bond’s price is affected when rates rise, the total cashflows that investors earn over time (coupon + par) are not affected. It is worth noting that prices will tend to get closer to par as the bond gets closer to maturity.

The reinvestment of the coupon income will occur at higher yields (since rates are now higher), so that can help offset that initial price impact.

Yields typically rise as interest rates rise, so the return potential can be higher for many

traditional types of bonds. Yield is an important consideration, as it is usually the best proxy for future returns in fixed income.

So, while a negative price impact will likely mean negative returns, the yield and any reinvestment effects kick in over time and, in some cases, the return potential may increase relative to what it would have been had interest rates stayed the same or fallen. This can seem counterintuitive, but higher interest rates over time can actually be a good thing for bond investors.

Another point to remember – interest rate exposure is a diversifier to traditional credit or equity risk, so that a bond allocation can make sense, even if rising interest rates may cause some near-term adverse impact.

In the current environment, what are some key considerations for investors?

As our most recent Secular Outlook – titled “Rude Awakenings” – outlines, the next five years may be characterized by factors that look markedly different than those from the past five years.

The post-crisis world has generally been influenced by unprecedented and globally coordinated central bank support, which has helped lower volatilities across economies and financial markets.

As this era comes to a close, we believe investors should be cautious, given rising uncertainties and the meaningful likelihood of a recession over that three- to five-year period. Shifting from a secular lens to a more cyclical one, it is worth noting that our fundamental outlook for at least the next year is fairly positive.

We think more synchronized growth globally will continue in the near term, particularly as developed regions like the U.S. experience some boost from fiscal stimulus.

However, most markets have already priced in the positive outlook and may be less appreciative of near-term risks, so we are positioning more defensively.

The macro backdrop – an aging expansion, elevated valuations, waning monetary policy support and the potential for higher volatility going forward – suggests that investors should think about de-risking and more defensive postures while also considering diversification so that portfolios can be more resilient in bouts of volatility.

In addition, more flexibility to avoid generic market exposures – those that may be overvalued – can provide more appealing risk-reward profiles.

What guidance do you have for those in the beginning stages of incorporating bonds into their portfolio?

There are many types of bonds, and so investors should be clear on what objectives they are trying to meet with fixed income allocations.

Is the goal diversification? Or is the objective to substitute fixed income for higher risk / higher return assets like equities?

Or, is capital preservation the goal? The answers to these types of questions can help drive the types of fixed income solutions that could be additive for an investor’s portfolio.

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