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Pimco Says ‘Generational Reset’ on Yields to Spur a Bond Revival

In Business
June 04, 2024

(Bloomberg) — Forget the stock market or private credit. Fixed income will outstrip other asset classes after “a generational reset higher in bond yields,” according to one of the world’s biggest bond managers, Pacific Investment Management Co.

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“Active fixed income is positioned to perform well if there are no recessions over our secular horizon and to perform even better if there are,” Pimco’s Richard Clarida, Andrew Balls and Daniel Ivascyn wrote in an outlook released Tuesday. As prices climb and inflation recedes, they expect bonds will be even more attractive than cash.

So far this year, bond markets have registered modest losses versus a rise of some 10% for key US equities benchmarks. Many money managers have been caught flat-footed on calls to snap up government bonds by the still-resilient US economy. The $147 billion Pimco Income fund, managed by Ivascyn, has climbed 7.8% over the past 12 months and is up 1.7% so far in 2024, outperforming roughly 80% of its peers.

With an investment horizon over the next three to five years, the $1.8 trillion bond manager said active investors can build portfolios yielding roughly 6% to 7% “without taking on significant interest rate, credit, or illiquidity risk.”

This time is different as high quality bond benchmarks — including the Bloomberg US Aggregate and the Global Aggregate — are providing 5% or higher yields. “Starting yields are highly predictive of bond returns over a multiyear horizon,” they said.

“Markets don’t appear to price significant recession risk, meaning bonds may be an inexpensive means to hedge that risk,” they added.

The asset manager warned of “the rapid growth within private, floating-rate markets that may not have been tested through prior default cycles,” and said it increases “the risk of excesses building in areas such as technology and direct lending to companies with high leverage and lower credit ratings.”

The seemingly stretched valuations in stocks are favorable for bonds, according to the Newport Beach, California-based money manager. The debate over the Fed’s neutral policy rate — a level that neither stimulates or slows the economy — also offers “further opportunities for bond investors, as yields today already embed cushion in the form of positive real rates and term premium.”

The bond market is currently positioning for a neutral rate close to 4%, while Pimco is more closely aligned with the Fed’s 2% to 3%, once inflation has settled back near the target set by central banks.

Read the QuickTake: What’s the Fed’s ‘Neutral’ Rate? Why Does It Matter?

Still, the asset manager is cautious about the US and global fiscal outlook and the potential for the longer-dated yields to lag the performance of shorter benchmarks. In the US market, Pimco sees value in five-year bonds as longer dated Treasuries currently trade around similar levels but carry greater interest rate risk.

The authors reiterated recent warnings about the potential underperformance of the longer-dated debt over US budget deficits. And November is unlikely to change that, Pimco said. “Fiscal deficits are likely to remain near historic highs regardless of the election outcome.”

Of last October’s Treasury “tantrum,” when yields on the benchmark 10-year hit 5%, sparked by debt issuance concerns, they said: “Our baseline is not a sudden financial crisis, but recurring episodes of market volatility when focus shifts to fiscal issues.”

Other points of consideration for investors over the next five years include:

  • Both developed and emerging market global yields “have returned to attractive levels,” while “many economies outside of the US face more fragility yet enjoy better starting fiscal conditions, both supportive of bonds.”

  • The potential for a more volatile path of inflation favors owning Treasury Inflation-Protected Securities (TIPS), commodities, and real assets, as they provide “inflation-hedging properties and higher real rates than pre-pandemic levels.”

  • Expectations of government support via rate cuts and more spending amid future economic downturns “are further out of the money today.” That should further fuel volatility.

  • Central bank bond buying is less likely to resume in a downturn as the “financial strain of maintaining large securities portfolios, where the costs of funding exceed the returns from these assets, has become increasingly apparent.”

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