​In an economic environment of lower nominal growth, low yields and lingering market uncertainty, the hunt for income remains a key challenge for investors: Traditional sources of income, such as government bonds and deposit rates, are unlikely to provide an attractive level of income or growth. Investors may therefore want to look “outside the box” to meet their income needs.

Mike Amey, managing director and head of sterling portfolio management in PIMCO’s London office, discusses the current and longer-term environment for bonds and how Bank of England (BoE) monetary policy is shaping his pursuit for consistent income in PIMCO’s UK Income Bond Strategy.

Q: With global growth likely to remain subdued over the next few years, what is PIMCO’s outlook for the UK economy and UK bond yields?
A: The UK economy continues to face the twin headwinds of tepid overseas growth and persistently weak domestic demand as both the public and private sectors attempt to rebuild their balance sheets. With this process likely to continue for several years to come, investors may continue to face low interest rates as the BoE attempts to support economic growth as best it can. Of course, a world of high borrowing and, at best, flat real income growth is subject to a greater degree of uncertainty from a capital perspective, as companies find it harder to generate and sustain strong profit growth.
 
Confronted with greater market uncertainty, a protracted period of negative real interest rates and a wider distribution of performance outcomes, investors in the UK will be forced to seek alternative sources of income rather than rely on deposit rates, government bonds and equity income funds.

We believe that a strategy that can look beyond the traditional universe of income streams to achieve enhanced income makes sense in this environment. The PIMCO UK Income Bond Strategy does just that.

Q: What is your investment approach in the UK Income Bond Strategy?
A: In line with our aim to generate consistent income and preserve principal, we look for the best income ideas in UK-denominated bonds and global fixed income markets of varying maturities. We have divided our investment approach into two components: a higher-yielding segment, one that we would expect to benefit from stronger economic growth (accompanied by higher interest rates); and a higher-quality segment that we would expect to benefit from weaker economic growth (accompanied by lower interest rates). 

Historically, UK investors sought sterling income streams by only focusing on strategies that emphasised corporate bonds or equity. In both cases, these strategies had relatively high levels of price volatility, usually combined with less consistent dividend payments. For example, the GBP Corporate Bond Index yielded 3.8% with an average maturity of 13.5 years, according to recent data from Bank of America Merrill Lynch (as of 30 June 2013). Additionally, the prolonged rally in high yield bond markets and the resulting yield and spread compression have challenged investors’ search for consistent and attractive sources of high-quality income.

Rather than seeking income at the expense of locking into longer-term bonds or chasing yield, our strategy seeks to identify assets that have more attractive average maturities, but that are slightly unloved by investors. We also seek out exposure to a diversified range of sectors globally to generate additional levels of income. Indeed, uncovering such “safe spread” is the key to this strategy. While no investment strategy is without risk, we define “safe” as a security or sector likely to withstand a wide range of possible scenarios.

Q: Where do you find value for the PIMCO UK Income Bond Strategy?
A: We take a diversified approach to building our UK-dominated income portfolio by complementing modestly higher-yielding securities with alternative fixed income sectors.

For instance, we have identified some good opportunities in asset-backed securities (ABS), both in the UK and globally, which benefit from attractive income potential combined with high credit quality. While ABS suffered the greatest stress during the financial crisis of 2008, we have found that a number of securities within this sector, both in the residential mortgage and commercial real estate markets, have seen their investor base eroded to such a degree that there is an imbalance between demand and supply. This type of imbalance is classically where you find good opportunities to invest in high-quality assets with relatively low capital risk.

In the current environment, we see a number of securities within securitised credit that continue to offer attractive returns for a slight liquidity premium. Analysis of each individual security is critical to achieving this return, both in the quality of the bond collateral and seniority in the capital structure in the event that economic conditions deteriorate beyond our expectations. As an example, we have taken exposure to senior tranches of select UK residential mortgage-backed securities (RMBS) backed by pools of high-quality, low loan-to-value UK mortgages. We target senior tranches of these bonds so that in the event there are losses on the underlying mortgages over and above our stress tests, we retain priority over other bondholders.

When investing outside of the more traditional unsecured corporate bond markets, the depth of resources and the ability to understand more complex securities are paramount. For those with sufficient resources, the higher complexity and marginal reduction in liquidity are more than compensated for by the additional yield. The higher degree of capital security embedded in these asset-backed markets is critical given the long-term challenges facing the UK economy.

Given that supporting the real estate markets and the banking system more generally is a key part of the BoE’s strategy, the old adage of “don’t fight the central bank” sits well with our approach. Combined with rigorous security selection, this gives us the required degree of comfort that the additional yield available within the asset class remains attractive.

But not all opportunities are specific to sterling-based assets. Over the secular horizon, we expect growth in emerging markets to continue. As a result, we have identified good opportunities to buy high real-yield assets in domestic currencies across select emerging countries, which will complement the opportunities in the UK domestic sectors. Asia and select Latin American countries, where real yields are very attractive, remain of particular interest.

Q: Looking at UK fiscal and monetary policy developments, where are you seeing longer-term opportunities for the strategy?
A: We believe the current coalition government in the UK will serve the full parliamentary term through to 2015 and is likely to continue tightening up on spending. As a result, the BoE may keep rates very low to support the economy over the course of this parliamentary term.

We will therefore focus our exposures on bonds maturing over the next five years. At present, we believe that buying longer-dated bonds is not attractive given that yields are low relative to the uncertainty of predicting longer-term growth and inflation. If interest rates on longer-dated bonds rise, we would use this as an opportunity to extend the average maturity of our portfolio.

We do not believe that it is necessary to increase interest rate exposure substantially to gain attractive levels of income. For example, some ABS, which I mentioned earlier, offer yields of up to 5% for maturities out to five years. Even if yields rise, we should be able to take advantage of changing conditions by reinvesting the proceeds of maturing bonds.

Q: In this environment, what is your approach to credit quality in the UK Income Bond Strategy?
A: It is important to focus on the quality of the assets that we buy. If we go through a period in which markets start to worry about a double-dip recession, we will likely see opportunities to buy lower-quality assets at attractive prices. Conversely, there will be periods when markets will price in strong growth. Overall, the strategy has maintained a predominately investment grade credit quality; in the current environment, we are being highly selective in our high yield purchases.

Despite the uncertain economic environment, we believe there are many opportunities to invest in high-quality securities that offer a consistent and attractive income stream. We are scouring both the UK and global fixed income markets to achieve our primary objective of generating income while minimising risk. Dedicating a portion of an investor’s fixed income allocation to an income strategy that actively targets both consistent distribution and risk management can make a lot of sense for investors. In addition, the strategy’s investment universe differs somewhat from that of most core bond funds, offering investors additional diversification within an overall fixed income portfolio.