Q: What are the PIMCO Low Duration US and Low Duration Euro Corporate Bond strategies?
Kiesel: These strategies offer investors a long-term, strategic allocation to the short-dated segment of either the US or the euro corporate market.

The Low Duration US Corporate Bond Strategy will invest primarily in US-dollar-denominated corporate bonds rated BBB- or higher by at least one of the nationally recognised credit rating agencies and having less than five years to maturity. Similarly, the Low Duration Euro Corporate Bond Strategy will primarily focus on investment grade corporates with less than five years to maturity but denominated in euros.

Q: How do these differ from existing PIMCO credit strategies?
Chan: These two strategies differ from most of PIMCO’s credit strategies as they are focused on corporate bonds with less than five years to maturity and are constrained to a lower duration band of zero to four years.

Investors in these strategies can benefit from the expertise of the same credit portfolio/research teams and the same investment process as all of our credit strategies. And as with our other strategies, PIMCO’s top-down macroeconomic forecasts help determine duration, sector and regional positioning, while our credit research and portfolio management teams look to find the best bottom-up ideas.

As a result of this team’s strong and consistent track record of adding alpha over the portfolio benchmark, it won the Morningstar 2012 Fixed Income Fund Manager of the Year (USA) award.

These strategies are two new additions to our already well-established suite of low duration strategies, including the Low Duration Global Investment Grade, US/Euro
and UK Low Duration and Global Low Duration Real Return strategies.

Q: How can investors use these strategies in their investment portfolios?
Kiesel: We have seen investors utilise these low duration strategies in different ways.

First, some investors are concerned about the potential return on their credit portfolios in a rising rate environment, especially in the US where the Federal Reserve has ended quantitative easing policies and may start to raise rates at some point next year. By moving from a full-maturity spectrum to a short-dated credit strategy, an investor can reduce a portfolio’s sensitivity to changes in interest rates. Additionally, the spread, or the yield premium above similar maturity government bonds that investors gain when investing in corporate bonds, can provide a cushion to help weather potential future rate hikes.

Second, with policy rates in the US and the eurozone anchored close to zero, many investors are still searching for additional yield in this low rate environment.

Berndt: In particular, euro investors feel this pain acutely as the European Central Bank (ECB) has lowered deposit rates to negative levels. Investors can lessen the effect of this financial repression by segmenting their cash portfolios and moving a portion of their cash that isn’t needed immediately into low duration credit strategies to gain additional yield and enhance cash returns. In general, substituting short-dated corporate bonds for government bond allocations may boost portfolio yields due to the higher coupons on corporate bonds. In addition, investors may benefit from investing in companies whose balance sheets and growth prospects have improved since the financial crisis.

The key here is that investors now can use these two low duration strategies as tools in their portfolios to implement their own regional credit views while still benefiting from PIMCO’s bottom-up credit expertise and active management capabilities.

Q: How does the one- to five-year universe of corporate bonds compare with the full-maturity spectrum?
Kiesel: The market capitalisation of US-dollar-denominated corporate bonds with less than five years to maturity is approximately $2 trillion (source: BofA Merrill Lynch). This constitutes about 40% of the overall full-maturity US-dollar-denominated corporate bond universe. Comparing the sector breakdown with the full-maturity market, the short-dated segment has a higher weighting in the banking sector and lower weightings to the utility sector. By moving from full maturity to the one- to five-year universe, the benchmark duration is reduced by 60%, from 6.85 years to 2.82 years.

Berndt: The size of the short-dated euro corporate bond market is approximately €850 billion (source: BofA Merrill Lynch), representing half of the overall full-maturity euro-denominated corporate bond universe. Similar to the US dollar corporate market, the short-dated euro corporate market is more biased towards the banking sector and less to the utility sector. The euro short-dated corporate market reduces duration from 4.85 to 2.76 years, a 45% reduction in interest rate risk.

Interestingly, short-dated corporate strategies in general are characterised by higher Sharpe ratios, which measure risk-adjusted performance, than their full-maturity counterparts. Both of these local short-dated corporate markets present a rich array of attractive investment opportunities.

Q: Why did you choose to lower duration through short-dated bonds instead of duration hedging?
Chan: On the surface, both low duration and duration-hedging strategies on investment grade corporate bonds can reduce interest rate risk in investors’ portfolios. However, investors should be aware that each strategy carries very different risk profiles.

Utilising duration hedging on investment grade corporate bonds can remove most, if not all, interest rate risk. Investors would primarily be exposed to credit spreads. A low duration strategy can reduce, but not eliminate, interest rate risk in a portfolio because short-dated corporate bonds still retain some duration, as well as credit spread risk.

However, low duration strategies historically have been less volatile than duration-hedged strategies. The historical negative correlation between changes in interest rates and credit spreads represents a source of diversification that dampens volatility in low duration strategies. On the other hand, duration-hedged strategies are exposed entirely to credit spread volatility, which can be quite high under certain market conditions (Figure 1). The ability to time the market is important when using duration-hedged strategies. For this reason, many investors may prefer a low duration strategy.

It is also important to note that by reducing or removing interest rate risk, both low duration and duration-hedged strategies may offer lower yields than comparable credit strategies. The amount of yield given up will depend on the steepness of the government yield curve. Given the fairly steep US Treasury curve, investors should not be surprised that duration-hedged strategies have lower potential returns than low duration strategies, which can benefit from capital gains as the bonds “roll down” the steepest part of the government curve between three and five years (Figure 1).

Q: How does PIMCO’s investment process inform this strategy?
Kiesel: PIMCO takes a consistent, three-step approach to managing our credit strategies, including the Low Duration US and Euro Corporate Bond strategies: We evaluate the top-down macroeconomic dynamics, bottom-up fundamentals and valuations. Our cyclical and secular macro views provide the foundation for regional and sector allocations. We then fill these regional and industry weights with securities that we believe represent the most attractive investment opportunities through our bottom-up selection process. Our global team of over 60 credit analysts conducts independent credit research to understand company fundamentals, while our credit portfolio managers leverage their years of trading experience to purchase corporate bonds we believe are undervalued.

Q: Which sectors are attractive currently?
Kiesel: We are seeing many opportunities globally in the credit markets in companies with high barriers to entry, strong cyclical and secular growth and solid pricing power.

Regionally, the US stands out in terms of improving private sector fundamentals. We are favouring US cyclicals, including airlines, lodging, gaming and building materials. We also like hospitals and cable. We are quite positive on the outlook for the US consumer now given the improving outlook for job creation and income growth combined with low energy/commodity prices, higher housing and equity prices and low interest rates.

Berndt: We also favour European banks, which tend to issue shorter-maturity bonds; they will be the main beneficiaries of accommodative monetary policies, such as the ECB’s targeted long-term refinancing operations (TLTRO). In addition, we are constructive on the US banking sector, which remains relatively concentrated. Scale coupled with cheap funding provide a large competitive advantage for big banks.