Strategy Spotlight

PIMCO UK Income Bond Strategy: A Diversified Approach to Sustainable, Consistent Income

With traditional sources of income providing diminished return value, the strategy seeks to offer investors a consistent, high quality income yield while preserving capital.

A recovery still vulnerable to shocks, together with a high level of debt, suggests that any hikes in short-term UK interest rates will take place gradually, with the official policy rate unlikely to rise materially above the Bank of England’s (BoE) 2% inflation target. This environment presents considerable challenges for investors, particularly the growing number of retirees in the UK looking to generate attractive and sustainable income without having to stretch for yield and be exposed to potential capital loss in the event of heightened market stress.

In the following interview, Mike Amey, managing director and head of sterling portfolio management, and Tanya Sanwal, product manager for income strategies, discuss the rising popularity of income-oriented strategies such as PIMCO’s UK Income Bond Strategy, the impact of a rising rate environment and attractive income opportunities in The New Neutral landscape.

Q: What is driving the significant interest in income-oriented investment strategies? And what are the primary challenges facing income-oriented investors today?
Sanwal: The rise in popularity of income-oriented strategies is in part due to a secular demographic shift: an increasing number of workers reaching retirement age. The impact of the “Baby Boomer” generation – those born in the post–World War II period from 1946-1964 – on retiree populations is manifest in G-8 economies, and the UK is not immune. According to the Office for National Statistics (ONS), the number of people aged 65 and over has increased from 15% in 1985 to 17% in 2010 in the UK, an increase of 1.7 million people. By 2035, ONS projections show that those aged 65 and over will account for 23% of the population.

However, retirees today face a very different retirement landscape than prior generations. First, the shift away from defined benefit schemes means that income security is significantly lower than in the past. And second, the investment environment has materially changed as traditional sources of high quality income, such as bank deposits or government bonds, provide very little value in today’s low yield environment.

In the UK, baby boomers have historically relied on income from either corporate bond or equity strategies. Both strategies have exhibited a relatively higher level of price volatility, usually combined with less consistent dividend payments. Additionally, the prolonged rally in both equity and high yield bond markets means that yield levels today provide little cushion to protect capital in periods of heightened market stress. As retirees seek to invest for a changed investment landscape, the key challenge they face is finding solutions that emphasise income generation without compromising capital, the base on which income is generated.

Q: In this context, can you discuss the objectives and investment approach of PIMCO’s UK Income Bond Strategy?
Amey: We launched the UK Income Bond Strategy in February 2011 to meet the growing needs of income-oriented investors wanting to allocate a majority of their income in sterling-denominated investments. The strategy’s primary objectives are to achieve a consistent and competitive dividend distribution and to focus on long-term capital preservation. To this end, we are willing to give up an incremental portion of yield so as not to compromise our objective of capital preservation.

The strategy’s built-in flexibility allows us to invest across the full spectrum of the sterling fixed income market, with less of a focus on anchoring the strategy to a traditional benchmark. Mindful of the potential risk stemming from rising rates over the secular horizon, we also have significant duration (or sensitivity to interest rate movements) flexibility. Instead of seeking income at the expense of locking into longer-term bonds or seeking the highest yield, we focus on identifying fixed income sectors where the income potential and maturity structure is more attractive, but which may have been overlooked by investors. In addition, the strategy may invest up to one-third of the portfolio in attractive income-generating opportunities from outside of the sterling market.

An active management approach historically has enabled the strategy to meet its dual objectives. Since inception, the strategy has achieved capital appreciation which, combined with a competitive dividend, has generated an attractive overall total return. More importantly, the strategy has done so while maintaining an investment-grade-quality portfolio.

Q: Do you expect the UK to be the first among major developed markets to start along the path of rate normalisation, and if so, when? What are the likely ramifications for the UK fixed income market?
Amey: Yes, we believe that the BoE will likely be the first among major central banks to raise policy rates, most likely starting in the fourth quarter of this year. To that end, we are currently making use of the strategy’s scope to source up to one-third of the income in the portfolio from outside the UK. Within the UK, we expect the rate cycle to eventually settle in the 2%–3% range, consistent with our secular expectation for The New Neutral: modest growth coupled with continued high debt levels and neutral real policy rates below historical levels.

Looking ahead, we do see opportunities in intermediate UK interest rates, where implied official rates by the end of this decade are in the 2.75%–3.5% range (based on one-year interest rates from 2019–2024 as implied by the UK swaps curve – data is from Bloomberg as of 19 June 2014). We believe that the carry and roll-down on intermediate duration rates are attractive as we do not expect market expectations of implied rates to be realised.

Q: Given our expectation for The New Neutral, what are your overall investment themes for the strategy? Also, which UK fixed income sectors offer attractive opportunities today?
Amey: The strategy’s diversified investment approach combines high quality core government bond and corporate credit exposure with higher-yielding securities and allocations to alternative fixed income sectors. Overall, we maintain an intermediate duration positioning with a focus on shorter maturity bonds, avoiding long-term bonds that are not attractive given low yields that do not offer commensurate compensation for longer-term inflation risks.

Several areas of the UK fixed income market offer attractive opportunities today. First, the banking sector continues on its multi-year deleveraging journey, driven by regulatory pressures to increase capital buffers and liquidity requirements. The secular implications should be positive from a bondholder’s perspective, reducing bank net issuance and future default risk. We find select UK financials attractive and are positioning for further spread compression in the lower part of the capital structure. For example, contingent convertible securities issued by UK banks offer yields of 4%–6% (based on BofA Merrill Lynch data as of June 2014), which represents a significant pickup versus senior debt, as well as versus their global counterparts in the U.S.

We also want to take advantage of the current strength of the UK recovery by investing in sectors that are exposed to rising consumer confidence, lower negative equity and support from government policy. For example, the UK pub sector is benefitting from a pickup in employment and disposable income. We like senior tranches of pub securitisations, and we focus primarily on first lien positions in the capital structure which are backed by property assets and where management is committed to deleveraging.

Looking at residential securitised credit, we see a number of select opportunities that continue to offer attractive returns for a slight liquidity premium. For example, we have taken exposure to senior tranches of select UK non-conforming residential mortgage-backed securities (RMBS) backed by pools of high quality, low loan-to-value UK mortgages. UK non-conforming RMBS offers an attractive way to take advantage of the UK housing recovery. These are complex structures and detailed analysis of individual securities is critical to achieving an attractive return, both in the quality of the bond collateral and the seniority within the capital structure in the event that economic conditions should deteriorate beyond our expectations.

Finally, we are taking advantage of opportunities in select European peripheral bonds which are an attractive source of carry given a supportive European Central Bank. Our exposure is primarily in the three- to five-year part of the maturity spectrum, where debt sustainability risks are lower.

Q: In light of the new flexibility afforded to UK pension savers by the March 2014 Budget, what role can PIMCO’s UK Income Bond Strategy play for retirement investors?
Sanwal: The tax changes proposed in the 2014 UK Budget – due to come into effect in 2015 – mean defined contribution savers may no longer be compelled to purchase annuities in order to release retirement income from their pension scheme. Instead, they have been given greater control, allowing retirees to take their portfolio as cash upon retirement, draw down gradually on their assets over time and/or opt to pursue a more traditional route and purchase an annuity. We believe that many will seek to receive a steady income from their pension savings to sustain them in retirement, drawing down gradually upon their capital and the yield it generates to provide them with income.

Pension savers will also likely have a low tolerance for volatility – while they may be comfortable drawing down their capital, they may not be comfortable with the value of their capital fluctuating materially. Hence, the strategy, which is designed to make monthly distribution payments, generate a consistent, high quality income yield while preserving capital and providing daily liquidity should access to retirement savings be required at short notice, may serve as an eminently sensible approach for pension savers.



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A word about some risks : Investing in the bond market is subject to certain risks that fixed income securities will decline in value because of changes in interest rates, and the risk that the manager’s investment decisions might not produce the desired results. Bonds with longer durations tend to be more sensitive and more volatile than securities with shorter durations; bond prices generally fall as interest rates rise. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Derivatives may involve certain costs and risks such as liquidity, interest rates, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Diversification does not ensure against loss.

This presentation contains the current opinions of the manager and such opinions are subject to change without notice. This presentation has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this presentation may be reproduced in any form, or referred to in any other publication, without express written permission.

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