Daniel Ivascyn, chief investment officer of PIMCO, speaks during the Bloomberg Invest Summit in New York City on June 7, 2017.
A dicey combination of renewed market turbulence, softer economic data, and crowded trades—all against a hotter political backdrop—makes bonds the best bet as a defensive play heading into the rest of the year, said Daniel Ivascyn, chief investment officer at Pacific Investment Management Co. (PIMCO).
Global markets have been convulsed by a spike in volatility that began last week after weaker-than-expected U.S. employment data and a hike in benchmark Japanese interest rates sparked a rout in stocks and sent investors scurrying out of bets involving borrowed yen. The tumult sent investors flocking to U.S. Treasuries, intensifying an already powerful rally and sending yields on Monday to their lowest in more than a year.
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Even as a sense of relative calm has returned in recent days, the likelihood of further shakeouts in currencies, equities, and riskier areas of credit, as well as simmering economic risks, support the case for bonds, Ivascyn said in an interview Wednesday. U.S. and global political shocks also can't be ruled out, he said.
"Investors still should have a defensive mindset," said Ivascyn, who joined PIMCO in 1998 and replaced predecessor Bill Gross in 2014. "We could be in for a bumpy, bumpy road."
Ivascyn, 54, helps steer the $158.3 billion PIMCO Income Fund, the largest actively managed bond fund. It has returned 4.1 percent so far this year, ahead of the 2.2 percent gain for the Bloomberg U.S. Aggregate bond index during the same period, and beating 82 percent of its peers.
A softening trend in U.S. jobs and cooler inflation since mid-July has fueled sweeping gains in the Treasury market, with traders piling into bets that the Federal Reserve will need to be aggressive with interest-rate cuts to keep the economy in balance. On Monday, as stocks slumped and the so-called yen carry trade came under intense pressure, the bond market at one stage anticipated the Fed would ease rates by some 150 basis points (bps) before the end of the year.
As the dust settled Thursday, 2- and 10-year Treasury yields traded back up around the 4 percent level, while traders were still leaning toward a half-point Fed rate cut when they meet in mid-September followed by another half-point of cuts by yearend.
Referencing the tension between central banks and markets, Ivascyn said market pricing "may be a bit too optimistic about cuts," but the new viewpoint reflects shifting probabilities around the outlook for the economy. Where earlier this year many investors supported the notion that the Fed could achieve a soft landing with gradual rate cuts, traders now fear that the Fed may have left rates too high too long, putting a recession in play.
"There's certainly economic scenarios that can justify what's priced into the rates curve," he said. "The probabilities of a harder landing have gone up, and if they were 15 percent to 20 percent before, they could be as high as 25 percent or 30 percent today."
Ivascyn said PIMCO had reduced its exposure to bonds as the market rallied sharply and would take a tactical approach and add more exposure to Treasuries should yields back up further. "We're back to 4 percent in two-years, and if the market takes out a cut or two from here, we would add back more tactical duration," he said.
The bond manager sees the possibility of equities being tested by an earnings recession or a slowing in profit growth or some challenge across sectors that bleeds into the credit markets. Under any of those scenarios, the case for owning top-tier bonds remains even after the rally of recent months, as they still look "cheap to equities and other more economically sensitive assets that are on the expensive side."
PIMCO, with $1.88 trillion in assets under management, expects "a high probability the Fed will cut in September, and they will probably cut a couple more times going into yearend," Ivascyn said. "If the economy or the employment picture deteriorates more and/or inflation comes down at a more rapid rate, then the Fed could accelerate their cuts."
After Treasury yields peaked above 5 percent last October, PIMCO made a case that bond funds would become attractive to investors as inflation was seen easing and growth moderating in 2024 under the highest Fed policy rate in over two decades.
Through July of this year, PIMBO Income had attracted $15.25 billion of net inflows, and its assets under management of $158.3 billion marked the largest month-end fund size it ever reported, according to Morningstar Direct. It represents a full recovery from the turmoil inflicted by the Fed hiking cycle when investors pulled $23 billion during 2022, the most since its launch 17 years ago.
So far this year, 91 percent of bond funds with assets of at least $1 billion are outperforming the aggregate index, the best since 2012, according to data compiled by Bloomberg.
As a bond manager with a long time horizon, Ivascyn concluded that "looking at bonds over a three- or five-year period, they're a little bit less attractive than they were a few months ago, but a 4 percent 10-year yield, even in a 2.5 percent inflation environment, still represents pretty good value long-term versus equities or cash."
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