As the chances of recession grow, high-quality bonds should form a key part of resilient portfolios since they offer the potential for equity-like returns with less volatility and downside risk compared with the stock market.
This forms part of PIMCO’s longer-term market outlook, which proposes a patient focus on high quality assets while also preparing to pivot over the next few years to more economically sensitive or lower-rated areas of the credit markets.
Over the next few quarters, the US fund house believes that policy tightening and bank challenges will begin to impact the markets more directly, but slower than past cycles due to the high proportion of consumer and corporate debt locked-in at low rates.
Then, for several subsequent years, PIMCO sees more pronounced economic cycles with risks skewed to the downside. In particular, the firm expects high sovereign debt levels and a hesitancy to reignite inflation to limit the willingness and capacity of policymakers to inject fiscal and monetary stimulus.
“We expect more aftershocks after a number of acute tensions disrupted financial markets and set off inflation around the world,” explained Richard Clarida, global economic advisor at PIMCO.
He sees events such as the sharpest rate increases by central banks in 40 years, and the bank failures in the US which followed, as being likely to reveal hidden vulnerabilities in the global financial system. “Economic volatility will likely rise in the next five years from the relatively smooth decade before the pandemic,” added Clarida.
Craving credit
The recent trends have also led to specific credit opportunities. Broadly, today’s traditional high yield and investment grade (IG) markets have much higher overall credit quality than in the past.
Being mostly fixed-rate markets, companies and households locked-in record-low interest and mortgage rates during 2020-2021, bolstering their resilience to a slowing economy, explained Daniel J Ivascyn, PIMCO’s group chief investment officer.
“The higher-quality areas we are focusing on in the near term are IG credit as well as consumer and securitised credit, where you can potentially get additional buffers in the form of subordination, hard collateral and better documentation,” he noted.
Yet it is private credit which Ivascyn said is among the firm’s favourite targets for new capital over the next several years.
Challenges for the asset class might exist in the near term, due to sharply higher rates and earnings headwinds for many of the typically smaller, highly leveraged companies which represent the majority of the borrowers of these floating-rate loans.
Yet PIMCO is seeing higher returns and more rational underwriting standards in this space, and this should slowly improve. “The degree of stress will likely be a function of how deep the oncoming recession will be,” added Ivascyn.
But over the next several years, he expects to see opportunities to provide liquidity directly to performing companies and to buy deeply discounted loans from private debt funds and banks as they may be forced to sell to raise liquidity.
“A meaningful mismatch in the supply of private capital to address these opportunities should offer the potential for strong returns,” Ivascyn said.
