We posed four questions for Pacific Funds portfolio managers about today’s fixed-income markets. Here are their answers.
Pacific Funds Senior Product Strategist Craig Imamura sat down with three portfolio managers of the Pacific Funds fixed-income funds to get their thoughts on the markets during 2021 and potential fixed-income opportunities in 2022.
While 2021 saw many ups and downs for investors, what were some of the major themes during the year that you felt benefited from your approach?
We spent the majority of 2021 believing that the economic backdrop would remain favorable for risk-taking and that flare-ups were opportunities to add risk, not reduce it. Rolling COVID waves certainly provided plenty of occasions to debate that view. We continue to believe that the U.S. is much better equipped to handle increased case counts, and the economic effect of COVID will diminish as the year progresses. 2022 will bring a different set of challenges, but our current thinking is similar to last year: We believe the economy should be strong enough to handle its share of curve balls.
—Brian Robertson, CFA
Portfolio Manager for Pacific Funds Strategic Income and Pacific Funds High Income
In 2021, distressed loans significantly outperformed during the year. For our loan strategy, given our focus on fundamental credit analysis, our bias toward performing loans was a headwind to our performance versus peers. Despite this headwind, our loan strategy still managed to finish near the top third relative to peers¹, which we are proud of.
As we look to 2022, we feel like we are positioned quite well versus peers. First, our loan portfolios currently have limited exposure to high-yield bonds. To the extent interest rates rise and high-yield under performs, we believe we’ll do quite well versus peers who tend to own more high-yield bonds. In addition, returns for the asset class may approximate a coupon clipping environment going forward, which favors our style.
—J.P. Leasure and Michael Marzouk, CFA
Portfolio Managers for Pacific Funds Floating Rate Income
Is there something investors may be overlooking that could shift the headwinds fixed income experienced in 2021 into tailwinds for your strategies in 2022?
From our viewpoint, aside from COVID, the biggest headwind for most of credit has been inflation and the potentially rising-rate environment, combined with fairly tight starting valuations. This has put a cap on absolute return expectations. While we broadly think that higher rates are likely across the curve in 2022, we think there is a reasonable chance that the intermediate to long part of the rates curve remains lower than many are expecting. This would provide more return upside potential to fixed-rate credit assets in 2022. This view is clearly contingent on factors such as improvements on the COVID front, workers returning to the workforce and the unclogging of supply chains. If we were to see moderating growth, slowing inflation and increased credibility that the Federal Reserve (Fed) will be able to keep medium-term inflation in check, we believe those factors would provide a lot of support for the longer end of the rates curve.
—Brian Robertson, CFA and Michael Marzouk, CFA
What do you see as the single most important decision the Fed will have this year?
We all agree that the Fed has a lot of history in managing the economic cycle through rates but much less experience in doing it through the size of their balance sheet. The prior experience of quantitative tightening starting in 2017 was choppy to say the least. We expect that the market is priced to expect three or four rate hikes in 2022, but how the Fed manages potential quantitative tightening as new economic data arrives, especially if volatility picks up materially, may be their biggest challenge this year.
—Brian Robertson, CFA, J.P. Leasure and Michael Marzouk, CFA
One common question we hear from advisors is: “With the backdrop of multiple rate hikes expected by the Fed and inflation likely to persist, what are some opportunities in fixed income to consider in 2022?”
From my perspective, below investment-grade credit—both bank loans and high-yield bonds—should benefit from strong credit fundamentals, a healthy economic backdrop and expected below average default rates. In an environment where the Fed is raising rates and inflation is running above normal, the additional spread income from bank loans and high-yield bonds will be an important driver of returns in 2022. At this time though, I believe bank loans offer a slightly better opportunity relative to high-yield bonds given the prospect of Fed rate hikes. While investors may not have realized it, 2021 was a year of extremely low volatility. Bank loans, represented by the Credit Suisse Leveraged Loan Index, produced the highest risk-adjusted return, as measured by the Sharpe ratio, in fixed income at 4.01% vs. 2.01% for high-yield bonds, represented by the Bloomberg US Corporate High-Yield Index and -0.55% for the Bloomberg US Aggregate Bond Index. Given the Fed is likely to withdraw liquidity in 2022, we believe that utilizing asset-class flexibility to manage any increased volatility will be a more important driver of returns in the quarters to come.
—Brian Robertson, CFA
Bank loans, of course, without a doubt. With the December Federal Open Market Committee (FOMC) projections showing three potential hikes in 2022, expectations for below-average default rates, strong investor demand and robust collateralized loan obligation (CLO) issuance, bank loans may benefit from these carryover tailwinds from 2021 and offer investors an opportunity to reduce duration risk and increase yield. Remember, in the last six rising-rate periods, bank loans, represented by the Credit Suisse Leveraged Loan Index, have averaged a return of 4.36% vs. -2.44% for the Bloomberg US Aggregate Bond Index. Bank loans have also seen their yield increase from 4.91% to 5.27% in 2021. So, bank loans in 2022.
— J.P. Leasure and Michael Marzouk, CFA
Bloomberg US Aggregate Bond Index includes investment-grade U.S. government and corporate bonds, mortgage pass-through securities, and asset-backed securities.
Bloomberg US Corporate High-Yield Index measures the USD-denominated, high-yield, fixed-rate corporate bond market.
Credit Suisse Leveraged Loan Index is designed to mirror the investable universe of the U.S. senior secure credit (leveraged loan) market.
Duration is often used to measure a bond’s or fund’s sensitivity to interest rates. The longer a fund’s duration, the more sensitive it is to interest rate risk. The shorter a fund’s duration, the less sensitive it is to interest rate risk.
The Sharpe ratio measures the performance of an investment compared to a risk-free asset. It is calculated as the quotient of the annualized excess return of the fund over the cash equivalent and the annualized standard deviation of the fund return.
Spread is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, represented by treasury bonds. Spread income refers to the additional income from this difference.
¹ Rankings based on Morningstar Category Percentile Rank. As of December 31, 2021, Pacific Funds Floating Rate Income (I Share) had the following Morningstar Category Percentile Ranks in the Bank Loan category: 36% for 1-year, 33% for 3-year, 21% for 5-year, 10% for 10-year, and 6% since inception.
Morningstar Category™ is a proprietary Morningstar data point. Percentile Rank in Category is a fund’s total return percentile rank relative to all funds that have the same Morningstar Category. The highest (or most favorable) percentile rank is 1 and the lowest (or least favorable) percentile rank is 100. The top performing fund in a category will always receive a rank of 1. Percentile Rank in Category is based on total returns which include reinvested dividends and capital gains. The information contained herein: (1) is proprietary to Morningstar; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. © 2022 Morningstar Investment Management, LLC. All Rights Reserved.
About Principal Risks: Past performance does not guarantee future results. All investing involves risks including the possible loss of the principal amount invested. There is no guarantee the Funds will achieve their investment goal. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security. Not all U.S. government securities are checked or guaranteed by the U.S. government, and different government securities are subject to varying degrees of credit risk. Mortgage-related and other asset-backed securities are subject to certain rules affecting the housing market or the market for the assets underlying such securities. The Funds are subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default). High-yield/high-risk bonds (“junk bonds”) and floating rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. The Funds are also subject to foreign-markets risk.
Pacific Asset Management LLC is the sub-adviser for the Pacific Funds℠ Fixed Income Funds. The views in this commentary are as of January 19, 2022 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Any performance data quoted represents past performance which does not guarantee future results. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party. Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding investment products.
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