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PIMCO: Playing It Safe at the Short End of the Curve

Jerome Schneider says he’s de-emphasizing interest-rate risk to produce a smoother ride for investors as changing expectations drive volatility.

Sarah Bush: Hello. For Morningstar, I'm Sarah Bush, and I'm here today at the Morningstar ETF Conference with Jerome Schneider from PIMCO and our 2015 Fixed Income Manager of the Year.

Thanks so much for joining me, Jerome.

Jerome Schneider: Thank you, Sarah. And thank you to Morningstar for having us back here. We love to be partners with you in this regard. So, it's great to be back.

Bush: Great. So, we just wrapped up a panel on fixed income and ETFs and what some of the challenges surrounding liquidity are. I'd just be curious to hear what are a couple of takeaways that you took from that panel.

Schneider: It's surprising to me that the notion of liquidity is one that's gone from basically the very bottom of the pecking order to the top of the pecking order in terms of that regard. And it's obviously a topic of conversation that is very poignant right now and liquidity of ETFs. We've just come through several different periods whether it's the Brexit; we've seen funds meet liquidity challenges; we've seen periods of stress earlier this year and during February and March where different segments of the market reacted differently. And what we've all come back to is a common, resonating theme, which is, liquidity.

And with that in mind, we have to realize that it isn't necessarily that there is no liquidity within the market, which people quickly point out and try to highlight as a banner ad on the front page of the paper, but it's really that the cost of liquidity has changed. And with that, we need to recognize that products themselves have inherent pros and cons to managing exposures in and with regard to liquidity.

So, just be mindful, here at the ETF Conference you spent an awful lot of time talking about exactly that, that the cost of liquidity within an ETF structure is something that should be observed, recognized, and effectively embraced by an investor once they enter into that strategy. But understand, most importantly, that the cost of that liquidity, whether it's the bid offer of the ETF itself or the underlying assets, is inherently reflected by that price. And so, just because there might be an access point through an ETF complex it doesn't mean that there is a zero transactional cost to maintaining liquidity that you would have in other near-cash assets.

Bush: I think that was one of the concluding points we came to, is: Understand what the underlying portfolio is and those liquidity costs will come through to you as an investor regardless of the vehicle.

Schneider: Exactly. Market makers are there to do exactly that, provide a market. But what that really means is providing a liquidity on the ETF, with contextually the cost of liquidity on the underlying assets. So, you have to very cognizant of what the market reaction is to that cost of the underlying assets to reposition them, the transactional costs, that will be reflected in the bid offer of the ETF and most importantly, the price volatility of the ETF during volatile times. So, gaining exposure is one point in time, but also maintaining or repositioning the exposure is a transactional cost that can be clearly articulated in liquidity costs for such structures.

Bush: OK. I want to shift gears a little bit. Your expertise is at the short end of the yield curve. I wanted to talk about--PIMCO has put out a paper about some changes in LIBOR that are fairly dramatic in the context of that part of the yield curve. So maybe you can talk a little bit [about] what's happened and what's been driving that.

Schneider: Primarily money market reform. We've known since 2008 when the Reserve fund broke the buck that regulations were going to come in place to help preserve money market land and more importantly, protect investors from different circumstances whether it's credit risk or interest-rate risk.

We've had two stages of this. The first one was back earlier in 2010 where they regulated and redacted the amount of interest-rate exposure, and now, subsequently in October of 2016, we're going to have the second stage be implemented.

Why is this important? Well, the second stage is very important because we're moving primarily from a world of $1 par NAVs, meaning, fluctuations in the NAV doesn't happen, to one in a world of prime money market funds where that NAV will fluctuate. So, many investors don't necessarily want that. What does that mean? We've had prime money market funds, those where the NAV will eventually fluctuate, seeing redemptions to the tune of over $500 billion over the past year. That's a tremendous amount. So, from PIMCO's perspective, we've been anticipating structural changes. We thought that investors would seek and look for different opportunities to manage liquidity. That's why we've seen interest in products like our short-term strategies. But most importantly, we needed to take advantage of the structural changes we've seen. And the one that comes to mind is LIBOR.

Well, why is that? Well, when you have $500 billion plus of redemptions in prime money market funds, the assets they invest in, predominantly bank commercial paper and bank CDs, have to find another home or more importantly, those banks are going to have to reprice that cost of funding to a level to entice new investors. That's what we're seeing is the re-inciting action for LIBOR moving higher over the past few months. And structurally speaking, LIBOR--relative to risk-free rates, like OIS [overnight indexed swap]--will continue to move at a wider spread and settle at a wider spread compared to what we've seen over the past two to three years once money market reform is fully implemented.

So LIBOR for us is a structural change which we've recognized, embraced in many of our strategies through owning floating-rate paper, like LIBOR-based floaters, and brought that to our clients despite very low interest-rate environment outside of the spectrum. It's been something that's been very advantageous as a tailwind to our clients.

Bush: OK. I want to shift gears one more time and talk a little bit about the Fed-- obviously, the Federal Reserve policy is very important in understanding what's happening at the short end of the yield curve. How is PIMCO thinking about what the end of 2016 might bring in terms of Federal Reserve actions?

Schneider: Sure. We think there's a strong possibility that the Fed continues to tighten over the next few weeks, few months before the end of the year. And I think that it's important to highlight again is that we still continue to believe that the terminal rate is lower than we've seen in previous rate hike cycles. So expect a terminal rate closer to 2% or so. But most importantly, the sequencing of that is going to be prolonged. It's been a significant period of time since last December when we had a rate hike obviously to where we stand now, and it could continue to be a prolonged period even after the next rate hike. So, while we foresee one to two rate hikes over the next calendar year or so, one thing we would see is that the reaction function in the marketplace is going to remain relatively volatile.

What does that mean for positioning? Well, it really means that the emanating source of volatility in the market is recalibrating expectations for Fed increases. And even over the past few trading days we've gone from absolutely a view that the Fed is absolutely not going to increase rates to one where the Fed is going to increase rates to one where the Fed probably won't increase rates. The reality is somewhere in the middle. And as a portfolio manager my goal is to help provide my clients with the smoothest ride possible and volatility based on the changes in interest-rate expectations, that's a very challenging thing to adapt to. But there's ways we've done that through our short-term strategies. So, just de-emphasizing interest-rate risk right now at the current time is a prudent stance to be taking.

Bush: So, de-emphasizing interest-rate risk, investing in floating-rate securities. What are a couple of other themes that you're looking at in your funds?

Schneider: So, the main one is--and I want to highlight this--de-emphasizing interest-rate risk, specifically at the front end of the curve where it's most volatile and I think that's a key clarification. But most importantly, look globally for opportunities. Just because the rest of the world is infected with negative interest-rate policy doesn't mean that U.S. investors don't have opportunities. And one of those great opportunities is really looking to lend U.S. dollars abroad to those investors.

What do I mean by this? You have global banks looking to buy U.S. dollar assets. There is a structural demand for U.S. dollars. If you're able to lend dollars and invest assets in those nondollar currencies, it's actually a positive arbitrage for U.S. investors. Doing simple trades such as buying Japanese T-bills, three-month T-bills will yield you on a hedge basis basically 1.25% for a relatively attractive point. To get to that point in the U.S. Treasury curve you have own the five-year Treasury or beyond. That's a pretty attractive yield. So, find ways, look globally. Use structural changes to your force such as LIBOR, and most importantly, nondollar investments and then you can have basically a better way to earn risk-adjusted returns in your portfolios.

Bush: Great. Well, thanks very much for joining me today, Jerome.

Schneider: Thank you very much.

Bush: For Morningstar, I'm Sarah Bush.