Text on screen: PIMCO

Text on screen: PIMCO EDUCATION, Fixed Income Portfolio Construction with host Roger Nieves (10 minutes)

Text on screen: Roger Nieves, CFA, Senior Advisor, PIMC Advisor Team. PIMCO provides services to qualified institutions, financial intermediaries and institutional investors. This is not an offer to any person in any jurisdiction where unlawful or unauthorized.

Roger: Hello and welcome to a Fixed Income Portfolio Construction. We know that this is a tricky time to be a bond investor.  This presentation has been developed to give you the tools and techniques that you need - to navigate today’s fast moving investment landscape - and build robust bond portfolios .

Full page graphic; text on screen: TITLE – Agenda, NUMBERED BULLETS – 1) Market environment, 2) Fixed income portfolio construction 3) Manager selection

We are going to touch on three topics: One, the markets. Two, asset allocation and portfolio construction. And three, manager selection.

And let’s start where we, as bond investors, often start - and that is by looking at the interest rate paid on US government bonds.

Full page line chart; text on screen: TITLE – Forty years of falling interest rates; The chart, titled US Government 10-Year Treasury Yield %, shows the yield on the 10-year Treasury note from 1962 through 2020. From 1962 through roughly 1982, the yield rose steadily before falling steadily through 2020.

This chart shows you the yield on the 10 year Treasury note going back to the early 60s. As you can see, interest rates are pretty low from a long run historical perspective.  Not quite the low for the series, but close.

And in a world where yields are low and cryptocurrencies and the like garner more attention, some investors may ask themselves - well do I still need bonds?

Full page graphic; TEXT: I am more concerned with the return of my money than the return on my money – Will Rogers. 

One answer to that perhaps lies in this quote from cowboy philosopher Will Rogers, who reminded us that sometimes we should be “more concerned with the return of my money than the return on my money.” 

US government bonds for example are still viewed as among the safest and most liquid investments in the global financial markets.

Full page graphic: TITLE - Three major types of bonds in the US; THREE SECTIONS 1) US Government Bonds, 2) Mortgage and Asset-Backed Bonds, 3) Corporate Bonds

There are high quality bond issuers in the corporate and mortgage space too.

But what about the risk of higher rates.  Don’t bond prices typically go down when interest rates move up?

Full page graphic: TITLE - Bond prices are typically inversely related to interest rates; Graphic of seesaw with navy circle with “Rates Rise” and up arrow on the up side, and burgundy circle with “Prices Fall” and down arrow on the down side; text below graphic reads, As yields move up and down, bond prices move up and down

Yes, bond prices can go down when yields move up. But there is an underappreciated benefit to investors from higher interest rates, sort of a silver lining. The potential upside of higher yields is higher yields. Let me give you an example of that.

Full page graphic: TITLE - Across market environments fixed income has generated positive returns; this chart shows annualized 3 years rolling returns from bonds (as represented by the Bloomberg Barclays U.S. Aggregate Index). Going back to 1978 over any rolling 3-year period core bonds have rarely dipped below 0. With equities (as represented by the S&P 500 Index), there are strong periods outperformance but also strong periods of underperformance. This is evident from the aftermath of the tech bubble and US financial crisis which are shown in red boxes.

Here in green, you see the three year annualized returns for investing in the stock market, represented by the S&P 500 over different periods going back to 1975. In blue you see the corresponding returns for the bond market, represented by the Bloomberg index.

As you would expect, stocks have outperformed bonds over most three year periods.  The green line is generally above the blue line. But the other important takeaway here, if you look really closely at the blue line, is that historically it has been really difficult to lose money in a high quality bond portfolio if you hold your investment for three years.

This was true even in the early 80s when Paul Volcker, who ran the Fed at the time, was trying to break the back of inflation by hiking interest rates. In the bond market, if you have a tough period when rates rise, in the subsequent period you may benefit from those higher rates.

Full page graphic; text on screen: TITLE – Agenda, NUMBERED BULLETS – 1) Market environment, 2) Fixed income portfolio construction 3) Manager selection

Let’s dive a little deeper into portfolio construction

In the context of a portfolio, bonds potentially play three roles:

Full page graphic; text on screen: TITLE – Fixed income allocations may offer multiple benefits to a portfolio; graphic of circle with three parts: Capital Preservation, Income/Total Return, Equity Diversification

One, defense.  To protect principal. Two, to generate income from their coupons and three, to provide diversification.  Historically bonds zig when other markets zag.

But it is important to note that how you emphasize those three potential benefits may vary depending on the risk tolerance and goals of each individual investor – and this is one of the secrets to effective bond portfolio construction. Let me give you an example.

Full page graphic: TITLE – Set fixed income portfolio objectives; image shows five sample asset allocation pie charts with of equity/bond %s– from left to right they are: Income 20%/80%; Balanced toward Income 35%/65%; Balanced Growth and Income 50%/50%; Balanced Toward Growth 65%/35%; Growth Focus 80%/20%; text at bottom reads, At larger allocations, fixed income may serve primarily as a source of income/return; At smaller allocations, fixed income may be used primarily as an equity diversifier.

Let’s take a look at the asset allocation for a Growth investor on the right hand part of this page. Is our main focus for this investor trying to maximize the yield on a bond investment that only represents 20% of the portfolio – perhaps by investing in riskier securities?  Not necessarily.  What might work better here is to allocate to a high quality core bond portfolio that provides diversification when equities sell off, given that STOCKS are your return driver in growth portfolios.

How about an investor that is positioned the opposite way? The Income investor on the left hand side of this page only has 20% in stocks.  With this investor, we may want to focus more on generating yield in that fixed income bucket and importantly diversifying within that bucket. Let’s drill into that a bit further.

Split screen graphic: TITLE – Select fixed income sectors that align with objectives; left side: TITLE – Fixed Income Portfolio; graphic of satellites orbiting a planet; copy reads, Build around a core strategy; Complement the core with high quality diversifying strategies; Consider satellite  allocations to increase return potential.

Here on the vertical axis of the table, you see the names for different asset classes within the bond market.  You have core, which includes allocations to government bonds, and you have international, etc.

In the columns, you see yield.  You have annualized volatility.  You have correlation to the equity market, and you have the historical max drawdown.  Just looking at a few numbers, you see for example that core bonds shown in the top row have a moderate yield – call it 1.6% in this example, but core bonds have historically had a low to negative correlation to equities – that makes them a very appealing diversifier in a portfolio context.

On the other hand, at the bottom of the table, high yield bonds, as the name implies, have a higher yield at 4.5%, but they have historically been more volatile, and more correlated to the equity market, making them a bit of a less effective diversifier for say a growth portfolio.

Understanding these sector correlations, yields and drawdowns is important as these are the building blocks that we are going to use to build real life portfolios.

Split screen image: TITLE – Example Goal Portfolio – Paying for Education Story A 529 plan for Cheryl and Tom’s daughter; Story— Cheryl and Tom have been saving for their daughter’s college saving through a state 529 plan; Time Horizon -- They won’t need the savings until their daughter enters college in nine years and also aren’t concerned about receiving monthly income; Goal -- They are looking to grow their investment to meet future tuition needs; Fixed Income Objective-- With equities as an intended growth engine, fixed income may be used as a diversifier to potentially smooth the ride Graphic at right shows satellite image with a table: Balanced Growth & Income (Fixed Income Allocation); Core Strategy; Sector; Intermediate Bonds; Core Complements; Sector; IG Corporate; International; Satellites; High Yield.

Here is one example. Cheryl and Tom have been saving up for their young daughter’s education. Their daughter is still nine years away from college, and they have a balanced asset allocation. How would we construct a bond portfolio for Cheryl and Tom? Here, it really is about “balance”.

We want to emphasize the diversification benefits of bonds, and as we just saw previously, an allocation to core bonds potentially gives us maximum bang for the buck in terms of diversification to equities. As a result, for Tom and Cheryl, intermediate core bonds represent our largest allocation. We would also complement that with some International and corporate bonds.

Split screen graphic: TITLE – Example Goal Portfolio – Saving for a New Home: Chris and Joanna’s first home; Story— Chris and Joanna have been saving for the down payment on their first home; Time Horizon --They are looking to make an offer on a home in 12-24 months; Goal --They can’t afford to lose a large percent of their down payment but would like to earn a bit of return on the cash while they wait; Fixed Income Objective--Minimal downside risk, greater return than their savings account. Graphic at right shows satellite image with a table: Preservation of capital; Core & Core Complements (~60% - 80%); sector; ultra short term; short term, Satellite (0% - 15% each); Sector; Intermediate Bond; IG Corporate; Mortgages; Global.

Next we have Chris and Joanna, a young couple that is saving up to buy their first home in 12-24 months. Here, a longer maturity core bond allocation might not be the best answer given the possibility of negative returns if interest rates move up over the next 12 months. Chris and Joanna need something more defensive

Full page graphic: TITLE – Short term bonds may provide attractive yields and diversification benefits.

But if you get really defensive and put them in zero yielding cash, then you lose any opportunity at generating a positive return, or keeping up with inflation. The sweet spot here is likely a short duration bond portfolio that generates more yield than cash (perhaps 1% or more), but has less interest rate risk than a core bond portfolio.

Full page graphic; text on screen: TITLE – Agenda, NUMBERED BULLETS – 1) Market environment, 2) Fixed income portfolio construction 3) Manager selection

OK we discussed picking asset classes, now let’s discuss picking actual funds.

And on that front, we’ll just start by noting that investing in bonds can be challenging. A large company may only have one class of common stock outstanding but can have dozens of different bond issues around the globe.  Each with different terms, currencies, and legal protections. As a fixed income investor, you need resources to conduct this in depth global research, and pick these bonds. The upshot here is that because of these challenges and resource requirements, active management can work really well in bonds.

Full page graphic: TITLE – Consider active management for fixed income allocations; % of active funds within each category that outperform the median passive fund (10-year return as of December 31, 2020). Bar chart shows the historical track record for active management in different Morningstar fund categories. 84% of active bond managers in Morningstar’s Intermediate Core and Core Plus categories outperformed the median passive fund over a 10 year period. In the Ultrashort bond category, 97% of active bond managers outperformed the median passive fund

Here you see the historical track record for active management in different Morningstar fund categories. 84% of active bond managers in Morningstar’s Intermediate Core and Core Plus categories outperformed the median passive fund over a 10 year period. In the Ultrashort bond category, 97% of active bond managers outperformed the median passive fund.

In conclusion, this is a tricky environment for bond investors.

Full page graphic: TITLE – Summary & Key Takeaways; This is a challenging environment for bond investors; Thoughtful fixed income portfolio construction can help your clients pursue their goals in Advisory and Brokerage; Manager selection is key and active management has a strong track record in fixed income; Edward Jones portfolio tools can help you evaluate your clients’ investments and keep them on track toward their goals.

Cash investments, yield little, close to zero.  Other bond sectors may pay higher yields, but you have to be more deliberate about how you incorporate them into your portfolio. In Cheryl and Tom’s case for example we learned that core bonds provide nice diversification to the equity risk in their daughter’s 529 plan. We also saw how Chris and Joanna emphasized short maturity bonds as they saved up for a down payment on their first home. Lastly, we saw how active management can be really effective, in fixed income given the diversity and complexity of this $114 trillion global market.

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Text on screen: For more information, please contact your account manager, or visit us at pimco.com/advisoreducation

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Disclosure

Past performance is not a guarantee or a reliable indicator of future results.

All investing involves risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Certain U.S. government securities are backed by the full faith of the government. Obligations of U.S. government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. Diversification does not ensure a profit or protect against a loss.

HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM.

ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

Asset allocation is the process of distributing investments among various classes of investments (e.g., stocks and bonds). It does not guarantee future results, ensure a profit or protect against loss.

The correlation of various indexes or securities against one another or against inflation is based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility.

The portfolio structure shown is a representation of a sample portfolio and no guarantee is being made that the structure of the portfolio will remain the same or that similar returns will be achieved.

There is no guarantee that these investment strategies will work under all market conditions or appropriate for all investors and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.

©2021 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (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. Past performance is no guarantee of future results. “Core” Bonds refer to bonds commonly found in the Bloomberg Barclays US Aggregate. These include mortgage backed securities, investment grade corporate bonds, and treasuries. Intermediate-Term Core-Plus Bond Morningstar Category: Intermediate-term core-plus bond portfolios invest primarily in investment-grade U.S. fixed-income issues including government, corporate, and securitized debt, but generally have greater flexibility than core offerings to hold non-core sectors such as corporate high yield, bank loan, emerging-markets debt, and non-U.S. currency exposures. Their durations (a measure of interest-rate sensitivity) typically range between 75% and 125% of the three-year average of the effective duration of the Morningstar Core Bond Index.

Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis.

S&P 500 Index is an unmanaged market index generally considered representative of the stock market as a whole. The Index focuses on the large-cap segment of the U.S. equities market. It is not possible to invest directly in an unmanaged index.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material 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.

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