Fine time to jump in, but be advised to ignore the noise

PUBLISHED : Thursday, 27 March, 2008, 12:00am
UPDATED : Thursday, 27 March, 2008, 12:00am

When Pimco opened its office in Hong Kong in January 2006, the timing was probably not the best. Stock markets in Asia were on a roll and fixed-income securities provided less impressive returns. By the middle of last year, the United States subprime crisis had snowballed into a liquidity crisis, which has led to a global credit crunch.

In the rapid deterioration of market sentiment over the past six months from bull to bear, the Hang Seng Index has lost steam since making significant gains during the first half of last year.

Nevertheless, this year will be a bullish one for the bonds market, according to Pimco Asia's CEO, Brian Baker.

'I think the bond markets are a lot more attractive today than they were a year ago. In 2005, 2006 and 2007, risk premiums around the world were compressed, offering very little return opportunities in some of the risky asset classes. Given the crisis that we are going through, risk has repriced. Corporate bonds are cheaper, mortgage-backed securities are cheaper ... and for an investor who has the liquidity, now is a very attractive time to buy very good, solid assets at distressed prices, cheap prices.'

He said Pimco had anticipated the souring of the subprime home loans, and moved away from risky US mortgage-backed and asset-backed securities before they became the huge liabilities they are now for several US investment banks such as Bear Stearns.

'We positioned our portfolios in high-quality instruments and positioned our portfolios expecting the US Fed to lower rates aggressively. In the first half of the year there was more talk of the Fed raising rather than lowering rates. We had more exposure to US Treasuries, to triple A-rated mortgages.'

Last week, the Fed cut interest rates for the third time this year - 75 basis points to 2.25 per cent.

Typically, falling interest rates are good for bond investors. If interest rates fall, bonds already in one's portfolio become more valuable because they were sold in a higher interest rate period and carry higher coupons. But Mr Baker said investors had to be careful when buying bonds in this volatile environment. He said it remained unclear when the markets would hit rock bottom, and whether the expected US recession would be long and deep.

'Risk assets are repricing to fair value. But in a crisis situation like this, investors will not buy assets that are at fair [value]. Risk assets have to go cheap before people say, 'Okay, I'm going to buy this now'.'

Asian investors are cautious about putting money at risk because of the uncertainty. Non-dollar investors also have less incentive to buy into US dollar assets because of the risk of foreign exchange losses from the depreciating dollar. In addition, local fixed-income securities may carry higher coupons than foreign paper.

'We work with many institutional investors,' Mr Baker said. 'They are liquidity providers. And today in a liquidity crisis, investors would get well compensated to provide liquidity to the financial markets. So we are talking to our investors about these opportunities such as in agency-backed securities or in bank capital, or in municipal bonds in the US which are trading very cheap, or in bank loans which banks are trying to sell off their balance sheets. Many investors have dollar assets, so the exchange rate is not a big concern.'

One area that the Newport Beach, California-headquartered fund manager is looking at is the US housing market - in particular triple A-rated agency mortgage-backed securities. These are securities issued by Ginnie Mae, Freddie Mac and Fannie Mae, which are guaranteed (Ginnie Mae) or implicitly guaranteed by the government.

'Agency mortgage-backed securities had sold off not only because of concerns about housing. As people need to de-leverage they sell their most liquid assets and that would be mortgage-backed securities. And so we think that in a triple A-rated government guaranteed, or implicitly guaranteed securities with very solid collateral underneath, agency mortgage-backed securities are extremely attractive at prices you've not seen since the 1980s,' Mr Baker said.

The Total Return Bond Fund has 69 per cent of its holdings in mortgages with average credit rating at AA, as of the end of January. The fund recorded an annualised return of 10.25 per cent as of February 29.

If the US goes into recession and this does not drag out and isn't severe, Pimco is optimistic that Asian emerging economies can ride out the crisis because of increasing intra-regional trade, strong domestic demand and solid fiscal and monetary policies. Mr Baker declined to provide details on Pimco's Asian exposure, but in the past it has bought US dollar-denominated government bonds from Pakistan, Vietnam, Indonesia and South Korea. He said Pimco was also interested in Asian corporate issuers.

'Because we are bearish on the dollar we are looking more and more on local currency Asian emerging market bonds rather than US dollar Asian emerging market bonds. We're playing much more in the local currency market, and moving more and more in the corporate market,' he said.

Pimco uses sector analysis of the bond markets to identify opportunities across sectors depending on changes in relative valuations and spreads. In investing in Asian fixed income, Mr Baker said Pimco evaluated securities vis-a-vis the price of bonds in other emerging markets in Latin America or Eastern Europe. 'We do want to buy [Asian] bonds, but we do want to buy their bonds at a relatively attractive price for our clients vis-a-vis what bonds are selling at in Brazil, Mexico, or Russia.'

The Emerging Bond Fund, which holds debt rated on average BA+, held 23 per cent of its assets in Brazilian bonds and another 23 per cent in Russian debt as of the end of January. Indonesian bonds accounted for only 4 per cent and Philippine bonds 3 per cent. The fund earned an annualised return of 6.55 per cent for its investors as of February29.

Amid the economic and market chaos, Mr Baker said it was important to have an investment partner that rose above the noise.

'The market will have a lot of ups and downs according to that noise, but we want to assess where the market will end up ... not try to guess where they will be tomorrow and the next day,' he said. 'When you keep trading on the noise you generate revenue for Wall Street but you're not adding value to your clients.'