PIMCO recommends overweighting credit and underweight duration

Investment outlook

But on one of those thin pages the prospective author should introduce the caveat that the past 15 or even 30 years have been a rather remarkably short and non-volatile period of time, and future Sharpe ratios or other measures of risk/return may not exceed Treasury Bills in the same amount as before. A rather familiar graph of 10-year Treasury yields as shown in Chart 2 would hint at this. What I hope the reader will note is not only the dramatic decline in yields since the early 1990’s but the relative linear (non-volatile) path that they followed. Granted, for other asset classes such as stocks, there was 1987 and the aforementioned dotcoms and subprimes, but the linear path is clear: higher asset prices over long periods of time generated in part by the steady decline of 10-year Treasury yields to a 2012 bottom of 1.39%. A Bull Market almost guarantees good looking Sharpe ratios and makes risk takers compared to their indices (or Treasury Bills) look good as well. The lesson to be learned from this longer-term history is that risk was rewarded even when volatility or sleepless nights were factored into the equation. But that was then, and now is now.

 

So wait! There comes a point where prospective returns relative to risk don’t ensure such optimistic outcomes. While there’s always an element of subjectivity to all predictions – future profit margins, forward Shiller P/E’s, normalized real interest rates, geopolitical rest/unrest, etc. – there should be at least some objectivity and common sense. Chart 3, provided by CreditSights as well (good firm), provides a basis for that common sense. In the bond market, there is a measure of risk/return known as “yield per unit of duration.” Duration is a standard measure of price risk relative to interest rate changes – the lower duration the less the price change (generally). But shorter duration (maturity) bonds usually have lower yields!

This doesn’t seem to be very helpful for a bond investor at first blush. It implies that if you want more return than a Treasury Bill and a positive Sharpe ratio, then extend your duration. Yet “how much to extend?” would be an active manager’s question. Chart 3 provides some perspective although as noted, no positive conclusions, other than today is different than the past 15 years!

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