Rethinking the price of certainty in fixed income- PIMCO

Traditional asset allocation models tend to use the language of fixed income when comparing equities and bonds, with measures of yield the focus.

Rethinking the price of certainty in fixed income- PIMCO

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Turning that around and measuring bonds and equities in price:earnings terms, however, underlines the current value being placed on certainty, argues Pimco MD and portfolio manager, Geraldine Sundstrom.

A look at the graph below, which Sundtrom describes as a picture of how certainty and uncertainty are priced, demonstrates just how highly a ‘certain’ payday is valued.

 

“U.S. Treasuries now trade at a P/E ratio of close to 70x, while uncertainty, in the form of equities, trades at a multiple of 20x. Credit, with its intermediate risk profile, comes in at 35x,” she said.

Given the level of uncertainty in markets both economic and socio-political, that certainty is highly prized makes sense, she said. What makes less sense, is the “inexplicably large valuation gap between the mild uncertainty introduced by investment grade credit and the perceived certainty of U.S. Treasuries”.

Still a good diversifier

Sundstrom pointed out that, because historical cumulative defaults in the U.S. IG universe have averaged a little over 1% annually over the past five years, according to S&P, default rates would need to be almost twice as large to justify the current discount to Treasuries.

“This is pretty hard to achieve barring a severe and protracted recession, which is not our outlook – though we see risks to the global economy rising over the longer-term horizon,” he added.

On the Treasuries front, Sundstrom said that while a P:E of 70x may seem high, “extraordinary central bank policies such as asset purchases and fears of recession could conceivably push the Treasury P/E to infinity (if yields go to zero)”.

And, she added, while they are expensive treasuries remain an important downside tail risk hedge.

But, she said, it is also important to maintain exposure to riskier assets that may benefit from any upside surprise. “Credit is likely to remain attractive, while the jury is out on equities.”

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