Pimco’s Sabrina Callin and Lisa Kim spot the benefits of an unconstrained approach to bond investing

Sabrina Callin (pictured), who oversees PIMCO’s derivatives-based equity and unconstrained bond suite of products, and Lisa Kim, who is product manager in the New York office, responsible for absolute return-based products, have outlined the opportunities seen in an unconstrained investment approach to bond investing.

Investors today are facing numerous headwinds. It is widely acknowledged that prospective returns from both bonds and equities likely will be well below historical averages for the foreseeable future. The current environment is still marked by uncertainties emanating from the European sovereign debt crisis, while in the US anxiety related to ongoing drama from the persistent debt presents additional noteworthy risks. Indeed, downside risk to asset prices is a very legitimate concern – especially after the substantial losses sustained by many during the financial market crisis. And, investing at the risk-free rate today yields an effectively zero return – or negative returns when adjusted for inflation. With all of this in mind, it is not surprising that investors are increasingly focused on alternatives to traditional investment strategies and approaches to diversify risk and achieve a reasonable return on (and of!) capital.

A blank canvas

One such approach is unconstrained, absolute return oriented bond market investing. These approaches generally allow the portfolio management team a broader range of investment discretion than more traditional approaches. The primary components of many unconstrained strategies are:

• the absence of a bond market benchmark
• a goal of delivering positive “absolute” returns independent
of the market environment
• a focus on downside risk management
• a very broad-based, global opportunity set
• reliance on manager’s skill as the primary driver of performance

The absence of a bond market benchmark means that unconstrained approaches have a different starting point for portfolio construction – a blank canvas so to speak rather than the structural risks embedded in the bond market.

This allows the manager to make decisions in an absolute return framework, where success is measured by the absolute level of return on an investment over a period of time, as opposed to a relative return framework where success is measured by performance relative to a benchmark.

For these reasons we believe unconstrained bond portfolio construction should be driven by an outcome-oriented goal, with strategies assessed on an individual risk/reward and correlation basis, and each investment in the portfolio evaluated rigorously for the expected risk and return as well as the potential impact of the correlation to other investments in the portfolio. As such, rather than “underweighting” a less attractive market exposure, the portfolio manager can choose to forgo the unattractive risk altogether and position much more defensively as appropriate. Likewise, rather than limiting attractive market exposures – as traditional bond strategies may be required to do, particularly with “out-of-benchmark” exposures – in an absolute return oriented approach the positions and the scaling will solely be a function of the manager’s best ideas and degree of conviction together with downside risk management considerations, unconstrained by a specified bond index benchmark.

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