Rebuilding Your Core
November 17, 2020
An allocation to credit can complement an investor’s fixed-income portfolio in today’s yield-starved market.
- We believe that investor expectations need to be recalibrated for the next 12 to 24 months because investments—without additional risk—may not generate the return and income to which investors have grown accustomed.
- Investors may need to consider increasing or adding risk to their fixed-income portfolios to meet income and return objectives due to the effects of the global pandemic that have pushed yields lower and prices higher for traditional fixed-income safe havens.
- We believe a modest allocation to credit should be considered due to a better term premium relative to safe-haven assets, recent central-bank stimulus, and more attractive relative value, especially with credit spreads still wider than their historic average.
Market concerns during the global pandemic have driven many investors to seek shelter in investment-grade, fixed-income safe havens. However, the relative value in what has been typically a core fixed-income position has become less attractive with increasing prices and decreasing yields for most investment-grade sectors.
With the expectation that the Federal Reserve (Fed) will likely keep short-term interest rates near zero through 2023 due to the global pandemic, and with approximately 70% of the Bloomberg Barclays U.S. Aggregate Bond Index comprised of now low-yielding U.S. government-related securities, investors may have less exposure to potential price and coupon return than ever before. Although corporate credit tends to struggle during market selloffs when investors sell riskier securities and buy safe-haven assets, it tends to be a leader in fixed income coming out of the lows of a correction or recession when the economy recovers and investors search for growth opportunities.
Currently, the Bloomberg Barclays U.S. Aggregate Bond Index’s yield and price sit well below and just off its 10-year average, respectively. Investors searching for a reasonable level of income or better-than-coupon returns may need to consider adding a modest allocation to credit in order to seek to meet these expectations.
Bloomberg Barclays U.S. Aggregate Bond Index Allocations
Source: Bloomberg Barclays as of 9/30/20.
No bank guarantee • May lose value • Not FDIC insured
For investors considering a low-cost passive alternative for their core fixed-income position, the likelihood of those funds closing the delta between actively and passively managed funds in the intermediate-term bond space may continue to decrease given greater exposure to safe-haven assets such as Treasuries, agencies, and mortgage-related debt. On average, active intermediate-term core plus bond funds carry 36.76% exposure to corporate credit versus only 26.08% for passive intermediate-term core bond funds:
Active versus Passive
Source: Morningstar® Inc., as of 9/30/20. Active average is calculated using the Morningstar Category filtered for actively managed mutual funds only, not including ETFs. Average passive is calculated using the Morningstar Category filtered for index OE funds, or when not available, index ETFs.
The COVID-19 Credit Crunch
Coming into 2020, some of the key concerns for investors included:
- Slowing U.S. and global growth.
- Sino-American trade and tariffs.
- The initial outbreak of a new deadly virus, COVID-19, in China.
- The risk of a significant spike in fallen angels.
Then came the global pandemic and accompanying economic halt. The Fed and Congress quickly jumped into action, pouring massive amounts of stimulus and liquidity into the economy, which stabilized companies and caused corporate bonds to rally. The broader risk to credit markets may have somewhat subsided as a potential wave of downgrades and defaults appear to have been delayed. But idiosyncratic risks still remain as companies will have to reinvent themselves for the post-COVID world.
After a coronavirus-related selloff in risk assets, many equity investors didn’t sit on the sidelines as some expected, perhaps hoping for a so-called U- or V-shaped recovery for stocks when COVID-19 and its impacts taper off. But with company earnings likely to be affected by the pandemic for some time and unemployment likely to remain elevated, those investors may be leaving returns on the table in their fixed-income portfolios.
Consider that when credit spreads have been equal to or higher than where they currently stand, we have historically seen the following performance over the next 12 months:
- U.S. credit averaged a return of 8.04% vs. 5.44% for U.S Treasuries.
- U.S credit averaged a return 1.89% higher than the Bloomberg Barclays U.S. Aggregate Bond Index.
- BBB rated credit averaged a return of 9.28%.
- S&P 500® index averaged a return of 6.02%.
Given higher yields, better risk premiums and attractive relative value, an allocation to corporate credit may benefit an investor’s fixed-income portfolio over the long term.
Diversifying Risk in an Investor’s Portfolio
Investors seeking higher levels of income or reduced equity risk may want to consider adding or increasing exposure to credit.
Total Return versus Standard Deviation
Source: Morningstar® Inc., as of 9/30/20.
With the investment-grade bond market and broad intermediate-term bond funds currently yielding 1.18% and 1.45% respectively, the addition of a fund such as Pacific FundsSM Core Income may ease yield shortfalls for income seekers and/or be a complement to those looking to generate alpha beyond core fixed-income safe havens:
Yield and Average Bond Price
Source: Morningstar® Inc., as of 9/30/20.
Pacific Funds Core Income
Since inception, Pacific Funds Core Income’s focus on credit has led to consistent outperformance relative to the Morningstar Intermediate Core Plus Bond Category. In 3-year and 5-year rolling periods, and since inception, our team’s expertise in credit has led this selective and nimble portfolio to favorable results.
Pacific Funds Core Income versus Morningstar Intermediate Core Plus Category
Source: Morningstar® Inc., as of 9/30/20.
Core stability across meaningful periods
The team’s ability to navigate the fixed-income market has generated significant outperformance relative to the fund’s category and benchmark, as well as providing better risk-adjusted returns since inception.
The Fund has also done well to manage the ups and downs of the market. Since inception the fund has had higher upside and lower downside quarter-over-quarter compared to both Intermediate Core Bond and Intermediate Core Plus Bond funds relative to the Bloomberg Barclays U.S. Aggregate Bond Index.
Source: Morningstar® Inc., 1/1/11-9/30/20.
PACIFIC FUNDS CORE INCOME
Net annual operating expenses for Advisor Class are 0.55% and total (gross annual) expenses are 0.73%. Returns reflect reinvestment of dividends and distributions. The Fund’s annual operating expenses shown above are effective 8/1/20 through 7/31/21. Gross Expense Ratio reflects the total annual operating expenses paid by the Fund. Net Expense Ratio reflects waivers, reductions, reimbursements, and the limitation of certain “Other Expenses.” Expense caps and/or fee waivers are reevaluated annually. There is no guarantee that the investment adviser will continue to cap expenses after the expiration date. Please see the current prospectus for detailed information. Advisor Class shares incepted on 6/29/12. Performance shown prior to this date is hypothetical and is that of Class I shares (12/31/10 inception date), restated to reflect applicable service and/or 12b-1 fees. Advisor Class shares are sold at net asset value (NAV) without an initial sales charge and do not include a CDSC. Performance reflects any applicable fee waivers and expense reimbursements. If a sales charge had been deducted, the results would have been lower.
For performance data current to the most recent month-end, call Pacific Funds at (800) 722-2333 or go to PacificFunds.com/Performance. Performance data quoted represents past performance, which does not guarantee future results. Current performance may be lower or higher than the performance quoted. The investment return and principal value of an investment will fluctuate so that shares, when redeemed, may be worth more or less than the original cost.
All share classes may not be available at all firms, and not all investors may be eligible for all share classes. Indexes are unmanaged and cannot be invested in directly. Further, they hold no cash and incur no expenses.
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For financial professional use only. Not for use with the public.
About Principal Risks
All investing involves risks including the possible loss of the principal amount invested. There is no guarantee the Fund will achieve its investment goal. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security. Not all U.S. government securities are checked or guaranteed by the U.S. government, and different government securities are subject to varying degrees of credit risk. Mortgage-related and other asset-backed securities are subject to certain rules affecting the housing market or the market for the assets underlying such securities.
The Fund is subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default). High-yield/high-risk bonds (“junk bonds”) and floating-rate loans (usually rated below investment grade) have greater risk of default than higher-rated securities/higher-quality bonds that may have a lower yield. The Fund is also subject to foreign-markets risk.
Pacific Life Insurance Company is the administrator for Pacific Funds. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
Investors should consider a fund’s investment goal, risks, charges, and expenses carefully before investing. The prospectus and/or summary prospectus should be read carefully before investing.
Pacific Funds is a registered service mark of Pacific Life Insurance Company (“Pacific Life”). S&P is a registered trademark of Standard & Poor’s Financial Services LLC. All third-party trademarks referenced by Pacific Life, such as S&P, belong to their respective owners. References of third party trademarks do not indicate or signify any relationship, sponsorship or endorsement between Pacific Life and the owners of referenced trademarks.
Mr. Imamura is registered with, and Pacific Funds are distributed by Pacific Select Distributors, LLC (member FINRA & SIPC), a subsidiary of Pacific Life Insurance Company (Newport Beach, CA), and are available through licensed third parties. Pacific Funds refers to Pacific Funds Series Trust.