“Bonds have seen their best days,“ says Bill Gross, manager of the world’s biggest bond fund at PIMCO (a subsidiary of Allianz Global Investors) in a Bloomberg Radio interview in March. His comments have drawn extensive market attention and investors are getting worried over their bond investments.

The fact that real interest rates are rising is the main bear element in the bond market, according to Gross. Besides, he said that excess borrowing in nations including the US, UK and Japan will eventually lead to inflation as governments sell record amounts of debt to finance surging deficits. As a result, bonds suffer.

The bearish comment of the “Bond King” has  worried investors. Nevertheless, Gross’s opinion does not necessarily mean bond is losing all of its investment value. Indeed, Paul McCulley, managing director of PIMCO, has expressed in April 2010 in the PIMCO’s Cyclical Outlook that attractive investment opportunities remain in selected quasi-sovereign and corporate issuers in emerging market countries, as well as US bank and select financial bonds. Only government bonds of countries with heavy debt like US and UK are lacking investment values.

Emerging Markets – Attractive Relative Value
PIMCO publishes its views on global economy quarterly. Its April cyclical outlook revolves around two core themes in the global economy, one of which is the huge disparity between the developed and the developing economies. According to Brian P. Baker, Chief Executive Officer & Director of PIMCO Asia Limited, the emerging economies had healthy reserves and balance sheets, but the developed world have overleveraged economies and are still in the process of deleveraging. As a result, they continue to expect a “desynchronized” recovery across the globe, with less leveraged emerging economies likely to grow more robustly than the developed economies (Table 1).

Table 1: Regional cyclical Forecast

Corporate bonds of emerging markets are among the top-picks of PIMCO. Mark Kiesel, PIMCO’s global head of corporate bond portfolio management, said in his US Credit Perspectives in April 2010 that credit Spreads for emerging market corporate bonds can be 50 to 100 basis points higher than similarly rated US corporate bonds in the same industry, offering attractive relative value. Sectors that are strategically important for sovereigns (e.g. oil, natural gas, pipeline and mission-critical infrastructure and resource companies) in countries with stable and strong economic growth are particularly attractive. In addition, many of the entities operating in these sectors are global leaders in their industries. Nonetheless, they generally pay more for their financing relative to what their fundamentals justify, simply because they are domiciled within an EM country.

Steep Yield Curve in US Financials
Besides emerging markets, Mark Kiesel finds US bank and financial bonds compelling for their stable fundamentals, attractive valuations and supportive technical factors.

“The growth of US banks’ problem loans should gradually slow and balance sheet strength and profit growth should improve throughout the year. Banks are deleveraging their balance sheets…facing increasing regulatory oversight. US bank and financial companies should issue less debt, providing supportive market technicals. Financials and banks also offer compelling relative value with wider spreads than some other sectors, such as industrials,” says he.

On the other hand, McCulley does not expect the Fed to begin tightening until 2011, “The Fed resolutely remains committed, in its own words, to maintaining ‘exceptionally low’ short rates for an ‘extended period’. At some point in the next three to six months, the Fed is likely to moderate this language, but we do not expect the Fed begin tightening until 2011, which will be well before the ECB (European Central Bank), as Europe faces headwinds of a much greater magnitude than the US.”

Currencies with Upside Potential
In terms of currency outlook, given the discrepancy of global economic recovery, PIMCO favours Chinese yuan, Brazilian real, the Canadian and Australian dollars, and along with euro, they would underweight the British pound and the Japanese yen. For the Chinese yuan, McCulley expects China will allow the yuan to appreciate over the next year, in part to dampen inflationary pressures as well as part of a process to rebalance toward more household consumption and less investment and exports. But the timing of any currency appreciation is difficult to predict because of politics.

“China is pushing back hard against US pressure to revalue…the two competitors have to look very strong, but the match has not even begun yet. Politics are increasingly a major factor in our cyclical outlook considerations, not only in China but throughout the world. In our discussions, we at PIMCO have reiterated that the world economy is becoming ever more a world political economy.”

On the asset bubbles worries in China recently, he states that the risks are manageable. “In general, we believe the risks of overheating and asset bubbles in china are manageable. China has stronger underlying fundamentals than other countries that have experienced bubbles. China also has a range of administrative policy tools available to fine-tune the economy, tools which are not usually employed in developed economies.”

PIMCO Total Return Fund Increases Cash and Cuts Government Debt Holdings in March
The above market outlook and investment strategy orientate PIMCO’s fund management direction. After a period of market rally, the “best days” of bonds may have been seen as opined by Gross. Nevertheless, as McCulley points out, attractive investment opportunities remain in the bond universe. The key for investing in the current situation is a targeted and conservative approach in the credit markets.

Managed by Bill Gross, the PIMCO Total Return Bond Fund is now adopting a stable and conservative investment strategy. Lawrence Tse, Chief Marketing Officer of Allianz Global Investors Hong Kong Limited reiterates that the Fund’s investment strategy has reflected in full PIMCO’s credit market views.

As countries start planning for their exit strategies (and some of them had already worked on it), the rise in interest rates would have an adverse effect on bonds. Nevertheless, the Fund has the flexibility to allocate assets across a wide range of bonds under the total return strategy. As such, Tse is confident that the Fund could maintain its flexibility even under the interest rate hike period. “Since the off-shore fund of the PIMCO Total Return Bond Fund was launched 12 years ago, over the time we had come across two major interest rate hike cycle. But the fund’s flexibility allows it to deliver positive performances for each of the twelve years, including 2008.” While past performance is not necessarily indicative of the future or likely performance of fund, it does serve as a useful reference of the fund manager’s ability.

According to the Fund’s factsheets, the fund manager has cut its investments in US government debt to a 28% weighting at the end of March, from 30% at the end of February. Its non-US developed debt position decreased from 25% to 23%, mortgage backed securities is down to 13% from 15%; investment grade credit from 13% to 12%. The Fund’s weighting in emerging markets bonds held steady at 6%, and in high yield bonds was also unchanged at 2%. Among different asset classes, the weighting of net cash & equivalents increased the most, doubled from 7% in Feb to 14% in March.

Upside potential of bond may be inferior to that of equity during economic recovery stage. However, bond investment does help reducing portfolio volatility, and enable investors to play a winning game with more stability. For conservative investors or those who wish to diversify risks from equity market, bonds or bond funds might still be one of the “must-have” items in your investment portfolio.

For more details on the PIMCO Total Return Bond Fund, please click here.