Pimco says ‘bonds are back’ with recession likely this year

There’s “a strong case for investing in bonds” as a recession looms this year, fixed-income investing giant Pacific Investment Management Co. says in a new report.

Pimco, which oversees roughly $1.7 trillion in assets, says that while a recession could further challenge riskier assets like stocks, “we continue to see a strong case for investing in bonds, after yields reset higher in 2022 and with an economic downturn looking likely in 2023.”

The bond manager has a baseline outlook for “a modest recession and moderating inflation,” an environment in which bonds have “the potential for both attractive returns and mitigation against downside risks.”

US core bond funds that yield 5.1% or higher “may offer additional downside mitigation versus outer-circle assets in the event of worse outcomes,” Pimco says.

The Federal Reserve “may need to reach a roughly 5% nominal federal funds rate, which is already largely priced into markets and reflected in the Fed’s own projections.”

Pimco advocated being neutral on interest-rate risk and expects a yield range of about 3.25% to 4.25% for the 10-year US Treasury. More broadly, they “do not expect to make large changes in current positioning based on the outlook and valuations.” Instead, the bond manager is “focused on identifying asymmetric trades across the range of plausible scenarios to complement current positioning.”

One area is inflation bonds, and while the cyclical outlook is of disinflation, US Treasury Inflation-Protected Securities “could perform well given uncertainty over where core inflation settles versus current pricing.”

The outlook for US mortgage-backed securities is solid, and “an expected decline in interest rate volatility would support MBS.”

Beyond the US, they remain “underweight duration in many portfolios,” in Japan and anticipate further adjustments in the Bank of Japan’s yield-curve-control regime. “This reinforces the case for being overweight the Japanese yen, which we see as cheap in our valuation models and a position we would expect to benefit in a deeper-than-anticipated recession.”

Pimco said they “are also underweight interest rate risk in China, where the skew is toward higher yields given the country’s reopening.”

Across emerging markets more broadly, “valuations screen as historically cheap,” but “much depends on the Fed’s ability to tame inflation and China’s ability to reactivate economic activity. EM appears poised to perform well down the road, but we remain cautious until the monetary policy outlook becomes clearer.”