Pimco Income Has a Playbook for Rising Interest Rates

If interest rates rise over the next year, many bond funds could face tall hurdles. Steeper rates would push down the prices of their bonds. And if those IOUs aren’t paying out enough interest income, investors in the funds could wind up losing money. However, Pimco Income (PONDX) should be a good bet if rates continue to rise modestly, thanks to its robust yield of 3.5% (above the market average of 2.6%) and low sensitivity to rates.

Unlike bond funds that target one part of the market, Income, a member of the Kiplinger 25 can invest in just about anything the managers want. The fund recently held 9% of its assets in high-yield “junk” bonds, for instance, and 18% in emerging-markets debt. To keep the portfolio stable, Income holds large amounts of short-term Treasuries and mortgage-backed securities. Man­agers Alfred Murata and Dan Ivascyn (Pimco’s chief investment officer) also use complex hedging techniques to make side bets on the direction of interest rates, both in the U.S. and abroad.

Those side bets are the key to Income’s relatively low sensitivity to rates. The fund’s net asset value would likely fall by about two percentage points if market rates were to increase by one point. That would sting. But it wouldn’t be nearly as bad as the losses incurred by longer-term bond funds (Income’s average maturity is about six years) or those that don’t hedge against rates.

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Granted, this is a gigantic fund with a lot of moving parts. Income’s assets top $99 billion, making it the largest actively managed bond fund in the U.S. Managing so much money successfully takes a deft touch. If a few of Income’s big bets go awry, the fund could take some hits.

Another issue for investors to consider: Much of the bond market now looks fully valued, says Murata. With few bargains to be found, he says, “there’s little margin for error.” Rather than go out on a limb, Murata and Ivascyn are investing more defensively while trying to maintain the fund’s yield. The managers have bought more short-term high-yield bonds, for instance, which should hold up well if rates increase. In this environment, says Murata, “we think it makes sense to be more cautious.”