Pimco Diversified Income Bets Big on Emerging-Markets Bonds

When Pimco honcho Bill Gross introduced the idea of a “new normal” economy about two years ago, it was controversial. Today it’s conventional wisdom.

The new normal is a U.S. economy that struggles to grow as individuals and governments at all levels pay down huge debts. Returns from stocks are subpar, and the economy is more vulnerable to shocks -- such as the ones that we’ve experienced in the past few weeks.

Pimco Diversified Income (symbol PDVDX) is a superb fund for the new normal, and the views of its manager, Curtis Mewbourne, are timely even if you don’t need another bond fund.

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The recent downgrade of America’s debt rating by Standard & Poor’s didn’t come as a surprise to Mewbourne. “The reality is that the U.S. is not a triple-A credit,” he says. With accumulated federal government debt roughly equal to the nation’s gross domestic product, he says, the U.S. is “a lower-quality credit.”

The stock market’s dramatic selloff stemmed from “an acceleration of a lot of concerns that have been on people’s radar screens,” he adds. Congress was unable to strike a “grand bargain,” including spending cuts and tax increases, that would have made serious progress toward fixing the government’s debt problem. The euro zone continues to struggle with its heavily indebted countries. And the S&P downgrade, while expected, couldn’t have come at a worse time.

The U.S., Mewbourne says, could use short-term fiscal stimulus to boost growth. But Mewbourne and Pimco still think the U.S. will likely avoid a new recession. Instead, he sees real GDP growing at a sluggish 1% to 2% per year. The U.S. has never before grown that slowly for an extended period (although European countries have). The unanswered question: “To what degree can the U.S. operate so close to stall speed? Certainly, the odds of a recession are increasing.”

It’s not just deleveraging that’s slowing the U.S. economy. The new normal also acknowledges structural shifts in the economy, Mewbourne says. Most important, the unemployment rate is likely to remain relatively high, and many people will remain jobless for long periods. Reason: Many workers lack the education and training needed for jobs in the changing economy.

Many of those who built new homes lost their jobs when the housing bubble burst in 2007. Workers with construction and related skills are among the most likely to be unemployed. And that will likely continue for years to come, Mewbourne says.

Where to Invest for the New Normal

But investors can still make money. Emerging markets top Mewbourne’s list. “We feel very confident that many emerging markets will increase their wealth and the size of their economies,” he says. “Many people in emerging markets will undergo the transition from low income to middle income in a generation.” Diversified Income has about 40% of assets in developing-markets bonds.

Nor is it just emerging-markets companies that are benefiting from their growth. Much of Mewbourne’s portfolio is invested in high-quality companies in developed markets that are doing increasing amounts of business in emerging markets. “We own multinationals that are well positioned to benefit from growth in emerging markets.”

High-yielding corporate “junk” bonds account for 27% of the fund’s assets. I wouldn’t be overly concerned about that. Pimco’s credit analysts are among the best in the business.

The fund’s returns have been top-notch. Over the past five years through August 11, Diversified Income returned an annualized 7.4%, an average of 0.6 percentage point per year better than the Barclay’s U.S. Aggregate Bond index. It ranks in the top 10% among multi-sector bond funds over that period. The fund currently yields 3.9%. Mewbourne thinks the fund will return 6% to 8% annually in the coming years. Not to shabby for the new normal.

The fund should hold up reasonably well if interest rates rise. Its share price should decline by less than 5% if interest rates were to go up by one percentage point.

Mewbourne, 45, has been with Pimco 12 years and has a total of almost 20 years’ experience. He’s one of Pimco’s most trusted managers. He heads the portfolio-management team in the firm’s New York City office and manages Pimco’s in-house charitable foundation. Diversified Income has assets of $4.7 billion, and Pimco has about $20 billion invested in other vehicles that employ the same strategy.

Diversified Income’s one flaw is, unfortunately, a big one. The Class D shares, which are the only ones that individual investors can buy without a load and without ponying up a huge minimum, carry a 1.15% expense ratio. That’s outrageously high for a bond fund. Nonetheless, I’d hold my nose and buy the fund anyway.

Steve Goldberg is an investment adviser in the Washington, D.C., area.