Since the start of 2016, the dollar has fallen against most major and emerging market currencies. A debate has emerged around whether this downtick is a short break from its longer-term uptrend or the beginning of a new course lower. The fate of the greenback will have a tremendous global impact. The differences in exchange rates account for one-third of the total return derived from a basket of international stocks and twice that amount for international bond funds. Many leading commodities like copper and oil are also priced in U.S. dollars. Emerging market countries and various natural resource companies have borrowed dollars in order to conduct business. An appreciating U.S. currency places those who anticipated a stable or declining dollar on the wrong side of the trade.
Currency Trends
The dollar uptrend over the past several years has been the result of various central bank and government monetary and fiscal policies. Washington and the U.S. Federal Reserve responded early and aggressively to the 2008 financial crisis. The strong economic growth that resulted created a divergence between the U.S. and the rest of the world as other central banks waited several years before initiating their respective stimulus programs. While the Fed has raised its interest rate targets and is tapering its bond-buying program, the European Central Bank (ECB) and the Bank of Japan (BOJ) are still engaged in their quantitative easing programs and lowering rates into negative territory. U.S. banks also have far stronger balance sheets than those of their European counterparts.
The recent pullback in the dollar occurred primarily in response to near-term policy changes by the BOJ. The central bank did not initiate easing as expected at its policy meeting in April. The BOJ was also blocked from intervening by the G-7 ahead of the group’s policy meeting in May. The yen has risen almost 10 percent this year. The latest rise in the price of oil and other commodities has strengthened the currency of many resource-exporting countries as well. The Canadian dollar has risen close to 9 percent this year.
While there is near-term volatility, the longer-term divergence between the U.S. and the rest of the world’s economies is expected to continue as monetary policy disparities between the Fed and other central banks remain in place. Investors seeking higher income and growth opportunities across multiple global bond sectors should consider the PIMCO Diversified Income Fund (PDVBX). Investing across various credit and emerging markets, PDVBX is a risk-managed, income-oriented fund that serves as a complement to a traditional core bond holding.
Fund Overview
With $2.3 billion in assets under management (AUM), PDVBX is a four-star Morningstar rated bond fund that seeks to maximize total return while preserving capital through prudent investment choices. The fund typically invests at least 65 percent of AUM in a diversified portfolio of fixed income securities of varying maturities. While concentrating primarily in investment-grade debt instruments, the fund may invest up to 10 percent of assets in high-yield debt. Fund managers look to take advantage of global bond sectors that may provide an incremental yield over the opportunities presented by developed market government bonds. These sectors are primarily investment-grade corporate and emerging market sovereign bonds. The fund uses three equally weighted indexes as benchmarks. They are the Bank of America Merrill Lynch Global High Yield BB-B Rated Constrained Developed Markets Index USD Hedged, the Barclays Global Aggregate Credit Component excluding Emerging Markets USD Hedged and the J.P. Morgan EMBI Global USD Hedged indexes. PDVBX has an initial investment minimum of $1,000 and an expense ratio of 1.15 percent.
Investment Strategy
Fund manager Curtis Mewbourne, who took over in 2005, and his team of analysts rely on PIMCO’s “top-down, bottom-up” research. Mewbourne estimates that the team’s asset-allocation and sector-rotation strategies drive approximately 50 to 60 percent of the fund’s returns. Security selection and currency management as well as portfolio duration and yield-curve positioning account for the rest. Starting with macro cues from PIMCO’s investment committee, Mewbourne determines which of the benchmark sectors offer the best value. He then allocates assets to specialist managers who select individual securities using analytics to ensure that the positions match the fund’s macro theme.
Fund managers take a flexible approach to the portfolio’s sector weightings based on market and economic conditions. This strategy enables the portfolio to have a defensive stance and to take full advantage of compelling income opportunities across various regions and credit quality ratings. This forward-looking global outlook creates attractive risk-adjusted returns. Fund managers prefer bank and pipeline debt when compared with the underlying benchmarks.
Portfolio and Holdings
The portfolio has a 64.6 percent exposure to domestic debt securities. The remainder of the fund’s assets is primarily invested in European credit instruments. The fund has a small exposure to the Cayman Islands, Mexico and Indonesia. The portfolio is heavily weighted toward corporate bonds and commercial mortgage-backed securities as well as other domestic government-related issues. The fund has an effective maturity of 9.47 years and an effective duration of 5.28 years. The portfolio is predominantly rated BB or better. PDVBX has a 30-day Securities and Exchange Commission yield of 4.34 percent.
Historical Performance
Although somewhat more volatile over the past few years than its category average, PDVBX has attained 3-, 5- and 10-year returns of 1.03, 4.06 and 6.03 percent, respectively. The fund’s returns are better than the returns of 50 percent of its counterparts listed in Morningstar’s multisector bond fund category. A strong performance in the first half of 2015 as well as a surge in the fall enabled the fund to beat 97 percent of its multisector peers on a 1-year basis. This performance was aided by the fund’s exposure to investment-grade and high-yield corporate bonds along with its neutral position in emerging market debt.
Outlook
Supported by strong personal consumption, low energy prices and healthy job gains, the U.S. economy is still on track for above-trend growth. Despite continued stimulative actions by the ECB, European growth will remain modest. Based on the slowdown in China, emerging markets still face headwinds. As a result, the fund maintains a long bias toward the U.S. dollar. It will continue to do so as long as the divergent monetary policies remain in effect. The fund will look for short-term opportunities in the emerging markets and high-yield debt based on the value in these sectors caused by any selloffs. Managers expect company balance sheets to remain strong and default risk to be minimal. They favor financials, high-quality industrial names and residential mortgage-backed securities to take advantage of the strength in the U.S. housing sector.
Emphasizing assets with a strong yield and low downside risk issued by rising corporations and other favorable sectors, PDVBX can add global bond exposure to an otherwise well-diversified income portfolio. For that reason, we have issued a Strong Buy recommendation along with a Rank of 86. If you have any questions pertaining to your Vanguard bond positions or increasing your portfolio’s yield, call us anytime at (888) 252-5372.