One of the big challenges facing pensions and pension providers in an era of aging populations and extended life span is that liabilities are long term, while the investments that are meant to build up the assets to fund those liabilities are generally short, featuring equities and shorter-term debt.
For financial advisors who find themselves working with small to midsize business clients who are facing that challenge, there is the option of long-duration debt funds that invest in 20- to 30-year debt issues.
That would be funds like the PIMCO Extended Duration P Fund (PEDPX) and the PIMCO Extended Duration Total Return Fund (PLRPX), managed by Steve Rodosky, who for over a decade has been working on the Treasury trading desk at PIMCO, where he currently runs government bond trading.
Long-duration bonds had a field day over the past 12 months. Indeed, 23 out of the 38 top-performing mutual funds on a recent Morningstar list of 100 best fund performances were long-duration strategies (see pages 32 and 34). The remainder were dominated by REIT funds, biotech equity funds and inverse or other types of leveraged funds.
Tops on this list were two versions of the PIMCO Extended Duration strategy. Number-one on that list, with a 12-month gain of 55.88%, was the PIMCO Extended Duration Institutional fund (PEDIX), while the PIMCO Extended Duration P fund, for platform investors, with a 12-month gain of 55.73%, ranked third. Second place went to the Vanguard Extended Duration Treasury Index Fund (VEDTX), another institutional offering, which gained 55.78%.
PIMCO's long strategy has fared rather well over the longer term too. The three-year return for the PEDIX and PEDPX funds was an annualized 13.16% and 13.08%, respectively, and the five-year annualized return for the PEDIX was 14.63% (no five-year figure is available yet for the PEDPX platform version of this strategy, as the fund was founded in 2007).
Unique Factors Boost Long Bonds
The outsize returns for these funds and others that were high on the Morningstar performance chart were the result of a unique set of circumstances. As Rodosky explains, global tensions over the problems in the Euro zone as well as the U.S. debt downgrade last fall and the long summer stalemate over Congress raising the U.S. debt ceiling, conspired to produce an investor flight to quality, which favored long bonds.
Then there was "the surprise announcement from the Fed to embark on Operation Twist," where the U.S. central bank sold off medium-term debt to purchase longer bonds, in an effort to further push down the rates on shorter-term debt while driving up the price of long-term bonds. Because Rodosky focuses on zero-coupon Treasuries, he says the gains for his funds were even greater.
"Zero coupons fall the fastest and rise the fastest," he says.
Rodosky also manages another long-duration fund, the PIMCO Long Duration Total Return Fund (PLRPX). This fund differs from the Extended Duration Fund in that it is benchmarked against the Barclays Long Term Government/Credit Index, which is roughly 50/50 split between 10-/30-year investment-grade corporates and 10-/30-year Treasuries, rather than the Barclays Capital Aggregate Bond Index used as the benchmark for the PEDPX fund.
This second fund has a somewhat shorter duration than the PIMCO Extended Duration fund. "Which one makes the most sense depends on what else is in the blend of assets you are trying to balance and what the duration mismatch is at the outset," says Rodosky. "There is no uniform answer without considering the initial conditions of the pension plan in question."
He says, "Since corporate pension liabilities are discounted using an AA credit rate, many plans want an element of corporate bonds in their asset mix, so those assets and the liabilities behave similarly." But, he notes, "Since the duration of most pension assets is well below that of their liabilities, the Extended Duration Fund can add a lot of duration to their assets per dollar invested."
While the PIMCO Long Duration Total Return Fund did not have the stellar performance in 2011 that the Extended Duration Fund had, gaining just 18.6% for the year, its year-to-date return this year as of April 19 was positive at 1.64%, compared with a decline of -4.65% for the Extended Duration Fund.
Meanwhile, the Long Duration Total Return fund's three-year annualized return of 14.65% bested the Extended Duration Fund's 13.078 by almost 150 basis points. (The PLRPX fund's five-year annualized return was a respectable 11.04%.)
Morningstar analyst Eric Jacobson warns that these long-duration funds are not for the fainthearted, especially the PIMCO Long Duration Total Return Fund, which has among the longest durations among its class (about 14 years).
As a result, when fears of a European meltdown in the first quarter diminished, and there was a sell-off in U.S. Treasuries, with yield rising 48 basis points, the PIMCO Long Duration Total Return Fund lost 3%, "among the hardest hits taken by any fund in the long-term bond category."
Jacobson says Rodosky has "added value" to this fund by going outside of U.S. Treasuries and corporate bonds, putting 9% of the fund into non-U.S. bonds and 8% into municipals. This has helped the fund best its benchmark consistently by an average of 2% per year for the last five years.
Still, he warns, "While it may make sense for investors looking to balance out an otherwise short portfolio, or needing a portfolio of this type for other reasons, the fund's basic construction makes it appropriate for only the most risk-tolerant investors."