To illustrate how this investment process works in practice, we examine each step in more detail below and provide some specific examples of how each step in the process has influenced our investment strategy, starting with our macroeconomic outlook.

Starting From the Top: Macroeconomic Analysis
We begin with a macroeconomic outlook because we believe that long-term “secular” trends provide an important base for evaluating investment decisions.  These trends include: the social, political and economic forces that influence markets over the course of years rather than months.

To identify these secular trends, PIMCO’s investment professionals from around the world meet annually for our Secular Forum, a three-day discussion about the future of the global economy and financial markets. The goal of the Secular Forum is to look beyond the current business cycle and determine how secular forces are likely to influence financial markets over the next three to five years.

For example, the evolution of the so-called “Bretton Woods II” arrangement is one secular theme with significant implications for corporate bonds and our investment strategy. Under Bretton Woods II, China and other nations with large current account surpluses primarily invested their surplus reserves in U.S. Treasuries and agency bonds in order to support the U.S. dollar and thus support their own export-driven economies. As Bretton Woods II has evolved, nations with current account surpluses have begun to seek higher returns and diversification into non-dollar assets. In addition, oil-producing nations have accumulated large reserves following the rise in oil prices and are also investing those reserves in the global market with an apparent preference for riskier assets offering higher return potential. As a result, large pools of money have flowed into riskier assets such as corporate bonds, lowering and compressing risk premiums. 

What are the implications of these trends for corporate bonds and how does PIMCO implement these views in its portfolio strategy? One implication of the compression in risk premiums is that corporate bonds with lower credit quality offer little compensation for the additional risk they entail. Thus, based on our secular view, we are favouring corporate bonds on the higher end of the credit-quality spectrum. A second implication is that diversification away from the dollar should lead to a lower dollar and underperformance by dollar-denominated assets compared to assets denominated in other currencies. Based on this view, PIMCO’s corporate bond investment strategy favours increased international diversification.

Secular trends also influence whether PIMCO overweights or underweights specific industry sectors or regions. If secular forces favour a sector, we are more likely to overweight bonds in that sector and vice versa. Based on our current view for example, PIMCO likes the banking sector because banks need high credit ratings and healthy balance sheets in order to keep their funding costs low. This reduces their exposure to shareholder-friendly initiatives like leveraged buy-outs, which have increased significantly over the last years and have led to the issuance of more debt, often driven by hedge funds and private equity firms.

In addition to the annual Secular Forum, PIMCO’s investment professionals meet quarterly to examine shorter-term cyclical forces that are likely to influence the market over the next twelve months. Depending on the influence of cyclical factors, we may adjust portfolio strategy within the parameters determined by our secular outlook, but we do not change those secular parameters without the full review provided by our Secular Forum. 

Combining the Top-Down View with Bottom-Up Credit Analysis
PIMCO’s macroeconomic view provides our portfolio managers and credit analysts with a top-down risk framework around which the portfolios are constructed. When it comes to selecting individual securities that will fill out this framework, PIMCO’s credit analysts and portfolio managers analyse corporate balance sheets and meet with corporate management to pick specific companies and bonds that are the most attractive given our macroeconomic outlook. As PIMCO’s credit analysts identify bond issuers that are attractive based on fundamental creditworthiness (within the sectors favoured by PIMCO’s macroeconomic forecast), the analysts provide the portfolio managers with recommendations.

The portfolio manager then takes those credit recommendations and factors in prices and spreads to identify the securities that are most attractive from a value perspective, from a macroeconomic perspective, and from a credit-quality perspective. This process occurs through formal quarterly and weekly meetings, as well as through constant daily communications between PIMCO’s credit analysts and portfolio managers around the globe.

Rather than arbitrarily divide responsibilities between high yield and investment grade, PIMCO analysts cover sectors through the whole ratings spectrum. This provides analysts with a broad view of industry participants and performance metrics that can be used to evaluate the likely direction of credit fundamentals, and ultimately, ratings. In addition, an analyst looking at both high yield and investment grade credit within an industry will be able to quickly identify if a company is priced too low or too high versus other companies with similar credit risk profiles and buy or sell those bonds. In contrast, when different analysts cover high yield and investment grade companies separately, they may not be aware of a company about to be downgraded or upgraded until they see the research from another analyst, and it could be difficult to trade the bonds efficiently at that time.

Factoring in the Role of Supply and Demand
PIMCO’s investment philosophy focuses on finding fundamental value, but we must always be aware of technical factors that are driving supply and demand for corporate bonds, which can significantly influence the market value of bonds.

Technical factors can also influence PIMCO’s view on whether a bond’s valuation is justified. We are more willing to purchase corporate bonds trading at tight spreads to government bonds if fundamental and technical factors are both positive. However, the firm never loses sight of absolute and relative value when assessing corporate bonds. We will not invest in a bond if its spread does not compensate us for the historical risk of default or downgrade, even if the bond’s fundamental and technical factors are positive.

To fully understand the influence of supply and demand on the corporate bond market, PIMCO assesses technical factors at three different levels: the market level, the sector level and the company level.

At the market level, we examine the volume of bonds that are likely to be issued and the likely demand for those bonds. Bank lending is one factor we watch closely in trying to estimate the future supply of bonds. If banks have capital to lend and are aggressive in lending to the corporate sector, corporations may borrow from banks instead of borrowing in the capital markets by issuing bonds. We also gauge the corporate sector’s appetite for capital expenditure and business growth.

At the sector level, we are constantly seeking the answer to three specific questions. First, are certain business sectors likely to grow more rapidly than others and therefore require more debt to finance that expansion? Second, do certain sectors have debt that is maturing sooner rather than later, which will require refinancing of that debt? And third, are there dynamics within a sector, such as increased merger and acquisition activity, which could cause a change in the structure of the sector’s debt.

At the company level, PIMCO’s credit analysts play a critical role in providing the maturity profile of a company’s debt and assessing the likelihood that a company will need to issue new bonds. PIMCO portfolio managers and analysts speak directly with the corporate management to understand how they are thinking about their debt management program, even to the point of considering where along the credit curve the company would likely issue new debt.

When assessing demand for corporate credit, we consider how prospective returns in other asset classes might affect investors’ risk appetite, as well as the influence of market developments such as the creation of credit derivatives. In Europe, for example, the growth of credit derivatives has had a particularly positive effect on demand. Investors searching for higher returns have turned to the credit derivatives market for diversified exposure to corporate credit, and this demand has contributed to the narrowing in European corporate bond spreads.

Although some investors see technical factors as only a marginal part of corporate bond investment strategy, at PIMCO we understand that technical factors can have a significant effect at the market level, the sector level and the company level. PIMCO’s considerable credit research resources effectively analyze how to be ahead of the market instead of waiting for technical factors to play out.

Acting Locally, Thinking Globally
To find corporate bonds that offer value from a top-down, bottom-up, and technical perspective, PIMCO employs a team of 17 portfolio managers and credit analysts in Europe who are part of an integrated global team. This combination of local expertise and global scope provides key advantages when trying to find the maximum value.

Our global expertise is invaluable when it comes to identifying attractive securities that are issued globally but not in Europe. At the same time, our global capabilities enhance our ability to locate the most attractive bonds of a European issuer available in the global market, regardless of currency or location. Opportunities in the latter case stem from domestic investors’ tendency to prefer bonds issued in their local currency. Therefore bonds offered in foreign currencies often provide higher yields for almost identical risk.

This global market approach also integrates specialists on so called non-traditional sectors, such as asset-backed securities, and on derivatives. The potential for the use of derivatives in many portfolios has increased due to recent innovations in the credit markets, including in euro corporate portfolios. PIMCO’s European corporate strategy typically uses derivatives for two general purposes: to manage the portfolio’s exposure to currency as well as interest rate movements and to efficiently gain access to corporate bond exposure.

The growth of the credit default swap market (CDS), as one example, has brought liquidity into the credit market and provided an opportunity to substitute CDS exposure for traditional cash bond positions. The use of CDS index products allows portfolio managers to efficiently add or reduce credit exposure to deal with portfolio cash flows and to cost-effectively implement macro credit strategies such as sector or quality underweights and overweights. The use of individual name CDS provides further opportunity to maximise value added from security selection.

Conclusion
PIMCO believes the key to successful corporate bond investing is to find bonds that adequately compensate investors for taking risk. To fully understand the risks entailed in a corporate bond, we examine the market from top-down macroeconomic perspective and conduct extensive bottom-up credit analysis on individual bond issuers. Once we have identified companies that are fundamentally attractive from both a top-down and bottom-up perspective, our global team works together in an attempt to extract the most value possible from our investment in those companies.