Many sectors in both debt and equity markets have experienced positive returns recently, largely due to declines in interest rates, access to capital markets, and mergers and acquisitions (M&A) activity supporting multiples despite moderating earnings. While global corporate profits are slowing, declining rates and multiple expansions have helped boost returns in corporate debt markets, particularly in developed countries. Looking ahead to 2020, Mark Kiesel, PIMCO’s CIO of global credit; Christian Stracke, head of credit research and a portfolio manager; and Jeff Helsing and Matthew Livas, product strategists, discuss the outlook for credit investing globally amid the uncertainties of late-cycle markets, and highlight a PIMCO strategy that seeks attractive opportunities across credit markets while aiming to reduce downside risk, all with greater flexibility than a traditional index-focused strategy.
Q: What is PIMCO Credit Opportunity Bond Strategy, and how does it target its objectives?
Helsing: PIMCO Credit Opportunity Bond Strategy is a diversified, flexible global credit strategy that seeks to provide relatively attractive risk-adjusted returns regardless of market conditions. Because it is not constrained by a traditional corporate credit benchmark, it can more readily limit exposures to maturities, sectors, or regions that may have high weights in an index but unattractive investment profiles, in our view. The strategy has significant discretion to allocate actively across a broad range of global credit sectors, focusing on investment grade and high yield markets and supplementing this with selective exposure to emerging market bonds, bank loans, non-agency MBS (mortgage-backed securities), and convertible bonds.
Credit Opportunity Bond Strategy is one of PIMCO’s broad credit solutions. It seeks to deliver capital gains by identifying and investing in credits operating in industries or countries experiencing above-average growth rates as well as in areas with strong asset coverage. To help the strategy achieve its return objective, it also has the ability to pivot, taking on greater exposure to credit when spreads are attractive and, conversely, reducing the overall exposure and being more defensively positioned when necessary. We believe this strategy offers an attractive complement to traditional credit allocations, and it may appeal to investors seeking a less volatile path for credit with low sensitivities to traditional indices.
We believe experience and a deep bench of resources are all crucial in credit strategies. Credit Opportunity Bond Strategy is managed by Mark Kiesel, PIMCO’s chief investment officer for global credit and a portfolio manager, and Christian Stracke, global head of the credit research group and co-head of PIMCO’s opportunistic private strategies complex.
Q: What factors are you focused on when evaluating investments for Credit Opportunity Bond Strategy today?
Kiesel: Our investment strategy remains to “go for growth globally” by seeking specific companies with growth profiles that are higher than the economy’s overall growth rate in the markets where they operate. Growth is critical for investing in the global credit markets because it is such a powerful driver of potential expansion of enterprise value (the market value of a company’s debt plus equity) as well as of profit generation, which in turn can aid balance sheet deleveraging.
We watch fundamentals closely because they are linked to credit spreads: The degree of revenue growth drives expansion in enterprise value, and the magnitude of free cash flow generation influences reduction in net debt. As the ratio of net debt to enterprise value falls, the company’s credit fundamentals tend to improve, plus credit spreads can tighten. A focused, bottom-up perspective helps us pinpoint companies we deem to have healthy growth and free cash flow generation that may lead to credit spread tightening, rating upgrades, and potential outperformance relative to other credits in the same regions or sectors.
Q: Given that focus on growth, where are you finding attractive credit opportunities today?
Kiesel: We see opportunities in several areas. In U.S. housing, for example, the outlook remains constructive, supported by a strong labor market, solid pent-up demand, tight supply, attractive valuations, and ongoing recovery in credit availability and bank lending. There are many ways to invest directly and indirectly in companies that will likely benefit from higher housing prices, a pickup in home repairs and remodeling, and residential investment spending. We continue to favor select investments in building materials, lumber, specialty finance and banks, mortgage origination and servicing, and non-agency MBS.
The global consumer is another area of focus, and Asia gaming offers investment opportunities. Many companies in this sector have strong growth profiles supported by a growing middle class, significant regional infrastructure investments, and new property development.
Finally, we believe that growth in and demand for mobile data consumption should be very supportive for cellular tower companies. In recent years, mobile data consumption has increased at a rate of more than 30% per year, according to the Ericsson Mobility Report. If this growth persists as we envisage it will, it should translate into higher demand to lease tower equipment from cellular providers. These tower companies are essentially collecting a toll that’s increasing as customers use more cellular data, and are largely shielded from competitors given entry barriers and relatively high switching costs.
In all these areas, we seek specific companies whose growth is substantially higher than the overall U.S. economy’s nominal growth rate.
Q: Turning to other regions, what are your views on credit in Europe and in emerging markets (EM)?
Kiesel: In Europe, we remain cautious overall, but we are finding credit opportunities in select noncyclicals and U.K. banks. While Brexit-related issues may or may not lead to a U.K. recession, we find that several banks that are headquartered in the U.K. appear to be more diversified, well capitalized, and more resilient, in our view, than rating agencies or market prices indicate.
EM investing will likely continue to be more country- and company-specific. We favor companies that benefit from Chinese consumption along with Russian quasi-sovereigns and corporates that benefit from premier energy assets at the lower end of the global cost curve. We have positioned the portfolio for select offense, for example in Brazil, where the central bank is lowering rates to support economic expansion.
Q: Where are you seeing risks in credit markets, and how do you manage them?
Stracke: The combination of rapid growth in the bank loan and investment grade corporate markets, deteriorating underwriting standards, and strong structured product demand is leading to clear signs of excesses in certain parts of the corporate credit market. For example, the collateralized loan obligations (CLOs) that generate much of the demand for below-investment-grade loans are particularly sensitive to ratings downgrades, and often have structural disincentives to holding underperforming debt. Should growth slow, we would expect downgrades and coerced selling in these markets, which can create opportunities for flexible investors.
While a broad credit market downturn is not our baseline scenario, we have been moving up in quality, shortening maturities, and raising liquidity so that we can capitalize on the strategy’s flexibility to target special situations. As an example, the portfolio has recently increased its exposure to investment grade credit in the cable, telecom, and towers sectors. We have also increased exposure to select REITs (real estate investment trusts) where fundamentals are supportive and bondholders have covenants.
Furthermore, in the current aging expansion we have been able to identify cyclical (often political) challenges facing a range of companies and industries. Company-specific issues or industry microcycles often constrain the availability of capital for certain borrowers. For investors with the ability to source and evaluate those situations, this creates a range of opportunities, and we may see those increase should significant changes in confidence or market disruption lead to weaker growth.
Q: Could you explain the current short positions in the Credit Opportunity Bond portfolio?
Kiesel: The shorts we implement in the strategy fall into three broad categories: beta management, relative value, and individual credits.
For example, credit default swap indices allow for broader beta management, which can help keep the portfolio’s overall sensitivity to the market low while retaining positions in credit we believe are undervalued. In relative value positioning, we favor a long bias in select U.S. housing-related credits versus shorts in companies that develop and sell higher-end residential properties in states more impacted by recent changes in tax law. And for individual company shorts, we believe spreads in select retailers and consumer products at current valuations don’t reflect the changes in industry competitiveness and subsequent risk from higher leverage.
Our investment process, which combines top-down views with bottom-up research and valuation screens, is the same for both long and short positions. Our short positions typically reflect companies with weaker growth, low barriers to entry, and sectors with little pricing power and rising inventories. Typically, our shorts are likely to face rising leverage, and current valuations may not reflect these risks, for example because agency ratings are somewhat backward-looking or because the company is a relevant component of a credit index. Anticipating future spread widening and implementing short positions in these cases, if correct, can offer the portfolio the potential for incremental returns.
Q: Why should investors consider looking beyond traditional benchmark-oriented credit portfolios toward more flexible approaches?
Livas: We believe there are a couple of design issues in traditional credit benchmarks that can create distortions between price and value.
First, credit benchmarks are market-capitalization-weighted, meaning the more debt a company has, the greater its allocation in the benchmark. We believe this tends to create a disconnect between the benchmark representation and how creditors would lend capital in the real world.
Another concern we have with investing toward a market-cap credit benchmark is the backward-looking tendency. Large companies heavily represented in these kinds of portfolios often reflect growth models of the past, while companies that we believe have the potential to grow faster than other sectors and with less debt issued have smaller allocations, even in periods where risk-adjusted return potential is greater. PIMCO’s investment process and independent ratings include forward-looking views, and our ratings differ from agency ratings about one-third of the time.
Because sovereign yields globally are near historical lows and credit spreads are below or near longer-term averages, many credit investors expect returns to be lower and more volatile in the future. This is prompting many of them to look outside traditional approaches. Similarly, outcome-oriented and flexible strategies, like Credit Opportunity Bond Strategy, may be a useful way to diversify from core fixed income or manage risk from higher-yielding sectors while maintaining relatively attractive return potential. Higher allocations to more flexible strategies may help investors navigate credit market volatility in the aging expansion.