Viewpoints

Credit, Where Credit Is Due

The implications of an improving macro backdrop and the present late-cycle environment.

Q&A with Eve Tournier, managing director, portfolio manager, and head of European credit. Eve Tournier discusses the investment implications of an improving macro backdrop and the present late-cycle environment. With more than 21 years of experience, she has invested across multiple market cycles.

Q: PIMCO’S LATEST CYCLICAL OUTLOOK SAID THE PROBABILITY OF RECESSION HAS DIMINISHED, FOLLOWING STRONG CENTRAL BANK SUPPORT AND MILDLY RECOVERING GLOBAL MANUFACTURING DATA. WHILE WE ARE STILL AT A LATE STAGE IN THE BUSINESS CYCLE, DOES EUROPEAN CREDIT HAVE MORE SUPPORT THAN SIX MONTHS AGO?

Tournier: For the first time in a long while, we now have synchronised accommodating monetary policies and modestly stimulative fiscal support across developed markets. In November, the European Central Bank (ECB) restarted Quantitative Easing (QE) and cut interest rates to –0.5%. Its guide is that those measures will remain in place until the inflation outlook ‘robustly’ converges to its target. Given that our inflation forecast for 2020 is around half of the ECB’s 2% target, there is no reason to expect an end to QE anytime soon. With approximately half of Euro-area government bonds negative yielding, demand for income producing assets such as credit is likely to remain elevated.

Q: WHICH CREDIT SECTORS DO YOU FAVOUR IN EUROPE?

Tournier: We continue to like banks which have rebuilt their balance sheets since the financial crisis and are now better regulated and capitalized. In particular, we have a positive view on U.K. financials. While we were able to harvest most of the Brexit uncertainty premium over the past 6 months, we still see room for some further spread compression in specific banks likely to be upgraded post a managed Brexit. We also see further spread compression potential in Italian banks which continue to reduce non-performing loans and improve their balance-sheet. Finally, we favour real estate investment trusts and the real estate sector, which benefit from strong asset coverage and covenants that lessen the risk of over-leveraging. Furthermore, we have a positive view on cable media/broadcasting debt which is supported by high barriers to entry, and cash flow generation.

Q: WHAT IS YOUR VIEW ON THE U.S. CREDIT MARKET?

Tournier: We discussed earlier the expectation for a benign macro environment in 2020 keeping default rates low; unfortunately valuations already reflect this outlook and generally sit at the 20th percentile relative to the past 20 year history. This means that investors can expect to earn carry from their credit portfolios, but any material further price appreciation is currently limited given the starting yield.

As credit spreads have compressed, investors are rewarded with less and less spread pick-up when taking on more credit risk. In this environment we recommend a focus on bottom-up security selection to achieve higher returns rather than generic beta.

We also recommend investors focus on sectors that are supported by strong underlying trends or high barriers to entry. In particular, the US housing sector has finally absorbed excess homes built pre-crisis, and we are now entering a period of overall scarcity across the US. We also like sectors like pipeline operators, which benefit from steady revenue streams and hard assets, and cellular tower operators, which are supported by high demand as a result of the ongoing growth in mobile data consumption.

In today’s environment, the need for active, highly selective investing has become more important than ever.

Figure 1 shows valuations of various fixed income securities in terms of their option-adjusted-spreads and their percentile relative to historical levels. Three charts show the levels for December of 2017, 2018 and 2019, for U.S., European, and emerging market fixed-income securities. Current spread levels in December 2019 were relatively low, warranting an emphasis on bottom-up security selection.

Q: YOU HAVE ALWAYS BEEN A STRONG ADVOCATE OF DIVERSIFICATION AS A WAY TO REDUCE RISK. HOW DO YOU ACHIEVE THIS?

Tournier: By definition, if one can achieve similar yield to High- Yield (HY), but with a more diversified, less correlated, higher quality portfolio, then over time one should achieve better risk-adjusted returns.

A global opportunity set allows us to seek the most attractive relative value opportunities across regions and markets. We take into account differences in fundamentals and trends that may impact credit quality, as well as specific technical distortion and relative valuation opportunities across markets and different investor bases. By having access to a wide credit universe, consisting of HY, Emerging Markets and Investment Grade , as well as adjacent sectors like securitised debt, municipal debt and bank loans, our multi sector credit portfolios are truly diversified. While relative value and allocations ebb and flow, we find there are always some interesting alpha generation opportunities in some corners of the global credit market.

Q: AND WHAT DO YOU FAVOR IN HIGH YIELD?

Tournier: Given the late-cycle environment, we are naturally cautious in high yield security selection. Still, we like defensive and non-cyclical sectors with stable cash flows, such as the cable and healthcare sectors. High yield remains supported by fundamentals, with relatively stable leverage levels and issuance proceeds mostly used for refinancing, rather than expensive mergers and acquisitions (M&A) or dividend pay-outs. And although idiosyncratic risks are rising, we do not anticipate a significant increase in default rates, which we believe are likely to remain around 3-4% in the U.S., and lower in Europe, over the next 12 months. Technical factors are also constructive, given the demand for yield, a shrinking market as a result of limited net new issuance, and several “rising stars,” or companies moving from high yield to investment grade indices.

Figure 2 is a graph of the amount of global negative-yielding debt from 2013 to 2020. The line is basically at zero until mid-2014, when it starts to climb. The amount of debt in this category peaked in mid-2019 at around $17 trillion, and fell to about $11 trillion by mid-January 2020. The amount of negative yielding debt fluctuated between $6 trillion and $12 trillion from late 2015 to the first half of 2019, after which it spiked

Figure 3 shows a graph contrasting consumer sentiment with a manufacturing index. From January 2015 to January 2019, the University of Michigan US consumer sentiment and the US Manufacturing ISM Index fluctuated roughly in tandem. Afterwards, the two measures started to diverge, with consumer sentiment registering higher relative to manufacturing. By mid-January 2020, the difference between the two is at a maximum on the graph.

Q: OVERALL IN CREDIT, WHICH SECTORS DO YOU FIND UNATTRACTIVE?

Tournier: We have a cautious view on cyclical industries such as raw materials and retail, both of which have limited pricing power and face cyclical and/or secular challenges. The technology sector is also vulnerable to obsolescence risk, and furthermore generally lacks hard assets.

Q: AS AN ACTIVE MANAGER, HOW DO YOU SEEK TO GENERATE ALPHA IN THE CURRENT ENVIRONMENT?

Tournier: The key is to combine top-down macroeconomic views and their implication for asset allocation and sector rotation with bottom-up security selection, driven by the fundamental research of our 65+ credit research analysts. These views are then incorporated into four basic pillars of portfolio construction:

  1. Quality: We favour structurally senior positions in the capital structure of a company, as well as strong asset coverage. We find this is the most resilient segment in periods of market stress.
  2. Structurally inefficient markets: Despite the growth of credit markets, there are pockets that are less well understood or not as widely followed, like securitised credit. We aim to find value in less-researched markets in order to deliver better risk-adjusted returns.
  3. Risk management and diversification: We seek to build resilient portfolios, which are stress-tested, and in which we emphasize diversification to reduce risk.
  4. Catalyst trades: We look for securities with upside potential as a result of a potential catalyst, for example “rising stars” or companies that may be subject to M&A or refinancing.

Q: LASTLY, AS A PORTFOLIO MANAGER, WHAT KEEPS YOU AWAKE AT NIGHT?

Tournier: Cyclically the US election and geopolitical risks in general can provide some volatility. Medium term, the confrontation between the incumbent US super-power and the rising Chinese challenger is likely to be increasingly disruptive. Medium to long-term we are all starting to grapple with the impact of climate change. And then there is the issue of liquidity risk.

So, we must stay vigilant and disciplined, seeking to reduce risk in strong markets in order to be able to invest during periods of volatility, when we can potentially benefit from more attractive valuations or tactical opportunities. We combine this short-term view with our distinct, fundamental, and long-term approach, which we use to give credit where credit is due. As global credit investors, whatever the market circumstances, we will continue to finance high-quality businesses in exchange for attractive risk-adjusted returns for our clients, which is our ultimate goal.

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The Author

Eve Tournier

Head of European Credit Portfolio Management

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Past performance is not a guarantee or a reliable indicator of future results.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. Diversification does not ensure against loss.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material does not constitute an offer to sell or solicitation of an offer to buy any securities other than the Shares offered hereby, nor does it constitute an offer to sell to or solicitation of an offer to buy from any person or persons in any state or other jurisdiction in which such offer or solicitation would be unlawful, or in which the person making such offer or solicitation is not qualified to do so, or to a person or persons to whom it is unlawful to make such offer or solicitation.

The services and products described in this communication are only available to professional clients as defined in the Financial Conduct Authority’s Handbook. This communication is not a public offer and individual investors should not rely on this document. Opinion and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. We believe the information provided here is reliable, but do not warrant its accuracy or completeness.

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