Investors are experiencing numerous macroeconomic headwinds today, including a global economic slowdown, the European sovereign debt challenge, a looming U.S. fiscal cliff and lingering uncertainty about monetary policy’s effectiveness in light of high developed-market government debt levels. Because of these significant concerns, the demand for most high-quality, income-producing assets continues to exceed supply.
These powerful factors have driven interest rates lower and credit spreads tighter across many bond markets and in numerous sectors. Given current valuations and all the headwinds, investors should consider taking a more defensive and selective approach when evaluating current global investment opportunities.
In the global credit markets, we have been reducing risk across our portfolios, selling some cyclical companies exposed to areas where we expect continued weak or weaker growth, and also have trimmed risk to companies with lower-quality assets and balance sheets. Yet we still are finding numerous opportunities globally through our bottom-up research that targets areas around the world where fundamentals are supportive and the outlook remains constructive.
To get down to specifics, we see value in select companies across several industries, including pipelines, airlines, gaming, lodging, autos and chemicals, as well as in investments that should benefit from a recovery in U.S. housing. As we visit companies around the world, we are finding asset-rich companies with solid balance sheets that are currently benefiting from improving fundamentals, as well as a select group of credits that are being supported by a host of helpful factors, including: demand growth, improved market discipline, capacity reductions, high barriers to entry, supply constraints, efficiency gains, material cost advantages, and an improving outlook for pricing due to a reduction in inventory.
Here's a look at these global industry sectors – and the credit opportunities they are providing – in greater detail:
Pipelines
The pipeline sector can offer investors opportunities for exposure to asset-rich companies with stable cash flows. Our research has focused on a few pipeline companies that we believe are uniquely well-positioned to benefit from significant growth opportunities as a result of the emerging supply of energy resources being developed in the U.S. (See “Game Changer,” our March 2012 Global Credit Perspectives.) The increased development of oil shale assets and expansion of horizontal drilling throughout the country has resulted in a significant pick-up in U.S. crude oil production (Figure 1). U.S. pipeline companies that have gathering, processing, storage and transportation capabilities near these emerging oil and gas shale regions are currently benefiting from growth in U.S. energy production.
We've also uncovered several demand-pull pipelines that have high-quality strategic assets located in areas of the U.S. with significant growth opportunities as well as logistical advantages. In addition, we see numerous opportunities to invest in select pipelines with strong balance sheets in emerging markets.
Equity investors, for what we believe are good reasons, have moved into the U.S. pipeline sector in search of stable and non-cyclical cash flows and high asset quality and dividend yields. As evidence, enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) multiples have risen from roughly nine times in the last recession to almost 15 times today for U.S. pipelines (Figure 2). Given most investment grade pipeline companies maintain leverage or debt/EBITDA of four times or lower, bond holders in these companies currently benefit from over three times asset coverage.
Airlines
The airline sector currently offers investors opportunities to invest in bonds that have attractive covenants. In the airline enhanced equipment trust certificate (EETC) market, bond holders have security in a pool of underlying aircraft as well as some protection in the event of bankruptcy through special foreclosure privileges and liquidity facilities that cover bondholder interest payments over a period of time. Our research has focused on a select group of higher-quality EETC bonds that are the most senior in the capital structure and that are cross-collateralized by a relatively diversified pool of newer, more fuel-efficient airlines or aircraft that are critical to an airline’s operation.
Over the past several years, the U.S. airline industry has been reducing domestic capacity (Figure 3) while adding in international markets. The capacity reductions in the U.S. combined with a gradual pick-up in business and consumer demand has resulted in rising passenger loads (Figure 4) and a pick-up in total revenue per seat mile for the major U.S. carriers (Figure 5). Airlines are also currently benefiting from lower oil prices, the reduced bargaining power of unions, new fees on luggage as well as more disciplined management focused on maximizing profitability. In addition to improving industry fundamentals, rising demand globally for newer aircraft has supported valuations for relatively newer, fuel-efficient aircraft, also supporting asset coverage for EETC bond holders.
Gaming
The gaming industry currently offers investors the opportunity to invest in specific companies that stand to potentially benefit from improving infrastructure and rising consumer demand and consumption in the emerging markets. While gaming is experiencing a modest recovery in the U.S., gaming in areas of Asia such as Macau, a Chinese region, have been growing rapidly. As an example, total gaming revenue in Macau and Las Vegas were roughly equivalent less than seven years ago; today Macau revenue exceeds Las Vegas by roughly six times (Figure 6).
The growth in Asian gaming has been so significant that Las Vegas Sands (LVS), once a predominately U.S.-based gaming company with hotel and convention assets in Las Vegas, now generates roughly 90% of its EBITDA in Asia as a result of significant expansion in Singapore and Cotai, the newest area of gaming development in Macau. Both LVS and Wynn Resorts have become increasingly linked to Asian growth, as Las Vegas now generates only a relatively modest amount of each company’s cash flow (Figure 7).
To be sure, China’s economic growth is slowing from a cyclical perspective, and overall gaming growth in Asia is naturally slowing from very rapid growth over the past several years, and so high-end gaming revenues have recently come under pressure in Macau. But while higher-end gaming will continue to be cyclical, Macau may benefit secularly from a rising middle class and growing mass market of gamblers. Most important, the Chinese government is making significant investments in infrastructure to enhance transportation in the region, including high-speed rail developments throughout China as well as investments in new bridges and highway expansion to allow for faster access to Macau. As such, investors who are willing to be patient may wish to consider select gaming companies with strategic assets in Macau as well as in Singapore.
Lodging
The lodging industry continues to experience recent healthy growth rates of 6% to 8% in revenue per available room (RevPAR) in both the U.S. (Figure 8) and Asia Pacific (Figure 9). While early post crisis RevPAR improvements were primarily driven by improved occupancy – partly from discounting and promotions – recent RevPAR gains are mainly driven by increases in average daily rates on demand from both individual and business travelers. The recovery is also becoming much broader in nature. While luxury and upper end lodging names in particular sub-markets led the initial recovery, we are now seeing significant growth across the pricing spectrum and across various regions.
Improved demand, meanwhile, is complemented by a very attractive supply picture with modest new development in the sector, particularly in gateway cities such as New York and San Francisco, where operators are enjoying RevPAR growth. Our research is focused on identifying attractive names and investment opportunities across lodging bonds, lodging REIT bonds and commercial mortgage-backed securities backed by hotel assets with high barriers to entry.
Autos
The U.S. auto industry, like the airline and lodging industry, has benefited from significant reductions in capacity through the closing and shuttering of plants during the 2008-2009 economic downturn and financial crisis. U.S. auto companies also have been able to lower their unit labor costs by improving operational efficiency and through lowering fixed legacy costs in both labor and healthcare. In addition to production efficiencies, pricing discipline also has improved. On the demand side, U.S. consumers are primed to produce demand due to an aging fleet (Figure 10) as well as a growing need to trade in less fuel-efficient vehicles. This replacement cycle is supported further by credit conditions that have improved significantly for U.S. consumers with the interest rate on four-year auto loans now below 5% (Figure 11). Loan growth has picked up on both the demand and supply side due to improving fundamentals at banks and financial companies that are willing to supply credit for new auto purchases. As evidence, auto loan origination in the U.S. was up 15% year over year through the first quarter of this year. Overall, U.S. auto sales at 14.05 million units are up 23% year over year through June.
In addition to improving U.S. industry fundamentals, used car prices are holding up (Figure 12) due to healthy demand and improved access to credit. This trend is improving collateral values for auto finance companies which have seen a significant improvement in overall consumer credit quality due to falling delinquencies and charge-offs. We continue to favor investments in select U.S. auto finance companies which are benefiting from these supportive fundamental trends as well as in a few global auto companies which are running at high capacity utilization rates, have solid balance sheets, have strong brands and significantly improved overall operational efficiencies. Our bottom-up credit selection has focused on a select group of auto companies where we believe future product line-ups offer performance and value advantages as well as are targeted at higher-margin, more profitable segments of the global auto market in regions of the world with supportive growth.
Chemicals
America now has a significant and global cost advantage on the energy side due to low natural gas liquids (NGL) prices. And the U.S. is now among the lowest cost producers of ethylene, a fact that creates significant advantages for the country's chemical industry. Ethane-based producers of ethylene in the U.S. now have a cash production cost that is 60% lower than crude-oil or naphtha-based ethylene producers globally, according to IHS Chemical.
We have been favoring a select group of global chemical companies with a significant presence in the U.S. market where low NGL prices have materially reduced production costs. In the case of LyondellBasell – the second largest producer of ethylene in the U.S with 13% of total North American capacity – ethylene production costs have fallen almost in half (Figure 13) due to the company’s ability to access cheap U.S. ethane. LyondellBasell is experiencing significant margin expansion, generating healthy earnings and, as a result of low leverage and strong liquidity, is a candidate for moving up to investment grade.
Housing
Our generally more positive fundamental outlook for the U.S. housing market was recently featured in “Back In,” our May 2012 Global Credit Perspectives. Our overweight in U.S. banks, while reduced from previous positions, is supported by stable U.S. housing prices as bank balance sheets, capital and profitability all have improved significantly over the past several years. In addition to U.S. banks, we have been favoring investments in non-agency mortgages as well as in select companies that we believe stand to gain over time from the improving outlook for housing.
Take Weyerhaeuser, the Washington-state-based company with significant lumber, real estate, mineral rights and timber assets. The company is seeing a significant pick-up in home traffic and home closing, including 40%, 60% and 100% year-over-year increases in Seattle, Nevada and Arizona, respectively. The company also reported in the second quarter a 39% decline in unsold housing inventory and a 53% increase in order backlog. With housing demand improving, Weyerhaeuser’s lumber sales are picking up too, both in volume and revenue terms (Figure 14). We continue to favor asset-rich companies like Weyerhaeuser as well as investments in assets such as non-agency mortgages that we believe should benefit from an overall improved outlook for U.S. housing.
Diamonds in the rough
The outlook for the global economy remains uncertain, arguing for reducing overall risk in portfolios and focusing credit selection on a more targeted group of industries with supportive bottom-up fundamentals in regions of the world with the most constructive growth outlook. While we recognize all of the above opportunities involve risk and careful navigation, our global corporate bond portfolio management team and credit analysts have identified a group of companies in select areas that we believe should be relatively defensive and hold up well despite a challenging macro environment due to unique, bottom-up characteristics as well as supportive long-term, secular tailwinds.
Mark Kiesel
Managing Director