The European peripheral landscape is undergoing exceptional change, which in turn is transforming the face of European credit markets. Over the last year or so there has been a growing realization that spread risk is fast being replaced by credit risk, especially as these risks relate to sovereigns. The ongoing European peripheral crisis has resulted in the contamination of corporate credit markets and asymmetrical risk/return profiles. In contrast to 2009, when credit displayed equity-like returns, credit risk premiums on European corporate bonds now sit somewhere between the deeply overvalued levels of 2004–2007 and the wide spreads seen in the post-Lehman phase of 2008–2009 (Figure 1).
Navigating this new landscape through discerning credit selection is a key strategy for PIMCO, as is duration management. We think of it this way: It’s critical to differentiate in order to accumulate.
Greater Bifurcation and Long-Term Trends
European credit markets are marred by rising sovereign risk in the region. It is becoming increasingly rare for the market to price single names as standalone credit securities. The worst affected corporate credits are companies that are heavily tied to domestic economies going through massive structural adjustments. As a result of this growing correlation between sovereign and non-sovereign assets, investors must assess sovereign risk and not just the credit risk of the corporate bond in question. This trend highlights the significance of careful credit selection, especially in the peripheral countries of Spain and Italy where there are arguably better risk-adjusted opportunities.
Spanish debt has performed remarkably well this year; Spain does not face the same degree of solvency risk as Greece, Ireland or Portugal. But while the worst-case scenario has eased somewhat for Spain and Italy, it still pays to practice discerning credit selection: Consider companies with diversified distribution of earnings and that are mindful of offshore earnings, especially those emanating from emerging markets, which benefit from attractive fundamentals.
However, the challenge of analysis and valuation of credit securities in Spain and Italy – and, indeed, other eurozone countries – is likely to be exacerbated by a host of longer-term changes facing Europe. For instance, the pressure to “bail-in” European bondholders is growing, and this is likely to encourage greater differentiation across names and sectors, especially within the banking sector where the reluctance to impose losses on senior unsecured bondholders is fueling moral hazard. Following Ireland’s recent banking sector stress test, there is a growing feeling that governments need to break the unwritten code that senior bank debt in Europe is off-limits. Regulators, especially in Germany, are keen to force bank debt holders to take a haircut on their holdings should banks run into trouble again. This is likely to keep risk premiums volatile and elevated, resulting in greater differentiation between lower and higher quality banks. Expect more European banks to raise equity and issue more covered bonds as they continue to deleverage.
Additionally, consider the longer-term trends resulting from initiatives such as Solvency II, the new capital adequacy regime for the European insurance industry, when selecting credits. In anticipation of Solvency II, we expect to see less demand for ultra-long-dated corporate bonds, a segment of the market largely driven by insurance companies. Solvency II rules will impose significant capital charges on long-term bonds because of their increased volatility, making these securities expensive. But given that the implementation of Solvency II is still a couple of years down the line, we do not expect any immediate impact on credit curves. However, we feel it is prudent to focus on the three- to five-year part of the curve given its current attractive roll-down and total return characteristics.
Capitalizing on Valuation Anomalies
With credit risk premiums exhibiting greater differentiation and interest rates on an upward trajectory, bond yields and valuations face some difficult headwinds. However, a focus on alpha (excess return) strategies may counter the twin challenges of low beta returns and pricing anomalies. At PIMCO, we remain focused on seeking “safe spread” opportunities, which PIMCO defines as the sectors that are most likely to withstand the vicissitudes of a wide range of possible economic scenarios.
Actively managing duration exposure and selecting the most efficient part of the curve can be another way to target potential alpha. The credit curve is likely to remain steep and the three- to five-year maturity bucket currently offers good roll-down potential, allowing us to seek returns not only from the bond’s current yield, but also from additional carry (the effective yield from owning a security given its current price) through capital appreciation. This means the overall return has the potential to be higher compared with longer-dated and more volatile securities.
Another important potential alpha generator is individual credit selection. For example, when assuming single-name credit risk, a very strict focus on instruments that exploit the best value is important. At the moment, we are focused on the credit default swap (CDS). These are liquid instruments that allow us to seek credit risk premium while mitigating interest rate risk. Furthermore, with a large part of the cash bond universe trading tighter compared with the CDS instrument, we believe these to be an attractive opportunity. Conversely, in the event we think the corresponding cash bond is more attractive, we will look for cross-currency opportunities and invest in names or sectors that we deem to be cheapest on an foreign exchange basis. For example, there are currently certain sectors and single names that trade much cheaper in U.S. dollars relative to euros (with sterling credit being comparatively cheap).
We continue to monitor the bond universe and credit curves of each issuer while seeking to ensure that we are invested in the most attractive securities along the curve, if liquidity permits. Anomalies exist but will normalize over time, and it is therefore important to identify and capture them as they appear. PIMCO’s global credit team, through rigorous bottom-up analysis, is unearthing numerous opportunities to invest in companies with fundamentals we have determined to be improving, or what we refer to as “rising star” companies. These are companies that we believe are likely to be upgraded to investment grade status over the next 12 to 24 months. The potential for further tightening in credit spreads and their lower sensitivity to interest rate risk make these investments attractive additions on a risk-reward basis to investment grade portfolios.
Looking Ahead
The challenges for the European credit market are manifold. Firstly, the growing bifurcation between the smaller distressed European peripheral countries (Greece, Portugal and Ireland) and the two larger peripherals of Italy and Spain is blurring the lines between credit and sovereign risk. Secondly, inflation risk is giving rise to striking changes in the pricing of credit across the curve, calling for greater duration management. Third, since governments have limited resources to support their respective economies against the economic cycle (austerity takes precedence in European government circles), sovereign spending is unlikely to damp volatility across European credit markets. Finally, longer-term trends resulting from initiatives such as Basel III, “bail-in” and Solvency II are all serving to complicate sector and stock selection in credit.
In looking to combat the challenges outlined above, we believe that fixed income credit portfolios must be constructed using the global opportunity set across all bond sectors to withstand turbulence. Investors may need to be bold enough to avoid issuers and sectors that offer high spreads and yield but do not have coherent deleveraging plans. At the same time, investors may want to consider gravitating toward emerging markets issuers. As a substitute for financial risk, we look to allocate capital toward covered bonds and asset-backed securities (ABS), both of which sit higher up in the capital structure.
In our opinion, active duration management (underweight to duration), alongside much greater emphasis on individual credit selection, is the way forward . In a nutshell, you have to differentiate to accumulate.