With mounting worries about the simultaneous and large disruption in sovereign balance sheets of many peripheral European countries driving sovereign bond spreads to levels higher than some same-country corporates, European credit markets are seeing a rise in volatility and contagion risk. In such an environment, active security selection and bottom-up credit analysis will prove essential in not only mitigating such risks but also in unearthing new corporate credit opportunities in both European and global markets.
When Sovereigns Re-lever, Credit Markets Suffer
Not many individuals will contest the role government intervention played in stabilizing financial markets and the global economy during the financial crisis of 2008-2009. The transfer of debt loads from bloated private sector balance sheets to public sector balance sheets by way of government guarantees, check writing and quantitative easing went a long way in preventing a systemic collapse of the financial system. Unfortunately, it also produced another, if somewhat inadvertent effect by shifting the balance of debt to sovereigns: It blurred the lines between sovereign and non-sovereign assets. And nowhere is this more pronounced than in the European credit market where European sovereign bond spreads are significantly wider than some of their corporates (see Chart 1). This makes credit investing challenging, as one of the golden rules of credit investing is that government bonds should be safer than corporate bonds.
The risk of erosion to credit quality is further heightened by both the direct and indirect impact of the sovereign debt crisis. We have seen a rise in corporate credit default risk premiums as member states struggle to coordinate a collective and effective response to the crisis. For corporates in very stressed sovereigns, there is a risk that capital markets will close altogether. Corporate credits may suffer latent distress if governments raise taxes, change regulations and consumption levels drop due to wealth shrinkage. In a worst case scenario, corporate debt holders may be forced to accept haircuts or governments may respond by simply seizing assets.
Adding to the woes of the eurozone’s debt expansion are concerns around deflation. The eurozone peripheral economies and the U.K. are undergoing incredible fiscal tightening, which will impact growth significantly in these economies. Naturally, when you get this kind of fiscal retrenchment, the risk of deflation becomes much more pronounced.
As a result, the European credit market is likely to remain volatile as sovereigns face the risk of debt rescheduling or are forced to tap the EU/IMF bailout plan, all unthinkable outcomes for developed economies just a few years ago. Likewise, the growing risk of contagion, heightened volatility and the blurring of credit quality in much of the European credit market are posing challenges for European credit investors; and the situation is unlikely to reverse itself any time soon as these sovereigns make difficult multi-year adjustments in an attempt to reduce the debt burden.
So, where can credit investors go?
Given the degree of volatility in European credit markets and the lower growth prospects of the peripheral eurozone economies, corporate credit investors will increasingly look farther afield for interesting opportunities; aligning the appropriate top-down, macroeconomic themes with the best possible risk-adjusted opportunities that emerge from detailed bottom-up analysis.
For example, the eurozone crisis has further enhanced the relative growth prospects of emerging market (EM) capital markets. Emerging market issuers have had a remarkably resilient decade and are becoming a far more stable part of the credit market. This, coupled with the simultaneous rise of debt in developed markets, is fueling a shift from developed to emerging markets, which now have better fundamentals, stronger growth prospects and lower debt loads than sovereigns in developed economies. In other words, portfolios need to incorporate a global investment outlook in the New Normal.
While EM corporates offer attractive premiums to equally rated investment grade companies in developed markets, we remain very selective when it comes to EM credit and are careful to ensure that our microscopic understanding of the company fits into our desired risk/reward profile.
This global outlook extends to the sterling credit market where less than half of the sterling corporate bond index is made up of U.K. issuers, with the remainder being global issuers. The sterling credit market is very much a global market, with plenty of global borrowers and issuers generating significant earnings from both emerging markets and non-U.K. sources.
Capitalize on Corporate Deleveraging
Credit fundamentals are stable and continue to improve in the global banking sector (see Charts 2 and 3). With policymakers playing a more interventionist role, banks are forced to delever. As they do so, their earnings should become far more stable and we can expect to see a return to the traditional banking activity of borrowing and lending.
Over time, the banking system is likely to emerge with a much cleaner balance sheet and a regulatory framework that is designed for greater burden sharing for debt holders, even senior debt. To this effect, we expect the banking system to increasingly resemble utilities companies, characterized by lower return on equity and a reduced ability to leverage.
We also favor a select group of bank hybrids that we think will see a growing demand for a number of reasons, not least of which is encouragement from regulators. That is not to say such securities are without risk, but investors are being compensated with an attractive relative yield. It is important to remember that hybrid corporate bonds must be evaluated in the context of their unique characteristics: In contrast to traditional bonds, hybrids do not necessarily offer fixed maturity dates and may allow the borrower to defer interest payments. Due to these features, they trade with higher yields and lower ratings than their senior bond counterparts. Exceptional security selection is key to investing in this sector of the credit market.
Another key element of our strategy is capitalizing on the dramatic steepening in the yield curve. With key central banks around the world stuck in a place where they are unlikely to raise rates, there remain good opportunities to capture attractive yield from both investment grade and high yield bonds with maturities ranging from one to five years.
All of these opportunities, as well as risks, suggest investors should consider a credit strategy that places equal importance in determining what you should own as it does when determining what you should NOT own. In a levered sovereign world, active security selection will continue to play a pivotal role. It should be less influenced by rating and more closely focused instead on security selection based on curve positioning. Given the trend toward corporate deleveraging, the stronger cyclical uptick in GDP growth and better fundamentals of some EM, we remain overweight selected financials, global industrials and EM credits we perceive as “best in breed.” We also continuously monitor spread activity along with duration to ensure an accurate assessment of the risk/reward metrics.
Luke SpajicHead of pan-European Credit Portfolio Management
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.
No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2013, PIMCO.
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