Credit markets matter more than ever, as low yields and market uncertainty challenge investors seeking sustainable income. Marc Seidner is head of PIMCO’s global credit team and a member of the Investment Committee. In this interview, he discusses the risks and opportunities in today’s credit environment, where PIMCO is finding opportunities for value and why an allocation to credit may make sense.
Q: How should investors be thinking about credit today?
Seidner: Investors are finding it increasingly difficult to find attractive, risk-adjusted sources of sustainable income in the current environment. The Federal Reserve’s use of unconventional monetary policies was intended to spur investment and spending, but they’ve also translated directly to low yields and reduced prospective returns for fixed income investors. Many investors are looking to the credit markets to fill that gap – seeking to generate a steady income stream and contribute to total returns.
The good news is we have a wide field to choose from. Today’s credit markets are complex, global and extremely diverse, with opportunities across the quality spectrum, in different types of instruments and in both developed and emerging economies. That said, investors need to approach the sector with a defensive mindset and be cautious about exposing their portfolios to unintended risks, particularly now, when yields are low and many valuations are rich given growth expectations. For example, the Barclays U.S. Credit Index yielded just 2.57% in mid-October. With inflation expectations, as reflected by the breakeven inflation rate on 10-year Treasury Inflation-Protected Securities (TIPS), hovering between 2.5% and 2.6% as of mid-October, investors are barely being compensated for inflation risk – let alone default, liquidity or term-structure risk. So while there are many opportunities out there, being selective – and well-informed – is critical.
Q: Where is PIMCO finding quality yield in today’s credit markets?
Seidner: Because our income strategies have such expansive mandates, we can draw on the expertise of our specialty desks and look beyond the more traditional areas to uncover nuggets of value and attractive sources of income. Bank loans are a good example. These securities are senior in a company’s capital structure, which can help enhance principal preservation in downside economic scenarios relative to more junior securities, and because they’re floating rate securities, they’re cushioned against the longer-term prospect of rising interest rates. They also offer reasonable yields – average new issues are currently yielding near 5%, which we find attractive in today’s low yield environment.
Our deep fundamental analysis has also uncovered value in stressed situations, which we define as any company whose debt yields more than 10% over Treasuries. Often these opportunities arise in debt issued by companies that are smaller and less widely followed by buy-side and sell-side analysts. As a result, they present a great opportunity for PIMCO – with our deep, broad credit research platform – to capture very attractive yields for investors with slightly longer time horizons. And while they carry some additional risks, many of these stressed companies are solid issuers that we believe should be able to weather a variety of economic outcomes.
Another area we’re focusing on for yield and total return potential is non-agency mortgage-backed securities that are still offering loss-adjusted return potential of 5%–7% with additional return upside in an environment where house prices stabilize or rise modestly. We’re also finding value in emerging market corporates, which tend to have stronger balance sheets, wider spreads and higher risk premiums than their developed world counterparts. Avoiding "black holes" or credit surprises is an important part of our process, so we’re minimizing exposure to companies with higher sensitivity to GDP growth, and lower-rated high yield credits whose prices reflect overly optimistic economic expectations.
Q: How does PIMCO evaluate opportunities in a bond picker’s market?
Seidner: If we’ve learned anything in the last 10 years, it’s that a bottom-up focus is necessary but not sufficient. Here, we rigorously cultivate our macroeconomic outlook and marry that top-down viewpoint with a very stringent bottom-up security selection process. Bill Gross created PIMCO’s investment process and this framework has effectively guided our approach over numerous market cycles. Our Investment Committee, which is led by Bill and Mohamed A. El-Erian, helps to ensure that we’re getting that top-down, bottom-up balance right. We meet four days a week for roughly three hours a day to continually refine our outlook and evaluate trade strategy recommendations from our portfolio managers.
Our framework provides a common baseline outlook for the global economy – without it, each analyst could have very different assumptions about critical inputs, such as the rate of change of a company or industry’s sales, expenses and competitive dynamics. This consistency allows our portfolio managers to more accurately compare recommendations across different securities, industries and sectors.
Comprising more than 130 investment professionals, PIMCO’s global credit team is located around the world, operating virtually 24 hours a day. This allows us to stay on top of individual company, industry and sector fundamentals, market technicals, and valuations to help uncover the most attractive sources of yield across the entire fixed income universe. That breadth of expertise supports all of the portfolios we manage on behalf of our clients.
Q: Four years after the collapse of Lehman Brothers, what’s PIMCO’s approach to the financial sector?
Seidner: Before the financial crisis, the financial sector was a traditional, reliable source of investment income. Today that picture is more nuanced. Financial companies are caught between the positive benefits of deleveraging and the negative externalities of regulation, which explains why their valuation – from a bondholder’s perspective – remains rather elevated in terms of yield. That said, banks are direct beneficiaries of quantitative easing and other unconventional monetary policies. Over the last few months, they’ve been aggressively retiring their own longer-term bond issues to lower their cost of funds – a move that has decreased supply and increased the sector’s scarcity value. All of these factors provide a positive backdrop for continuing to own and look for selective opportunities in financial company debt.
Q: What’s PIMCO’s outlook for today’s uncertain economy and the potential impacts on corporate balance sheets?
Seidner: This is a constant topic of debate and discussion within PIMCO. We know that central banks are trying with all their might to reflate the global economy but we also know that monetary policy can only go so far. The U.S., Europe and many other countries around the globe face incredible fiscal challenges that have intensified headwinds for longer-term sustainable global economic growth.
While fiscal balance sheets have deteriorated over the last few years, the corporate sector is enjoying record profitability and stronger balance sheets than many industries have ever experienced. They are well positioned to weather a modest economic downturn. However, there is some uncertainty as to how corporations will fare as public sectors and governments begin to deleverage, which will form the basis for ongoing analysis.