In an environment of low returns, alpha generation plays an increasingly significant role in seeking overall total returns.
For credit, 2012 was an exceptional year and the second best since the introduction of the European Credit Market in 1999 (based on index returns using the BofA Merrill Lynch Euro Corporate Index). Only 2009, when markets recovered from the financial crisis, posted better returns. What started as a 4.39% yield (based on the BofA Merrill Lynch Euro Corporate Index ) at the beginning of 2012 ended as an annual performance of 13.03%, driven by significant additional capital appreciation from both tighter risk premia and lower European government bond rates, as represented by 10-year German Bunds (Source: Bloomberg as of 31 December 2012).
Such an exceptional year for credit returns has led to a current yield of 1.92% (as of 12 April 2013) on the BofA Merrill Lynch Euro Corporate Index, offering significantly less upside potential given historically low yields and credit spreads approaching their 10-year average. After several years of benefitting from outsized returns, corporate bond investors now find themselves facing several challenging questions:
- Are yields of less than 3% still attractive on a relative basis when compared to German Bunds and other high-quality government bonds?
- How can current yields be enhanced without taking on excessive credit or interest rate risk?
Although extraordinary central bank activism has distorted market prices on investments ranging from bonds and equities to real estate, we believe there are a number of tools an active credit manager can use in an effort to improve the forward-looking return profile of a corporate bond portfolio. However, these tools require a slightly different set of skills than a more traditional approach to credit investing would
Investors have basically three options:
- First, extend benchmark maturities to help increase portfolio yield and increase spread and interest rate risk; however, investors will then be facing the risk of higher sensitivities to future potential yield increases or higher corporate bond spreads.
- The second option entails decreasing tenors of benchmarks to help reduce the risks to a credit portfolio, thereby limiting the potential for future capital losses. Given steep sovereign yield curves and record steep credit curves, this decision would likely decrease the overall carry and starting yield of the portfolio and therefore decrease the potential total return for 2013 even further.
- Third, give their manager more flexibility in the way he/she can actively manage the portfolio to enhance return potential in a risk-controlled manner; we have always believed that a credit portfolio has to be managed actively. In a world of low returns, alpha generation becomes even more important and can be a significant part of overall total return.
Given the significant rally and compression of spreads we have seen, we believe a credit portfolio today should be focused on carry and roll down (a form of return that arises when time passes in a steep yield curve environment and bonds are re-priced at lower interest rates) as opposed to expecting large capital gains from further spread compression – especially in longer dated securities.
In full discretion accounts where clients grant PIMCO greater investment flexibility, we currently run a number of active strategies designed to enhance returns but also to hedge portfolios in potential downside scenarios.
Tools designed to seek enhanced yield while managing risk
As an active manager, we use a number of tools designed to increase potential returns without unduly adding risk to our clients’ portfolios. There are four primary ways in which we have historically sought attractive investment opportunities for European corporate bond investors:
1. Using credit default swaps (CDS) on an unleveraged basis
2. Tactically allocating to ‘Rising Star’ candidates
3. Exploiting relative value between sovereigns and credit
4. Allocating to credits on a global basis, including emerging market issuers
Credit default swaps
As market conditions evolve, we believe CDS investors can benefit from enhanced liquidity and relative value opportunities. Between 2008 and 2010, European corporate bond investors faced a ‘negative basis’ (basis represents the difference in spread between CDS and bonds for the same debt issuer and with similar, if not exactly equal, maturities) in which it was highly punitive to invest in CDS; at the time, the yield available for investors willing to hand over their cash and buy a physical bond was anywhere from 1% to 2% higher than for the equivalent CDS (Source: Barclays Capital, Markit).
Today, however, there may be numerous ‘positive basis’ opportunities in which the yield available to the CDS investor is in excess of the equivalent yield available to the physical bond investor. Within our portfolios, and when client guidelines permit, we believe it makes sense to capture these opportunities when seeking to enhance portfolio yield. Figure 1 provides a time series of the basis between European corporate bonds and the equivalent CDS. A basis above zero means that investors would benefit by using CDS as a substitute for cash bonds.
‘Rising Star’ candidates
Many investors are still constrained by ratings from official rating agencies, ranging from passive index funds/ETFs to insurance companies that must optimize their portfolios based on interest rate risk and credit quality. Due to these market segmentation and clientele effects, significant price action can occur when bonds move between investment grade and high yield. At PIMCO, independent credit research helps us to identify ‘Rising Star’ candidates that we believe should be rated investment grade or are likely to be rated investment grade in the next 12 to 18 months.
Investors should benefit from such early identification as prices have historically appreciated by several points once these bonds are upgraded and more rules-based or rating agency-oriented investors begin to buy (based on 2012 total returns. Source: BofA Merrill Lynch Global Research as of 30 April 2012). Our approach to credit research and issuer selection relies strongly on PIMCO’s internal assessment of issuer credit quality rather than on external rating agencies. By adopting this independent process, we look to identify companies that our credit team of nearly 50 analysts believes should be rated or will soon be rated investment grade by the agencies.
Opening up to sovereign investments
Sovereign risks started to dominate credit markets three years ago and represent a major source of dispersion within European credit. While credits in Italy and Spain currently exhibit more attractive risk premia compared with core country credits, most of them are trading well inside their respective sovereign curves. Given the better liquidity of the sovereign bond market, which offers higher yields in many cases, and the fact that numerous corporates are domestically oriented, this anomaly should not exist. A credit manager should therefore have the discretion to buy sovereign risk in an effort to enhance the yield of a credit portfolio.
Allocating to credits on a global basis
As the developments in the eurozone intensified over the last few years, European issuers increasingly took advantage of opportunities to borrow in the U.S. dollar-denominated bond market (i.e., issue ‘Yankee Bonds’). While the deeper U.S. credit market has been a welcome source of capital for these European borrowers, it has also come at higher funding costs. For investors who are familiar with these issuers and have the ability to hedge the currency risk back to the euro, Yankee bonds have presented attractive investment opportunities with higher spreads for the same underlying credit risk, even when taking into account foreign exchange hedging costs.
Moreover, while investors have traditionally differentiated between borrowers domiciled in developed countries versus developing countries, these lines are blurred today as many emerging market borrowers offer solid fundamentals coupled with higher risk premiums (based on Bank of America Merrill Lynch research as of 30 September 2012), in some cases providing investors with enhanced premiums and in other instances offering attractive yield pickup relative to European core corporate issuers with decreased spread duration (based on research by JP Morgan, Bank of America Merrill Lynch as of 31 December 2012).
In today’s low yield environment, clients should consider providing managers with more tools and flexibility to work towards enhancing the return potential of portfolios. By providing some added flexibility for CDS, ‘Rising Stars’, U.S. dollar-denominated bonds of European issuers and euro-denominated bonds of emerging market issuers, and capturing relative value opportunities between sovereigns and corporates, the return potential of a European corporate bond portfolio may be increased without materially changing the overall risk profile.