Investors seek opportunities in the universe of international fixed income for a number of reasons. They may look to invest in regions where demographics, deregulation and market liberalization spur economic growth, or in companies with potentially lower debt burdens in geographic areas with a relative growth advantage. Or they may seek investment diversification or the potential to capture additional sources of return. However, accessibility and the potential restrictions on the movement of capital into and out of these markets present a barrier to entry for some investors.
Much as it is in the United States, essential credit research in the international markets is a demanding, time-consuming and intensive quantitative discipline. When applying PIMCO’s credit research process to international credit analysis, we give careful consideration to cultural and political factors in addition to company- and industry-specific factors. And in the unlikely event of a corporate restructuring, an understanding of legal regimes and navigation of process risk could affect the ultimate recovery value, one of many scenarios we analyze prior to making an investment. Credit selection is paramount.
Credit research considerations
Effective investment decision-making requires dynamic, continuing appraisals of the risk/reward characteristics of investment opportunities. This analysis entails a thorough examination of a range of key factors, including the assessment of a company’s on- and off-balance-sheet assets and liabilities, cash flows, strategic direction, competitive position and prospects within the industry where it competes.
The unique risks, and cultural and political complexities in international credit markets may dissuade some investors, yet the potentially attractive credit profile of these companies may provide favorable risk-adjusted returns in what is a growing opportunity set. On-the-ground research is vital.
Economic factors. International economies and corporates operate under different macroeconomic circumstances than the U.S. economy. PIMCO’s credit research focuses on not just likely macro scenarios in these economies, but also the expected difference in economic volatility versus the U.S. and how that volatility will be expressed. We examine possible tail scenarios not just for GDP growth but for inflation, local interest rates, and exchange rate volatility, and assess how all these factors are likely to affect corporate credit performance.
Political risk factors. Understanding local political risks is key in any credit assessment, and can be much more relevant in certain international economies where the rule of law may be less dependable. This is not just about considering extreme scenarios like expropriation; rather, a more nuanced understanding of the various political actors and their potential impact on a given sector or credit is essential. Indeed, with the recent rise in geopolitical and social tensions emanating largely from the dispersion of income levels, this becomes more relevant in our examination.
Regulatory factors. The regulatory environment can be a material driver of credit performance for a given company. PIMCO credit analysts communicate regularly with local regulators to understand existing regulations, related political developments and risks, and any potential evolution in the local regulatory environment.
Operational factors. Corporate governance, transparency and accounting are critical in credit analysis, as is understanding that these risks can express themselves in different ways. Outright fraud is rare, though it captures the most headlines. More pervasive can be aggressive accounting: Particularly in emerging markets where detailed financials are often limited, understanding the vagaries of local generally accepted accounting principles (GAAP) can be critical. Where disclosures are lacking, PIMCO credit analysts work to supplement their understanding of a company by interviewing suppliers, customers, regulators and third party specialists.
Foreign exchange factors. Understanding the details of how a company can face divergence between its foreign exchange liabilities and its local exchange rate revenues can be vital in some cases. In the last decade, most countries have significantly reduced their overall macro exposure to balance-of-payments shocks, but individual companies can still face vicious foreign exchange swings. We closely focus on the hedging strategies a company has in place, their size and tenor as well as the margin call dynamics.
Industry concentration factors. Particularly in emerging markets, we may find greater industry concentration (or low fragmentation) of corporates, which can make diversification more inefficient. This structural challenge combined with higher friction costs emanating from pockets of illiquidity may pose additional challenges in hedging market and investment risk. The potential return advantages need to be balanced against exit barriers and costs, especially during times of market instability.
State of the local banking system. Banking systems vary across countries, and their strengths or weaknesses can have material implications for certain credits. For example, a company that relies almost exclusively on local banking partners for its short-term financing may benefit from those established local relationships, but also may suffer from a potentially more volatile banking environment if those banks have less reliable access to their own funding sources. Understanding the strengths and weaknesses of a local banking system, and the linkages between that system and a given corporate credit, is critical.
Controlling shareholders. An analysis of corporates would not be complete without a thorough evaluation of their equity economic ownership and corporate governance frameworks. A greater degree of family control could mean an even greater imbalance among economic and non-economic rights, often to the detriment of minority shareholders and company-related stakeholders. And in the event of a restructuring, the contestability for control through debt-for-equity exchanges becomes more challenging, affecting ultimate recovery.
Managing restructuring uncertainties
Credit events may occur following changes in credit ratings, mergers and acquisitions, government or market disruptions, or a failure on the part of a company to meet its financial obligations, which may lead to insolvency proceedings. The potential costs (both direct and indirect) of an insolvency proceeding, however unlikely, need to be considered. Historically, many countries lacked insolvency laws that allowed for rehabilitation of a company’s financial situation. Where such rules did exist, they may be relatively untested. Most creditors, therefore, have opted for “out-of-court restructurings,” often with suboptimal results leading to a less favorable risk/return profile. We analyze various criteria related to restructuring risks.
Forum shopping / center of main interest (COMI). International restructurings often have a higher tendency for what the industry calls “forum shopping” – jockeying to determine the venue of an insolvency proceeding, potentially benefitting some parties at the expense of others. Determining a company’s COMI means evaluating the locations of its headquarters, its primary assets, its managers and key decision makers, and its creditors, as well as the governing law in indentures or dispute resolution. Ultimately, the venue will depend on the circumstances in each case.
Ability to rehabilitate. We see little consistency across restructuring outcomes in international jurisdictions. The lack of a concept of debtor-in-possession financing (i.e., financing arranged by the company in an insolvency proceeding such as a traditional Chapter 11 U.S. bankruptcy, which generally takes priority over all other claims) in most jurisdictions makes it difficult to fund companies whose business model evolves from a going concern to what may be deferred liquidation. In addition to valuation, it is particularly important to focus on corporate liquidity and long-term viability.
Absolute Priority Rule. In reorganizations, the Absolute Priority Rule provides that senior creditors are paid in full before junior creditors, with the potential for equity holders not to share in distributions. The size and relative distribution depend on the business valuation as well as the liquidity and solvency of the post-reorganization enterprise (or the feasibility of a reorganization plan). In many jurisdictions, however, creditors’ priority can be violated, often in an ad hoc manner depending on the circumstances.
Stakeholders’ interest. Consummating an efficient restructuring may be prohibitive due to the costs potentially borne by stakeholders such as employees, customers and shareholders (especially where there are controlling shareholders who have a stronger incentive to preserve the residual interests of equity holders). The present value of a recovery can also be affected by management’s ability to “manufacture” intercompany claims.
Insolvency costs. The potential deadweight costs of an insolvency process, including legal, financial advisory and accounting fees, can be very high. In addition, the indirect costs of lost investment opportunities and potential misallocation of resources need to be considered.
In evaluating and managing against these uncertainties, negotiating leverage is important, and investors should consider investing in companies generating unlevered free cash flow, positions more senior in the capital structure and where business models are able to endure what may be prolonged periods of stress and uncertainty.
Uncovering value in international fixed income
The breadth of the international fixed income opportunity universe is increasing. The benefits and risks of investing in these markets are linked to economic development as well as continued economic liberalization, and a long-term investment outlook is warranted. In addition, the feedback loop is important as U.S. companies are increasingly affected by international developments.
At PIMCO, our multi-disciplinary research process applies (within the context of our top-down assessment) a rigorous fundamental bottom-up investment and valuation analysis with an emphasis on capital preservation. Our credit research and corporate distressed debt teams are positioned to uncover value for our investors in well-run companies that will likely overcome structural headwinds and in companies poised to benefit from cyclical recoveries.
In real estate, it is all about “location … location … location”; in fixed income investing, it is all about “credit selection … credit selection … credit selection.”