In today’s low yield environment, an active investment approach with a focus on picking both the right credit and the right instrument is critical in seeking higher returns. At PIMCO, the credit investment process involves a global team of analysts and portfolio managers collaborating to analyze a company’s fundamentals and to select the best instrument to express that view in portfolios. PIMCO has employed this integrated approach to credit investing for over 40 years.

Two key market characteristics inform our approach to credit analysis. First, credit is an asymmetric asset class where the investor has a high likelihood of earning a risk premium, but on the downside can risk a pronounced loss if the company defaults. For example, in an investment grade portfolio, it could take as many as a hundred performing credits to offset the loss from one default. Therefore, avoiding the “losers” and taking an active approach in an effort to pick “winners” in credit portfolios is one of the most significant factors in successful credit management.

Second, credit can offer a broad range of investment opportunities: A single company can offer a large range of bonds with different maturities, currencies and positions in the capital structure; investors may also be able to take exposure in credit derivatives (e.g., credit default swaps). These different instruments offer varying levels of compensation, liquidity, risk and performance potential. As a result, the universe of industries, companies and instruments within companies constitutes a large set of opportunities to actively exploit.

Integrated approach

Each with unique areas of expertise, PIMCO’s credit analysts, specialist portfolio managers and lead portfolio managers work together to actively manage credit portfolios (see Figure 1).

Because of the asymmetry of the asset class, PIMCO’s team of over 60 global credit analysts undertakes vigorous and independent analysis of each credit in our portfolios to evaluate the potential benefits and downside risks. We determine our own internal credit rating independent of the third party rating agencies. From a relative value perspective, this analysis also allows us to assess cheapness and richness of each credit versus our internal rating.

Due to the complexity in determining the right instrument at the right price, PIMCO has specialist portfolio managers who concentrate on selecting and trading the cheapest instrument in their respective credits and help ensure the team’s views are implemented in the most effective way. Specialist portfolio managers own the credit book in their respective sectors and recommend trades on a firmwide basis, based on relative value and the credit analysts’ views.

Finally, lead portfolio managers are responsible for deciding whether to include each credit in a particular portfolio along with implementing the appropriate sizing. They are also responsible for allocating among sectors and for the portfolio’s overall risk.

PIMCO’s credit research process

Our global analyst team is responsible for independent analysis of company credit positions. We conduct our own stress tests to assess downside risks and anticipate opportunities that could arise from changes in the outlook. 

Of note, the majority of the time, PIMCO assigns a different rating than the rating agencies, allowing portfolios the potential to benefit from investing in credits that we rate as higher and avoiding credits we rate as lower than the agencies do. We also rate deals that are unrated by agencies; this helps us to extract additional spread premium to officially rated credits with similar credit profiles.

We believe our ratings frequently diverge from the rating agencies’ due to a greater emphasis on forward-looking opportunities and risks, more stress testing of company performance and more frequent reviews of companies’ credit positions, all combined with our macroeconomic views. We put less emphasis on mechanistic rules (for example, automatically notching ratings within the capital structure). Our business model also ensures we work hard to anticipate the markets and the underlying credit trends rather than lagging them.

Our research focuses on identifying credits with lower risk on the downside and greater income potential and capital appreciation on the upside. When assessing the downside, we look for companies with a significant safety margin to survive adverse events. For the upside, we look for spread compression and potential for capital appreciation that will come from a rating upgrade – especially when taking exposure in credits with the potential to go from high yield to investment grade (“rising stars”).

Typically, more than 75% of the overall adjustment of the credit spread takes place ahead of an upgrade or downgrade of a credit by the rating agencies – see Figure 2 for one example in which spreads tighten days or weeks in advance of the rating change on “Day 0”. An investment team with an independent view may be better able to anticipate these moves and harvest the gains. Those who wait for the rating agencies may be too late.

Evaluating company fundamentals

For each company and security, our analysts focus on four areas: 1) business risk, 2) financial structure, 3) security structure and 4) relative value. (See Figure 3.)

For business risk, we assess both the industry characteristics and the company position within that industry. Our assessment of the industry will include a consideration of the growth rates, profit margins, capital requirements and volatility of returns as well as the industry’s barriers to entry. The company’s competitive position is assessed through its financial performance (both past and future estimations), the sources of its competitive advantage (for example, operating efficiency, scale, patents and regulatory barriers) and its longer-term strategy. In addition, we look to assess the governance of the organization (including the quality and integrity of management and the company accounts) and risks from off-balance-sheet areas such as environmental liabilities and social costs (e.g., restructuring costs).

For financial structure, we analyze a range of ratios specific to each industry, such as leverage, interest coverage, liquidity and off-balance-sheet debt. Our aim is to assess our margin of safety as bondholders. We incorporate PIMCO’s top-down global and regional macro views in designing stress tests and compiling financial projections.

For the security structure, we assess the position of each investment within the capital structure and the covenants that protect our position in downside scenarios.

The analysis, informed by our macro outlook, leads us to our own credit rating. This rating in turn allows us to identify relative value opportunities across sectors and security structures, helping us to identify potential rising stars and falling angels in portfolios.

Risk management is a priority at every level. Default and spread widening risk are dominant potential risks in investing in corporate debt securities. Our focus on higher quality corporates, combined with our comprehensive evaluation of credits both at purchase and on an ongoing basis, helps reduce the risk of a downgrade or default in any of our credit holdings.

Once the individual credits are assessed, the complexity of the credit market and the variety of instruments require an assessment of the risks and opportunities from a portfolio perspective. PIMCO’s proprietary analytical systems and portfolio management tools help us to look at risks across the different instruments and to assess exposure and risk across countries, sectors and single names.

Careful research and active management yield results

To help best position investors to reach their objectives, a credit portfolio management team should take an active approach to credit selection based on proprietary credit views. We believe these views need to be based on thorough credit analysis with a focus on managing and anticipating the downside. Portfolio managers need to select the right instruments at the right time and diversify both risks and opportunities in an effort to harvest the risk premium.

These factors are even more important in a world where yields are low and alpha, not beta, may make a crucial contribution to absolute return generation.