Text on screen: PIMCO
Text on screen: The Market
Text on screen: TITLE - Credit markets in review: YTD 2023
Image on screen: A bar chart shows the market returns for six different categories of credit for the first half of 2023. The first three bars, shaded in blue on the left-hand side, represent corporate credit, showing a 6.0% return for high yield, 0.4% for investment grade, and 7.4% for leveraged loans. On the right, three bars show the performance for securitized credit: a loss of 10% for commercial mortgage-backed securities, and –0.5% for residential mortgages, and a gain of 4.4% for specialty finance.
Credit markets have seen strong performance this year, with positive returns for most sectors continuing through the third quarter. However, there remains a bifurcation among credit sectors.
Generic, easily accessible corporate credit has continued to rally even in the face of sharply higher interest rates.
We think the impact of higher rates on corporate borrowers is starting to create real challenges. In our view, the existing stock of floating rate loans may disappoint going forward.
With the market now coming to accept the outlook of “higher for longer” interest rates,” investors may need to rethink the type of strategies that could perform well in this new, higher rate world.
Text on screen: PFLEX Portfolio positioning
Text on screen: TITLE – The PFLEX strategy takes a flexible approach to investing across a broad opportunity set; SUBTITLE – The portfolio has shifted allocation over time to capture opportunities across credit markets
Image on screen: A bar chart shows the allocation of five different asset classes within PFLEX for the last 1- quarters ending September 30. The first bar represents the quarter ending in September 2021. Each bar shows colored shaded regions that help show the changes over time in the allocations. It’s clear that corporate credit is the largest holding in all of the allocations over time, but it narrows over the last nine quarters. By September 2023, corporate credit makes up about 25% of holdings, down from a peak of about 45% the third quarter of 2021. Residential mortgages represents the next largest allocation in September 2023, with about a 23% allocation, up from its lowest level of about 12% in March 2022. Commercial mortgages in September 2023 represented about 22% of the holdings, up slightly from June 2023. Allocation to specialty finance in September 2023 is around 10%, which is close to its average across the period. Other holdings represent about 13% of the allocation, lower than its peak of about 21% in December 2021.
The PIMCO Flexible Credit Income Fund, or PFLEX strategy is a flexible, income-oriented solution to help enhance return potential while seeking to diversify away from traditional corporate credit and equity risk.
Faced with a “higher for longer” outlook, we have continued to follow a bend-but-don’t-break approach, and are focused on seeking relative value where yields are higher and spreads wider, but where we think credit risk has not significantly increased.
The strategy continues to emphasize securitized credit, where residential mortgages remain one of our highest conviction investments. The sector can benefit from substantial equity cushions, and cash flows that we think will remain resilient even in a recessionary environment.
In commercial real estate, we continue to identify opportunities in discounted commercial mortgage backed securities, or CMBS, with yields in the high single to low double digit range, and robust fundamentals.
Nearly half of our CMBS portfolio is invested in the hospitality sector. Hotels have experienced a remarkable recovery post-pandemic, benefitting from a surging demand in leisure and business travel.
Within corporate credit, the PFLEX strategy has focused on idiosyncratic opportunities instead of generic investments in high yield and leveraged loans. At current prices levels, the existing stock of generic floating rate loans does not price sufficient downside risk for the possibility of a deeper recession, in our view. For that reason, we have looked to identify idiosyncratic, special situations opportunities where we can leverage the scale of the PIMCO platform to obtain control of credit documentation, maintain seniority in the capital structure, and position ourselves to profit while seeking to mitigate downside risks.
While these investments often have a longer investment horizon and may experience higher mark-to-market volatility, we think they offer more attractive total return potential, both yield and capital appreciation, and better downside risk mitigation compared to other opportunities in the corporate credit markets.
Text on screen: The opportunity
Text on screen: TITLE – Securitized markets remain attractive relative to generic leveraged credit in our view; SUBTITLE – Spread valuations over the past five years
Image on screen: A chart shows the ranges of spread valuations over the past five years for five different fixed-income classes: specialty finance, residential mortgages, commercial mortgage-backed securities, leveraged loans, and U.S. high yield bonds. The chart plots the current spreads for the asset classes, represented by a green diamond plot on a horizontal line for each category. The X-axis shows zero to 100th percentile. The plots show how current spreads are all below the median of the range, or 50th percentile, which marks the middle of the ranges. To the left-hand side shows higher spreads, with the bottom quartile shaded in blue, representing cheaply-priced assets. Conversely, the right-hand side shows the top quartile, shaded in pink, representing the low end of the spread ranges, which are expensively-priced assets. The first category, showing specialty finance, indicates a current spread of 247 basis points above LIBOR, just putting it in the median, at the edge of the blue, or cheaply-priced, zone. Residential mortgages have a spread of 230 basis points, not in the cheap zone, but well below the median percentile. Next, CMBS have a current spread of 1,203 basis points above swaps, placing it in the bottom quartile of its range, well situated in the blue zone. Leveraged loans trades at 318 basis points above swaps, and U.S. high yield at 426 basis points versus LIBOR, both below their five-year 50th percentile medians, priced more towards cheap than expensive.
We think the benign credit environment of recent years is behind us and believe that the PFLEX strategy is the right one to not only capture opportunities, but to offer downside mitigation potential.
While the rapid rise in rates proved challenging for fixed rate assets and special situations corporate investments, with that pain now priced in, we think there is an incredibly attractive value proposition in the PFLEX strategy on a go forward basis, attractive because of starting valuations and our ability to generate income and capital appreciation potential, and the potential diversification relative to traditional corporate credit risk.
Valuations in securitized markets, including CMBS and Non-Agency residential mortgages remain very attractive compared to historical levels, and have lagged the recovery in corporate markets despite strong fundamentals.
For example, residential and commercial mortgage credit have only recovered 20% of their initial drawdowns, where corporate credit has recovered nearly 60%. While certain segments of the market such as private floating rate credit have seen less mark-to-market volatility, it’s highly unlikely, in our view, that after a massive move in interest rates, valuations for these assets are little changed because they are floating rate. Floating interest rate exposure has been a benefit to investors over the last year, however these floating rates are putting pressure on companies now struggling to service their debt at higher borrowing costs.
Simply put, we believe the strategies that worked in a rising rate, benign credit environment could be at risk in a more volatile, challenging credit environment.
An opportunistic approach and diversification will be more important than ever going forward, in our view. With a flexible mandate, a diversified portfolio of credit investments marked at a discount to par, we think the PFLEX fund strategy is an incredibly attractive solution to navigate this new, higher rate, market environment.
Text on screen: The recap
Text on screen: TITLE - We think the PFLEX strategy is an attractive solution for this higher rate market environment.
Image on screen: A graphic lists bullet points that follow along with the narration of the video. The bullets are divided into three sections: Market Review, Portfolio Positioning and The Opportunity. The three bullets under Market Review read, 1) Credit market performance has remained strong through Q3 this year, but experienced continued bifurcation among sectors; 2) Corporate credit has rallied in the face of higher interest rates, but corporate borrowers may face challenges going forward; if rates stay ‘higher for longer,’ investors may need to rethink the types of strategies that can perform well in this new environment. The three bullets under Portfolio Positioning read, 1) we are focused on seeking relative value where yields are higher and spreads wider, but where we think credit risk has not increased significantly; 2) we continue to emphasize securitized credit, where residential mortgages remain a high conviction investments, and we continue to identify attractive opportunities in commercial mortgages where fundamentals are strong, but prices are dislocated; 3) within corporate credit, we have focused on idiosyncratic, special situations opportunities where we think there’s an asymmetry of risk and reward in our favor, instead of investments in generic high yield and leveraged loans. The four bullets under Then Opportunity read, 1) we think the benign credit environment of recent years is behind us and PFLEX is positioned to capture opportunities and also offer downside mitigation potential; 2) valuations in securitized markets remain very attractive compared to historical levels and have lagged the recovery in corporate markets despite strong fundamentals; 3) we believe the strategies that worked in a rising rate, benign credit environment could be most at risk in a more volatile, challenging credit environment; 4) in our view, an opportunistic approach and diversification will be more important than ever going forward.
Text on screen: For more insights and information visit pimco.com
Text on screen: PIMCO
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