Investors in sterling investment grade credit were rewarded with sparkling total returns in 2014 as UK gilt market yields fell to 15-year lows (see Figure 1). However, in terms of spread compression, or excess return, it was a neutral year: Spreads relative to both UK gilts and UK swaps barely changed (Figure 2). The US-dollar investment grade credit markets fared similarly, with total returns driven by declining government bond yields rather than spread compression. Only in the investment grade euro markets did we see corporate bond spreads compress and “risk-free” rates fall.
In the months ahead, however, we expect to see spreads on many sterling investment grade securities tighten versus gilts and versus their euro-denominated counterparts based on their relative value and strengthening fundamentals, offering investors the potential not only for attractive total returns but also outperformance. Choosing carefully among sectors and issuers will be important amid varying regulations and risks across sectors.
Where are the opportunities?
First, it’s important to consider the macroeconomic backdrop for the sterling credit market. PIMCO’s forecast for 2015 includes several key points:
- The UK economy is set to grow by 2.5%‒3% in 2015, unemployment will likely continue to fall and productivity will likely pick up.
- Inflation will remain subdued – well below the Bank of England’s (BoE) 2% target level throughout 2015.
- We expect the BoE to remain on the sidelines over 2015, although this is strongly data-dependent.
- A new government in the UK in May 2015 is unlikely to deviate significantly from the UK’s current fiscal path.
Looking specifically at the sterling credit market, we expect to see several trends:
- Spreads will likely contract as the relative value in the sterling market (currently 123 basis points) versus the euro market (57 bps) brings in investors, including in investment grade credit.
- Fundamentals should remain supportive as subdued global growth reins in corporate animal spirits.
- Net positive supply should not be overwhelming.
So given these views, how is PIMCO investing?
Financials continue to be our sector of choice. From a credit quality perspective, banks and insurance companies remain a core overweight in our portfolios due to the material efforts they have made to meet greater regulatory capital requirements. There is regional variance in quality, and we continue to focus our overweights in issuers that find themselves in the strictest regulatory regimes – namely the UK, Scandinavia and Switzerland. The onset of the bail-in regime for senior bank holding company debt leads us to believe that the lower part of the capital structure of the strongest banks offers the best value. The steady stream of new Additional Tier 1 capital bonds (AT1) from banks looking to build up their regulatory capital implies we will have much to choose from. As a result, we favour the older contingent capital notes issued by the strongest-in-class issuers, which are likely to be increasingly scarce. These bonds generally benefit from final maturity dates, no coupon deferability and low capital triggers.
Away from the banks, European insurers have done much to improve their credit credentials since the 2008–2009 financial crisis, working hard to increase their capital buffers and respond to regulatory pressure. We prefer the larger, geographically diversified names with a good mix of life insurance and property and casualty businesses.
Non-financial companies: opportunities with varying risks
Non-financial securities in the sterling investment grade market are of notably better value than those in euros issued by the same companies. But the compelling cross-currency pickup must be weighed against the relative lack of liquidity; the sterling investment grade corporate bond market has a face value of only £291 billion ($448 billion), in contrast to its euro and US dollar counterparts at €1.5 trillion ($1.7 trillion) and $4.7 trillion, respectively. Average bid-offer spreads in 10-year sterling credit issues are about 10 basis points (bps) versus five in similar euro-denominated issues. With that in mind, we see value when option-adjusted spreads are more than 20 bps higher. Looking at BoA Merrill Lynch’s investment grade 1–10-year corporate index in euros versus that for sterling, we believe the current 40-bp pickup in the sterling market does offer greater potential for spread compression and offsets the relative lack of liquidity in the sterling market.
Drilling further into the non-financial market, we find that the risks vary across sectors. Politics continues to feature as a key risk for some, such as utilities – especially in countries where there are government elections. This is true in the UK, and pressure on future profitability remains a key concern. Companies may feel less inclined to invest in future activity if they fear that future returns from those investments could be overthrown by politically driven decisions, and we remain wary of some UK utilities in particular ahead of the May 2015 UK general election.
Western European companies have begun to increase their mergers-and-acquisitions activity (Figure 3), and although activity remains well below the pre-financial crisis peaks, the increase leaves us wary of certain sectors, including telecoms (Figure 4) and pharmaceuticals where industry consolidation continues to increase. The potential for deal-related issuance leads us to adopt a wait-and-see approach on telecoms, while in pharmaceuticals, we are selectively overweight in names where we see low M&A risk and decent valuation.
The UK retail sector, especially food retail, has seen damaging price wars between the major players and their increasingly powerful discount-store competitors, which have led to credit rating downgrades, declining profitability and rising leverage over the past 18 months. Spreads have underperformed, and we believe select names in the UK food retail sector offer good value on a risk-adjusted basis. Whilst challenges to profitability remain, the arrival of new management teams and a steadying in customer footfalls should result in a slow recovery in the sector’s profitability and a steady decline in leverage.
We continue to like the senior secured whole-business securitisations related to UK pubs. The issuers that we have invested in since 2009 have continued to reduce leverage through non-core asset disposal and retained earnings. Our favoured issuers are now free-cash-flow generative and look likely to return to investment grade over the next 12–24 months. Yet spreads are more representative of lower-rated securities and continue to narrow at a steady rate.
We believe the metals and mining sector remains vulnerable to a slowing Chinese economy and the related decline in commodity prices. Spreads in this sector do not offer sufficient reward to offset the danger of ratings downgrades. The recent decline in oil prices will prove beneficial to many manufacturers and industrials as input costs decline, but this will take time to filter through to bottom-line profitability (Figure 5). The oil industry, by contrast, looks set to face a period of consolidation and lower profitability, and we do not find spreads for western investment grade oil companies very compelling.
We believe that some corporate hybrids (subordinated bonds issued in various sectors, including utilities, telecoms, autos and retailers) offer attractive valuations; corporate hybrids are typically rated two notches lower than senior bonds, so we believe that stable and strong BBB or better ratings at the senior level are key. The next consideration is the spread relative to the issuer’s senior bonds and, if applicable, relative to its senior credit default swaps (CDS). Our main overweights in corporate hybrids feature multiples of 2.5x to the senior cash bonds and/or senior five-year CDS.
Across sectors, one of PIMCO’s goals in credit investing is to identify companies that are not yet investment grade at the rating agencies but display improving credentials that will likely bring them into (or indeed back to) the investment grade universe. When we find such “rising star” securities that also offer generous spreads, we will position them as overweights in our portfolios. In the sterling investment grade market, we have found examples in the UK pub sector, UK retail, financials and select construction names.