Many asset classes offered investors increased returns in 2013, largely due to highly accommodative central bank activity, mergers and acquisitions (M&A) and improving growth outlooks. While global corporate profit growth generally slowed, multiple expansion helped boost returns in corporate debt markets, particularly in developed countries. Looking ahead to 2014, portfolio manager Mark Kiesel and product manager Jeff Helsing discuss the outlook for credit investing globally and how PIMCO uses an absolute return strategy to seek attractive opportunities across credit markets while managing the risks, all with greater flexibility than a traditional index-focused strategy.
Q: What is the PIMCO Credit Absolute Return strategy, and how does it target its objectives?
Helsing: The PIMCO Credit Absolute Return strategy is a diversified, absolute-return-oriented global credit strategy. Because it is not constrained by a traditional credit benchmark, it can avoid exposures to maturities, sectors or regions that may have high weights in an index but unattractive investment profiles. The strategy has significant discretion to allocate actively across a broad range of global credit sectors, including investment grade, high yield, emerging market bonds, bank loans, municipal bonds, convertible bonds and credit default swaps. It can take both long and short exposures as it seeks to maximize risk-adjusted total returns across a variety of market conditions.
We launched the Credit Absolute Return strategy in August 2011. It is a natural extension of the corporate credit solutions PIMCO has developed for clients for more than a decade. Our focus is on delivering capital gains through the identification of companies that are operating in industries or countries experiencing above-average growth rates as well as in areas with strong asset coverage. To help the strategy achieve its absolute return objective, it also has the ability to pivot, taking on greater exposure to credit when spreads are attractive and, conversely, reducing the overall exposure when necessary.
Investors understand that experience and expertise are crucial in credit strategies. We were pleased when Morningstar named Mark Kiesel, PIMCO’s global head of corporate bond portfolio management and the manager for the Credit Absolute Return strategy, the 2012 Fixed-Income Fund Manager of the Year (USA) in recognition of the success of PIMCO’s credit team under his leadership.
Q: What factors are you focused on when evaluating investments for the Credit Absolute Return strategy in 2014?
Kiesel: Our investment strategy remains to “go for growth” by seeking out specific companies with growth profiles that are significantly higher than the economy’s overall growth rate in the markets where they operate. Growth is critical for investing in the global credit markets because it is such a powerful driver of potential expansion of enterprise value (the market value of a company’s debt plus equity) as well as of profit generation, which in turn can aid in balance sheet deleveraging.
We watch fundamentals closely because they are linked to credit spreads: The degree of revenue growth drives expansion in enterprise value, and the magnitude of free cash flow generation influences reduction in net debt; as net debt-to-enterprise value falls, the company’s credit fundamentals can not only improve but credit spreads can tighten (see “Growth and Rising Stars,” Global Credit Perspectives, September 2013). A focused “bottom-up” perspective helps us pinpoint companies with healthy growth that can lead to credit spread tightening, rating upgrades and potential outperformance.
Q: Given that focus on growth, where are you finding attractive credit opportunities today?
Kiesel: We see opportunities in several areas. In U.S. housing, for example, the outlook remains constructive, supported by an improving labor market, solid pent-up demand, tight supply, attractive valuations and a gradual recovery in credit availability and bank lending. There are many ways to invest directly and indirectly in companies that will likely benefit from higher housing prices, a pickup in home repairs and remodeling, and residential investment spending. We continue to favor select investments in homebuilders, building materials, appliance manufacturers, lumber, home improvement, banks, title insurance, mortgage origination and servicing, and non-Agency mortgage-backed securities.
Asia gaming is another area of opportunity. Many companies have strong growth profiles supported by a growing middle class, significant regional infrastructure investments and new property development.
Finally, the U.S. shale revolution is nothing short of spectacular – just look at the growth in the Bakken, Eagle Ford, Marcellus and Permian basins.
In all these areas, we find specific companies whose growth is substantially higher than the overall U.S. economy’s nominal growth rate. As such, we see many opportunities to benefit from improving credit fundamentals, ratings upgrades and rising stars (credits likely to see ratings upgrades).
Q: Turning to other regions, what are your views on credit in Europe and in emerging markets (EM)?
Kiesel: In Europe, we remain cautious overall, but we are finding opportunities in select credits where there are signs that top-line revenue is about to turn the corner – for example, the auto and building materials sectors. In the U.K., housing is also becoming more attractive.
EM credit underperformed U.S. credit in 2013 due to slower growth and fears of Fed tapering. That said, broad EM risk aversion failed to distinguish between vulnerable names and potential winners. Among the latter, we favor premier energy and commodity producers with strong fundamentals operating at the low end of the global cost curve. We also favor systemically important banks in lower-risk countries.
Q: What about the outlook for bank loans and high yield?
Kiesel: The bank loan market outlook remains positive for 2014: We expect to see strong credit fundamentals, continued robust issuance, low defaults and strong demand. We continue to focus on more liquid issuers, which also tend to be larger global or leading U.S. companies with more robust capital structures, and also companies with steady free cash flow generation.
In the high yield market, credit selection is critical. Demand for lower duration and higher income has made it very easy for companies to term out their debt and issue new securities with very few investor-friendly covenants. We continue to favor select bank loans, shorter-maturity high yield bonds and rising stars.
Q: Could you explain the current short positions in the Credit Absolute Return portfolio?
Kiesel: Our investment process, which combines top-down views with bottom-up research and valuation screens, is the same for both long and short positions. Our short positions typically reflect companies that carry higher fixed costs, have lower market share or are not well positioned to compete within their industry. Typically, our shorts may also see leverage increase, and valuations may not reflect these risks either because agency ratings are somewhat backward-looking or the company is a relevant component of a credit index.
The shorts we implement in the strategy fall into three broad categories: beta management, relative value and individual credits. CDX indexes allow for broader beta management, which can help keep the overall sensitivity to the market low while retaining positions in credit we believe are undervalued. In relative value positioning, we favor a long bias in select U.S. and U.K. banks versus short positions in select European financial institutions. And for individual company shorts, we believe spreads in select technology and media companies don’t reflect the changes in industry competitiveness and business risk and the subsequent impact on leverage and valuations.
Q: Why should investors consider looking beyond traditional benchmark-oriented credit portfolios toward an absolute return strategy?
Helsing: We believe there are a couple of design issues in traditional credit benchmarks that can create distortions between price and value.
First, credit benchmarks are market-capitalization-weighted, meaning the more debt a company has, the greater its allocation in the benchmark. We believe this tends to create a disconnect between the benchmark representation and how creditors would lend capital in the real world. Imagine a local banker turning down a loan application for a small business because it wasn’t deeply enough in debt. Strange as it sounds, this is essentially the process used to allocate over $10 trillion of capital globally in credit markets.
Another concern we have with investing toward a market-cap benchmark is the backward-looking tendency. Large companies heavily represented in these kinds of portfolios often reflect growth models of the past, while smaller companies looking to newer areas of growth typically have smaller capital allocations, even in periods where risk-adjusted return potential is greater.
Because yields are near historical lows and spreads are back to longer-term averages, many credit investors expect returns to be lower and more volatile in the future. This is prompting many of them to look outside traditional approaches, and in response, more investment managers have launched go-anywhere absolute return strategies. While many of these strategies are new to the scene and don’t have long-term track records, investors can instead review the track record of a credit portfolio management team across market environments for guidance on their ability to manage risk while employing more alpha-oriented investment approaches.