Strategy Spotlight

PIMCO Introduces the Capital Securities and Financials Strategy

​For investors in search of yield but reluctant to compromise on credit quality, the Capital Securities and Financials Strategy can offer a solution.

In the search for yield, many investors are reluctant to compromise on solid credit fundamentals. To meet this need, PIMCO’s new Capital Securities and Financials Strategy aims for attractive yield by investing in the subordinate debt and equity-like securities issued in the strengthening bank sector. Portfolio managers Philippe Bodereau and Yuri Garbuzov discuss the strategy, which is now available to U.S. investors.    

Q: What is the PIMCO Capital Securities and Financials Strategy?        
The strategy aims to offer investors a yield comparable to that of the high yield bond market, but with higher credit quality. It invests in the subordinate debt, preferred stock and equity-like securities, including contingent convertible bonds, or “CoCos,” issued by banks. These securities are typically counted towards regulatory capital – hence the name of the strategy. Our actively managed investment approach in capital securities may provide an alternative to traditional high yield bonds, convertible bonds or equities, while enhancing overall portfolio diversification and, potentially, after-tax returns.    

The strategy provides investors with a highly focused, well-diversified, “top- picks” global financial portfolio that has the flexibility to invest across the capital structure, from senior bonds to a limited amount of common stock, based on our assessment of risks and relative value. We seek to arbitrage pricing anomalies between currencies, regions and capital instruments in an effort to benefit from the long-term trends in the financial sector of de- risking, deleveraging and re-equitization.    

Q: Since the financial crisis, banks have deleveraged and bank bonds have generally appreciated in price. Where are you seeing value now?        
Garbuzov: The banking industry is undergoing a secular shift that is leading to more transparent, much better capitalized and highly liquid balance sheets. Regulatory pressure – whether in the form of regular stress tests, new leverage ratios or national capital rules – remains supportive for credit investors. This is particularly true in the U.K., the U.S. and Switzerland. With the European Central Bank (ECB) taking over regulation of banks in the eurozone, capital requirements are also getting pushed higher there.    

We have a constructive view on capital securities, as we see fundamental improvement in the global banking system, with stable economic trends in the U.S. and non-performing loans peaking in Southern Europe.    

We believe regulation will continue to play a meaningful role in the deleveraging process, and some regulators are substantially more conservative than others, creating investment opportunities around the world for active portfolio managers. By contrast, several other sectors within the global credit markets are taking advantage of low yields and easier access to capital to increase leverage.    

Q: What are the key benefits of capital securities for investors?
Bodereau: I would stress the fundamental story. Unlike other sectors of the credit markets, bank credit metrics are improving fast under intense regulatory pressure, to the point that many Western banks are running at record-high capital levels. From a valuation perspective, capital securities offer attractive total return potential.    

The higher yield in the strategy exists for a couple of reasons. First, these securities aren’t linked to traditional indices, which limits the buyer universe to investors who can tolerate “out-of-benchmark” concentrations. In addition, there can be embedded optionality in the securities, such as coupon deferral, that needs to be analyzed concurrently with company fundamentals and regulatory regimes. Finally, banks are mandated to issue these securities by regulators and have to issue billions worth of them whether they like the levels or not.        

We see solid value in preferred stock from U.S. financial institutions, which are benefitting from favorable asset-quality dynamics and yield 5.5%–6.5%. Outside of the U.S., we are seeing a broad spectrum of opportunities, with current yields ranging from 5%–8%, including U.K.-based issuers of CoCos, Swiss banks and select other European financial issuers. In emerging markets, the yields are generally higher but they come with both country- and issuer-specific risks, so, we are being very selective.    

Garbuzov: I would add that in the U.S., we have seen strong demand for preferreds as both fundamentals and valuations have been very supportive. Keep in mind that most U.S. preferreds carry specific tax benefits for domestic holders as the tax rate for individuals under qualified dividend income (QDI) is about half the maximum federal income tax rate applied to other securities, and tax benefits for corporations applying dividend received deductions (DRD) are even higher.

Essentially, some of the strongest U.S. banks issue BBB/BB rated preferreds that produce higher after-tax income than B rated credits. That said, investors can often over- or under- value the tax implications, and they should consider the fundamentals of the bank and the security, which are more relevant for total performance. And, of course, individuals may have specific circumstances and should consult their own tax advisors.    

Q: How does PIMCO’s investment process inform the strategy’s positioning?
Bodereau: Macroeconomic calls and comprehensive knowledge of regulatory policy are critical in identifying the most attractive opportunities, as well as managing downside risk and principal preservation. PIMCO’s global economic outlook, which is the result of our cyclical and secular forum process, is an important factor in determining the countries we believe will provide a stable backdrop for their banking sectors. The macro environment can affect banking in a number of ways, including regulatory and capital requirements, and we dedicate significant effort to understanding this aspect of the investment decision.

For example, in Europe – where the link between sovereigns and the banking system remains very strong – PIMCO’s European Portfolio Committee (EPC), one of the three regional portfolio committees complementing our global Investment Committee, focuses on evaluating the interconnectedness of the European macroeconomic outlook, regulatory developments and the banking sector. I am a member of the EPC and have regular contact with the firm’s Investment Committee.

Q: How do you select specific financial companies and identify the most attractive part of the capital structure?
Bodereau: We combine our macroeconomic analysis with a fundamental, bottom-up style of picking individual securities. For capital securities, top-down analysis is used primarily to assess macro risks, such as sovereign risk, and formulate the stress test assumptions we use for global banks. PIMCO’s bottom-up bond selection process is based on thorough fundamental credit research by our credit research group, which has more than 60 seasoned analysts, with nine focused exclusively on financials; they work with nine traders dedicated to securities issued by financial firms.

In financials, particular emphasis is placed on analyzing the structure of each issue. The team’s efforts are supported by quantitative financial engineers who assist in valuing the embedded optionality in many of the securities.

After screening securities through our top-down, bottom-up and valuation measures, we focus on those with the best risk-adjusted yields across the capital structure and in any currency available. Currency risk is typically hedged, so the decision is based on the attractiveness of the security’s credit spread.

Q: How big is the market for these bank securities and how in particular does this strategy approach it?
Garbuzov: Currently, there are over $100 billion of U.S. bank preferred stock and over $100 billion of similar securities outside the U.S., referred to as Additional Tier 1 (AT1). This market of preferred and AT1 instruments is expected to grow to more than $300 billion globally by 2019, with emerging market banks also being active issuers as they gradually implement Basel III. Additionally, the global financial subordinate debt market is around $600 billion now and will continue growing.

Yet, in this large and growing market many individual investors don’t get access to the premiums available in the primary market. We often work directly with issuers to structure deals that we believe offer the most potential value and minimize our transaction costs.

Q: Why are these types of securities becoming attractive to investors?
Bodereau: We have managed this strategy since 2011 in Europe, and I would say that investor demand picked up substantially in 2013 and late 2014 for a few reasons: Clarity from regulators on the treatment of AT1 securities was a catalyst for supply from Europe; the ECB’s AQR stress test led to balance sheet improvement and issuance of capital securities; and additional monetary support provided by the ECB through asset purchases led many investors to look for ways to capitalize on the recovery in Europe.

Essentially, the combination of a solid fundamental investment thesis, increasing supply and a dedicated strategy focused on the opportunity has been appealing to many investors seeking higher returns with lower sensitivity to governments bonds. We have seen similar trends in the U.S., as stricter regulatory rules have led to issuance of preferred stock that has been very well received in the current low yield environment.

The Author

Philippe Bodereau

Portfolio Manager, Global Head of Financial Research

Yuri Garbuzov

Portfolio Manager, Corporate and Financials


Past performance is not a guarantee or a reliable indicator of future results . Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Bank loans are often less liquid than other types of debt instruments and general market and financial conditions may affect the prepayment of bank loans, as such the prepayments cannot be predicted with accuracy. There is no assurance that the liquidation of any collateral from a secured bank loan would satisfy the borrower’s obligation, or that such collateral could be liquidated. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Investments in illiquid securities may reduce the returns of a portfolio because it may be not be able to sell the securities at an advantageous time or price. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. PIMCO does not provide legal or tax advice. Please consult your tax and/or legal counsel for specific tax or legal questions and concerns. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Any tax statements contained herein are not intended or written to be used, and cannot be relied upon or used for the purpose of avoiding penalties imposed by the Internal Revenue Service or state and local tax authorities. Individuals should consult their own legal and tax counsel as to matters discussed herein and before entering into any estate planning, trust, investment, retirement, or insurance arrangement.

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