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?
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?
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
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.
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?
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
Q: How do you select specific financial companies and identify the most attractive part of the
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
Q: How big is the market for these bank securities and how in particular does this strategy approach it?
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
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?
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.