For investors, the search for yield and strong appetite for income are complicated by the reality that roughly $12 trillion in bonds in the Barclays Global Aggregate Index are now at negative yields, including more than 75% of Japanese and German government bonds (see Figure 1). The European Central Bank, the Bank of Japan (BOJ) and, lately, the Bank of England are continuing with unconventional policies, including large-scale asset purchases and suppressing interest rates, even as the BOJ last month seemingly acknowledged that such policies were hitting the limit.
Consequently, in a world of low- and negative-yielding government bonds, investors are allocating more outside of their domestic markets, creating a wave of investment into global credit markets. This has continued to support credit markets from a technical perspective, with more demand for bonds relative to supply.
Even after this year’s rally, credit remains one of the more appealing sources of income in financial markets. We believe investors can still seek potential returns of 3%–6% in the credit markets by investing in investment grade and select high yield corporate bonds, bank loans, emerging markets and non-agency mortgages. At these levels, credit is especially attractive as an alternative to high concentrations in government bonds. The technical demand for higher quality credit may increase given the decline in government bond yields this year, while fundamentals and valuations also remain supportive, especially for U.S.-focused companies with growth potential and the ability to raise prices, as well as for select emerging market companies.
Credit fundamentals are really a function of how well the economy is doing. Among major developed markets, Japan and Europe are barely growing, but the U.S. should be able to achieve real GDP growth near 2% over the coming year. With inflation near 2%, that means almost 4% nominal GDP growth, which will likely keep default risk low.
Over the last year or so, credit market leverage has increased due to mergers and acquisitions and declining profits, especially in commodity-producing industries, but there are reasons to be constructive. If you look at what drives growth in the U.S., the consumer is roughly 70% of the economy and is well positioned to continue to spend and boost total economic activity over the next year. Over the last 12 months, the U.S. private sector has added 2.5 million jobs, incomes and wealth have risen and access to credit has improved. Over the next 12 months, a recession in the U.S. remains unlikely as there are few imbalances in the economy, and accommodative central bank policy should help extend the duration of this economic and credit cycle.
These positive fundamental factors, combined with a solid U.S. banking sector, relatively low borrowing rates and a reasonably confident consumer outlook, help explain consumers’ willingness and ability to spend on the goods and services produced by companies.
There is huge demand around the world for high quality income-producing assets, and credit markets can offer that income. While high quality credit is riskier than government bonds, it has typically had only one-third the volatility of equities, and the investment opportunity is more scalable relative to other credit market opportunities: The corporate bond market exceeds $6 trillion in the U.S. alone, and issuance this year is likely to exceed $1 trillion. Globally, the market for government bonds is nearly $30 trillion, but with an average yield of less than 1% (about 60 basis points).
With $12 trillion of negative-yielding global debt weighing on the overall market yield, we anticipate investors will continue to seek higher-income-producing securities and reduce low- or negative-yielding exposure. Because high quality credit continues to hold higher correlations to government bond returns than below-investment-grade credit, allocations to this sector can still offer diversification from equity market risk. Indeed, given their higher yields, portfolio diversification benefits and scalability, we continue to expect allocations will increase to investment grade credit at the expense of government bonds.
Even amid the huge demand around the world for high quality income-producing assets, credit spreads remain a little wider than their historical average relationship, based on fundamentals – and it is worth noting that few financial assets are near their historical average price multiples or spreads. While credit spreads are not as high as they were in February after the broad market drop at the beginning of 2016, they remain relatively attractive (see Figure 3): BBB rated corporate bond spreads have declined about 30 bps year-to-date, but five- to 10-year maturity U.S. Treasury yields have declined about 80 bps.
We think investors may want to consider high quality credit investments at current valuations, as they exceed yields on government bonds, which remain very low. Potential 3%‒6% returns over the next year aren’t quite the 9%‒10% for credit markets year-to-date, but mid-single-digit returns in bonds today are still attractive, especially in light of their diversification benefits in portfolios with equities. And for investors with slightly higher risk tolerances, we see the potential for 5%‒7% returns in emerging market corporate bonds.
FINDING THE MOST ATTRACTIVE COMPANIES
Given the positive backdrop, how can investors choose which companies to invest in? As part of our analysis, PIMCO’s team of more than 50 credit analysts around the world, along with credit portfolio managers, focus on several key questions: What sectors are likely to see better growth trends over the next one to three years? What companies are likely to take market share in global spending? Which of these companies are likely to act in bondholders’ interest? And what companies are able to raise prices on their goods and services?
Finding trends in the industries where prices are rising can provide meaningful investment insight. Pricing power is key to a company’s financial flexibility, which is a very relevant consideration when investing across the capital structure. The dispersion in pricing-power trends creates opportunities for active management – essentially, choosing companies in sectors that are growing, raising prices and acting in bondholders’ interest, and actively avoiding other sectors.
One way of identifying and confirming pricing power is to observe recent trends in the U.S. Consumer Price Index (CPI), excluding food and energy. Trends seen here often align with those we uncover in our own sector and company analysis. Based on the CPI pricing-power trends we see today, we are favoring healthcare, building materials and companies that are benefitting from strong demand tied to U.S. housing activity.
For example, in healthcare, we are seeing investment opportunity in hospitals, select pharmaceutical companies and medical device makers. These companies can be shielded a bit from competition due to patents or operating licenses, and maintain market share in an industry that’s benefitting from demographic demand trends, among other things. It’s not much of a surprise that consumers are paying more each year for products and services in the healthcare sector; in contrast, companies in some other industries have reduced prices to sell their goods, such as new and used cars.
Figure 4 shows changes in prices from last year, affirming many trends we see, with companies successfully raising prices in the building materials and housing, or shelter-related, sectors.
We are finding other investment opportunities in companies tied to U.S. housing as well as non-agency mortgages. Other consumer-related sectors, such as cable, telecom and gaming should also perform well if our base case outlook for U.S. growth holds. And even though there’s been a lot of pressure on global banks this year, U.S., UK and select European bank bonds are actually very attractive.
In addition, we are seeing more opportunities in emerging markets, which are supported by technicals and signs of improving fundamentals. Countries like Brazil, Mexico and Russia look attractive at current valuations as commodity prices have stabilized and the outlook for China is one of muddle-through rather than a hard landing. In the commodity-producing sector, pipelines are attractive at current valuations, but we remain cautious on many industrial metals companies. To be sure, emerging markets have rallied this year, and the asset class can be susceptible to bouts of global risk aversion as well as idiosyncratic developments.
In sum, we continue to see numerous opportunities in credit markets, although after this year’s rally, we think it is time to be a little more selective. Spreads on U.S. corporate bonds are lower than in early 2016, but yields and potential returns still make the sector an attractive way for many investors to seek yield and income.