Much has been written about the potential demise of active stock-picking, best reflected by the shift in flows toward passive equity vehicles after years of disappointing active performance. Many investors and the media assume the case for passive fixed income is the same – that investors can do better with lower-fee passive funds. However, bonds are different: In the U.S., more than half of the active bond mutual funds and exchange-traded funds beat their median passive counterparts after fees over the past 1, 3, 5, 7 and 10 years,i as four of my colleagues explained in the paper “Bonds Are Different: Active Versus Passive Management in 12 Points.”
Within credit markets specifically, we believe passive investors are implementing a suboptimal strategy and potentially leaving money on the table. Moreover, in an environment of low interest rates and modest expected future returns, potential alpha from active credit investing can significantly boost an investor’s overall return provided the active investment manager can overcome higher fees. For example, the global credit market yields around 3% today and assuming that starting yields are a good predictor of future return potential, then if an active credit manager can deliver 1% of alpha after fees, this would boost total return by 33%! This is much greater than 10 years ago, when yields were almost 6% and the additional return from alpha represented a much smaller share. Lower expected returns make alpha returns more important than ever.
STRUCTURAL SHORTCOMINGS OF CORPORATE INDEXES
We believe passive managers are at a disadvantage as they aim to replicate indexes, and indexes generally have substantial shortcomings. Most corporate bond indexes weight holdings based on the total debt outstanding. To put it bluntly, the more debt a company has, the higher its weight in the index and the more passive investors therefore lend to it. Does it make sense to blindly lend to companies that have the most debt?
A few of the largest industry borrowers in the U.S. investment grade corporate market over the last five years have come from the technology, pharmaceutical, healthcare, and food and beverage sectors. These same industries have underperformed the Bloomberg Barclays U.S. Investment Grade Corporate Index over the last five years, largely because fundamentals are closely linked to credit spreads and, more specifically, the ratio of net debt-to-enterprise value is correlated to credit spreads, with rising net debt-to-enterprise value leading to widening credit spreads (see Figure 1).
Another shortcoming, in our opinion, is the arbitrary ratings criteria for credit indexes. To reflect different levels of credit risk, standard credit indexes have strict rules regarding the credit ratings of the underlying bonds. In particular, investment grade indexes typically stipulate that bonds rated at or above BBB-/Baa3 can be part of the indexes. Therefore, if an issuer is downgraded to below investment grade and becomes high yield, it is usually forced out of the index at the end of the month of downgrade. Passive managers who track the bond benchmark will have to sell these bonds when all the other passive investors are also selling. This can leave money on the table, though, because such “fallen angels” can often bounce back. The losses initially experienced upon, or in the lead-up to, the credit rating downgrade can often at least be partially recouped in the following months. In these cases, passive managers lose twice: by selling as the bond falls out of the index and by missing out on any subsequent potential gains. Independent research from Barclays has shown that holding onto downgraded names has delivered about an extra 30 basis points per year (see Figure 2).ii
Additionally, passive credit funds often aim to replicate only a subset of the more common indexes, often by focusing on the larger, and thus more indebted, companies. This means passive credit investors may not be investing in a truly representative sample of the credit markets. Moreover, the larger bonds emphasized in many passive credit strategies have historically underperformed smaller bonds and been more volatile.
INDEPENDENT RESEARCH AND PICKING THE WINNERS
The variety and complexity of bonds outstanding represent alpha opportunities for active managers like PIMCO. It is the reason we have a large research team focused on independent bottom-up research. Our credit research team tracks over 44,000 securities. A company could have just one equity ticker but have literally hundreds of bonds outstanding across currencies, maturities and the capital structure. Consequently, a company’s bonds can have varying levels of risk, which can lead to very different return profiles.
PIMCO’s investment strategy focuses on anticipating credit rating upgrades. We model issuers’ financial statements by making projections and forecasts several years into the future. Our strategy is to buy companies supported by high barriers to entry and pricing power, exhibit above-trend growth and have management teams that act in the best interest of bondholders. This forward-looking investment process has helped us identify high yield corporate bonds prior to being upgraded to investment grade.
RISK MITIGATION AND AVOIDING THE LOSERS
The flexibility to actively manage all risks – interest rate, credit, currency, etc. – enhances an active manager’s ability to add value and deliver returns. For example, PIMCO can mitigate interest rate risk by: (1) decreasing portfolio-level duration, (2) investing in global markets that may be experiencing stable or falling interest rate environments, and (3) focusing on sectors with less interest rate sensitivity. Passive managers generally either cannot do these three things, or the extent to which they can is restricted by the index composition.
Active management in credit applies not just to what is bought, but equally importantly to what is not bought. A single default can significantly impair portfolio returns, but typical passive investments by their very nature do not sell or steer clear of likely defaults or over-valued bonds. In our high yield portfolios we actively seek to avoid defaults.
SIZE AND GLOBAL RESOURCES
Active managers with size and a breadth of resources can seek to harness information advantages across industries, markets and geographies. Our size helps us gain access to senior management at companies, influence corporate decisions and engage in reverse inquiries.
In addition, our global research and portfolio management teams conduct on-the-ground evaluations of companies and scour the universe of available instruments across currencies. For example, PIMCO will often go global in order to pick up extra spread in non-local currencies; there is often a home bias that can cheapen a company’s bonds issued in a currency different from that of its home market, even after hedging costs. A great example of this is the U.S. dollar-denominated bonds of Italybased banking group Intesa Sanpaolo, which are often cheaper than their euro-denominated counterparts (see Figure 3). So an active credit manager like PIMCO can take the same credit risk but implement the view with a potentially cheaper instrument. Passive investors may miss out on these opportunities if they are restricted to investing in a particular currency.
We believe having large and credible specialty desks in areas other than corporate credit also gives PIMCO an edge in evaluating companies. For instance, combining our stress test analysis and input from the commodity desk gave us an informed view on the performance potential of energy companies in a low-price environment, providing key insights into which companies might be stronger or weaker than their current ratings from the major ratings agencies. Also, we have combined fundamental company-specific analysis with PIMCO’s granular mortgage-loan level and structural analysis to value corporate balance sheets, specifically in the mortgage insurance, real estate finance and banking sectors. We believe these types of analyses lead to better results than basing investment decisions on how much debt a company has issued.
Taken together, our independent research, risk mitigation, large size and global resources support our ability to seek structural alpha for clients and dynamically allocate capital as market opportunities arise. This allows us to deliver on our main objective, which is to seek an attractive risk-adjusted return over a market cycle.
As we look forward, relative value between sectors and companies is expected to drive returns, as traditional credit asset classes are closer to fair value. Our bottom-up positioning emphasizes growth industries with high barriers to entry, and companies with management teams that favor bondholders in the capital structure. As a result, we favor sectors such as banks and brokerages, consumer cyclicals and those sectors related to the housing market, such as building materials and non-agency mortgages. On the other hand, we dislike credits facing slower growth or releveraging risk, such as metals and mining and retail, as well as sectors where management teams may favor equity holders, such as technology.
Overall, PIMCO is well positioned to help investors navigate credit investments across market cycles and to continue to show investors that active management is the way to invest in corporates.
For more on this topic, please visit the Why Bonds Are Different page.