Viewpoints

Credit, Where Credit Is Due

Eve Tournier, managing director, portfolio manager, and head of European credit discusses the investment implications of recent market volatility and the present late-cycle environment.

Q&A with Eve Tournier, managing director, portfolio manager, and head of European credit. With more than 21 years of experience, Eve Tournier has invested across multiple market cycles. In this Q&A, she discusses the investment implications of recent market volatility and the present late-cycle environment.

Q: CENTRAL BANKS HAVE BEEN DOVISH FOR MUCH OF THE 10 YEARS SINCE THE 2007-2008 GLOBAL FINANCIAL CRISIS, BUT TURNED BRIEFLY HAWKISH AND ARE NOW REVERTING TO DOVISH AGAIN. DID THIS POLICY PIVOT SURPRISE YOU?

Tournier: Not particularly, as we see economies around the world slowing down. What started as weak global trade last year has led to a contraction of the manufacturing sector in several countries. So far, the consumer is holding up, but the longer the weakness in trade and manufacturing persists, the more likely the spillover to the broad economy. Recognizing the downside risks, central banks globally have turned more dovish.

Q: WHAT ARE THE INVESTMENT CONSEQUENCES OF THIS RENEWED CENTRAL BANK DOVISHNESS?

Tournier: As central banks ease, they lower the cost of borrowing for governments, corporates, and consumers. This is generally supportive of fixed income assets, including government and corporate bonds.

Currently, we favour U.S. duration, as that is where yields are highest relative to other developed regions such as Europe and Japan, so they have more room to compress. We expect further Federal Reserve rate cuts over the next several months given the slowdown in the U.S. economy, the country’s contained inflation, and a weakening global outlook.

Q: HOW WILL CENTRAL BANK POLICY AFFECT EUROPEAN CREDIT?

Tournier: The European Central Bank (ECB) easing policy affects European credit most directly as the central bank will soon be purchasing euro-denominated investment grade (IG) corporate bonds on a daily basis.

In September, the ECB delivered a new comprehensive easing package including a rate cut to a more negative –0.5%, the provision of long-term financing to banks at attractive rates, and the restart of its asset purchase program, including the euro-IG corporate bond scheme. As a result, euro-denominated IG corporate bonds have outperformed U.S. dollar-IG credit and may continue to be supported by the daily ECB purchases, holding yields low.

The ECB is signaling that interest rates in the eurozone will remain negative for a long time, pushing investors further into risk to seek some positive income.

Q: DO YOU EXPECT THE SHARE OF NEGATIVE-YIELDING CREDIT TO INCREASE?

Tournier: Today, there is more than €13 trillion (US$14 trillion) of negative-yielding debt in the world, and as a consequence, investors are willing to accept yields that were once unfathomable: Over 30% of European IG corporate bonds are negative-yielding (i.e., companies are paid to borrow).

As the ECB restarts its corporate bond-buying program and government bond yields remain low, the share of negative-yielding corporate debt may rise if credit spreads tighten following the extra demand that the ECB purchase program may foster.

However, as corporate bond yields drop further, there is a risk that investors may decide to reduce their exposure to the asset class, thereby affecting companies’ access to credit – the opposite of what the ECB wants. We are already seeing some resistance towards high-quality, negative-yielding European credit, which is underperforming long-dated, lower-quality corporate debt on a risk-adjusted basis.

Q: WHICH SECTORS DO YOU FAVOUR IN EUROPE CURRENTLY?

Tournier: We have a positive view on U.K. financials, which have rebuilt their balance sheets since the financial crisis and are now better capitalized. Valuations are also attractive in light of the inherent “Brexit premium,” which in our view more than compensates for the associated risks. We also favour the REITS (Real Estate Investment Trusts)/real estate sector, which may benefit from underlying asset quality, and covenants that lessen the risk of over-leveraging. We also have a positive view of media/broadcasting debt, especially leading tower operators with high barriers to entry, long-term inflation-linked contracts, and strong cash flow generation.

Q: YOU HAVE ALWAYS BEEN A STRONG ADVOCATE OF DIVERSIFICATION AS A WAY TO REDUCE RISK. WHAT OPPORTUNITIES DO YOU SEE GLOBALLY?

Tournier: A global opportunity set allows us to seek the most attractive relative value opportunities across regions and markets, taking into account differences in macroeconomic fundamentals and trends that may impact credit quality. Given the outlook for slowing growth, we like the most resilient and high-quality parts of the market. This includes businesses linked to the U.S. consumer, including housing-related sectors, as a robust labour market, rising wages, and low interest rates continue to support consumption and housing. We also like pipeline operators, which benefit from steady revenue streams and hard assets.

Q: AND WHAT ARE YOU FAVORING IN HIGH YIELD?

Tournier: Given the late-cycle environment, we are naturally cautious in high yield security selection. Still, we like defensive and non-cyclical sectors with stable cash flows, such as the cable sector.

Overall, high yield is still supported by fundamentals, with relatively stable leverage levels and issuance proceeds mostly used for refinancing, rather than expensive mergers and acquisitions (M&A) or dividend pay-outs. And although idiosyncratic risks are rising, we do not anticipate a significant increase in default rates, which we believe are likely to remain around 3% over the next 12 months. Technical factors are also constructive, given the demand for yield, a shrinking market as a result of limited net new issuance, and several “rising stars,” or companies moving from high yield to investment grade indices.

Credit, Where Credit Is Due: The Implications of Recent Market Volatility and the Present Late-Cycle Environment

Credit, Where Credit Is Due: The Implications of Recent Market Volatility and the Present Late-Cycle Environment

Q: OVERALL IN CREDIT, WHICH SECTORS DO YOU FIND UNATTRACTIVE?

Tournier: Industries subject to global trade and tariff risks may be challenged in the present environment, and we have already seen global trade being impacted by the U.S.–China trade tensions. In particular, we have a cautious view on cyclical industries such as raw materials and retail, both of which have limited pricing power and face cyclical and/or secular challenges. The technology sector is also vulnerable to obsolescence risk, and furthermore generally lacks hard assets.

Q: HOW CAN INVESTORS HEDGE THEIR PORTFOLIOS AGAINST THIS WEAKENING GLOBAL OUTLOOK?

Tournier: In Europe, unfortunately, interest rates are already negative, giving the ECB limited room to cut further. This means that going forward, duration may not provide the degree of defense that it did in past downturns, so positions need to be sized accordingly. At PIMCO, we are currently running portfolios with less risk than a year ago. This may also enable us to opportunistically add risk in bouts of volatility. We consider the current environment to be particularly conducive for active management as dispersion has increased and certain pockets of the market have become more vulnerable than others.

Q: AS AN ACTIVE MANAGER, HOW DO YOU SEEK TO GENERATE ALPHA IN THE CURRENT ENVIRONMENT?

Tournier: For us, the key is to combine top-down macroeconomic views and their implication for asset allocation and sector rotation with bottom-up security selection, driven by the fundamental research of our 65+ credit research analysts. These views are then incorporated into four basic pillars of portfolio construction:

  1. Quality: We favour structurally senior positions in the capital structure of a company, as well as strong asset coverage. We find this is the most resilient segment in periods of market stress.
  2. Structurally inefficient markets: Despite the growth of credit markets, there are pockets that are less well understood or not as widely followed, like non-agency mortgage-backed securities (MBS). We aim to find value in less-researched markets in order to deliver better risk-adjusted returns.
  3. Risk management and diversification: We seek to build resilient portfolios, which we stress-test, and in which we emphasize diversification to reduce risk.
  4. Catalyst trades: We look for securities with upside potential as a result of a potential catalyst, for example “rising stars” or companies that may be subject to M&A.

Q: LAST, AS A PORTFOLIO MANAGER, WHAT KEEPS YOU AWAKE AT NIGHT?

Tournier: The ongoing trade war is increasing the level of unpredictability, hitting business confidence, and making a slowing economy more fragile to potential shocks. At the same time, the weaker market structure, where liquidity can evaporate quickly, can lead to sharp repricings.

So, we must stay vigilant and disciplined, seeking to reduce risk in strong markets in order to be able to invest during periods of volatility, when we can potentially benefit from more attractive valuations or tactical opportunities. We combine this short-term view with our distinct, fundamental, and long-term approach, which we use to give credit where credit is due. As global credit investors, whatever the market circumstances, we will continue to finance high-quality businesses in exchange for attractive risk-adjusted returns for our clients, which is our ultimate goal.

Read PIMCO’s latest Secular Outlook, “Dealing With Disruption,” for further insights into the longer-term outlook for the global economy along with takeaways for investors.

Read Here
The Author

Eve Tournier

Head of European Credit Portfolio Management

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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 low interest rate environments increase this risk. 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. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. 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. Management risk is the risk that the investment techniques and risk analyses applied by an investment manager will not produce the desired results, and that certain policies or developments may affect the investment techniques available to the manager in connection with managing the strategy. Diversification does not ensure against loss.

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. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.

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