After a turbulent 2015 and inconsistent start to 2016, global credit markets have since bounced back and continued to rally – nearly without pause. This has led many investors to ask whether there is still value in corporate bond markets and if so, how they can balance their return objectives against the downside risks. Here, PIMCO’s multi-sector credit team highlights where they see opportunities across the spectrum of global credit markets and offers insights into managing volatility and risks while seeking attractive yield.
Q: Why should investors consider a more diversified approach to credit markets?
Sageser: Many credit investors focus on specific areas of the global credit markets (such as investment grade corporate bonds, high yield bonds, emerging market (EM) debt or securitized loans). In addition, many investors attempt to time their allocations to various credit sectors – buying sectors that “overshoot on the downside,” for example, or reducing exposure when valuations appear stretched. Unfortunately, buying low and selling high (as simple as that sounds) can be far more difficult than many investors would like to believe – especially when higher-volatility credit sectors are in the mix, such as high yield corporates, emerging market debt and floating rate bank loans.
We believe an active, tactical, multi-sector approach to credit investing can produce better long-term results through structural diversification, bottom-up credit selection and the ability to scale into and out of risk as relative valuations become more or less compelling.
Q: What are PIMCO’s overall views on risk across credit sectors?
Pier: Credit spreads have continued to tighten since the first quarter of 2016, and PIMCO’s multi-sector credit team views this as an opportunity to reduce higher-beta credits and move up in quality. During pockets of weakness due to macro events (Brexit, for example) and brief shifts in investor sentiment, we believed it made sense to tactically add back risk through purchases of higher-yielding assets that our thorough credit research identified as strong fundamental credit stories. As credit spreads resume their tightening bias after these moments of weakness, investors can migrate back up in quality and wait for the cycle to repeat.
Q: What’s your current view on relative value in the high yield bond and bank loan markets?
Pier: While we see high yield as generally fully valued, there are still many attractive structural opportunities in credit default swap indexes (CDX), rising stars (i.e., high yield issuers that we expect will be upgraded to investment grade) and secured bonds. Given the symmetry of buyers and sellers in the synthetic market, we prefer to express long positions in the form of CDS and CDX, where investors can capture the benefit of “rolling down” the credit curve rather than owning longer-dated cash bonds that are subject to volatile fund flows and generally offer limited roll-down potential. Also, employing structural trades such as CDX, which tend to provide greater liquidity, provides flexibility to reduce beta more quickly when needed while less liquid securities are reduced over time, which can help preserve capital in turbulent markets.
Recently, we’ve heard investors express increasing interest in bank loans within their broader multi-sector credit allocations. Bank loans can help diversify credit and duration risk: Historically they tend to offer resilience when interest rates rise and during market sell-offs, and they tend to be structurally senior to corporate bonds. However, in the current environment, we have been highly selective when evaluating bank loans since most trade above par and borrowers can often prepay at par without penalty. In addition, we have witnessed a steady increase in loan-only capital structures coming to market, in which a borrower issues a senior secured loan with no subordinate debt beneath it. So while we still find opportunities in bank loans today, we would take a highly selective approach when incorporating them within a multi-sector credit allocation.
Q: Where else are you seeing attractive opportunities in the high yield market?
Pier: Given current valuations, we’ve been cautious as there are limited opportunities to buy discount bonds that ultimately get repaid at par. Instead, we’ve been looking for opportunities to “grind out alpha.” As an example, we recently did a private exchange with a high yield consumer finance company where we were able to sell a short-dated bond above market and buy a longer-dated bond that offered better upside convexity and relative value. This is one example of how PIMCO can leverage our size and access to company management to target opportunities in credit space. It is also important to rely heavily on the expertise of our credit research team, since today’s credit markets also offer plenty of opportunities to overpay or to take on unreasonable amounts of risk.
Q: What role can mortgages and other securitized instruments play in multi-sector credit portfolios today?
Murata: In the context of a multi-sector credit portfolio, we find non-agency mortgage-backed securities (MBS) to be attractive investments. Non-agency MBS are bonds backed by residential loans, where the investor depends upon the cash flows from the underlying loans to be repaid, rather than from a guarantee from a government or other entity. Consequently, the primary risk factor for non-agency MBS is related to the level of residential housing prices, rather than interest rate risk.
We find it attractive to invest in non-agency MBS within a multi-sector credit portfolio due to the stability of the yield profile across a wide variety of housing price scenarios, and as an alternative to corporate credit risk. In general we look to purchase non-agency MBS at a significant discount to par, such that the bonds would provide a potential yield (after taking into account estimated defaults on the underlying loans) in the 4%–5% range in the event that housing prices increase by 3% per year, while still providing a positive yield even if housing prices were to decline by a total of 10% over two years.
Q: How do you currently view higher-quality credit? Where does this fit in a portfolio context?
Tournier: We’ve been focused on a few key investment themes in the investment grade corporate space. We continue to see value in the financial sector, particularly within bank capital securities. We think that for many of these instruments, underlying balance sheet strength, improving asset quality and regulatory tailwinds more than offset the risk associated with capital structure subordination. In our view, there are good relative value opportunities in senior holding company instruments in UK banks or in lower Tier 2 (LT2) assets in European banks, along with additional Tier 1 (AT1) capital and other subordinate instruments issued by global financial institutions.
Building on the theme of grinding out alpha, we’ve harnessed a number of opportunities to provide liquidity to banks seeking to manage their short-term capital needs. For example, we purchased a five-year senior bond from a large global bank at Libor+290 bps, and then six months later the bank tendered for this bond at Libor+150. Although the banking sector is subject to occasional fits of volatility – which can lead to price declines in bank securities – PIMCO sees bright economic prospects for many of these issuers over the secular horizon.
Q: Is there value in emerging markets, and if so, how can investors incorporate EM debt in their multi-sector credit portfolios?
Arnopolin: Hard currency EM debt, such as quasi-sovereign and corporate debt issued in U.S. dollars, can boost portfolio diversification – which can be particularly helpful when other credit sectors struggle. We also think it makes a lot of sense to have a global perspective when looking for the best credit opportunities. If an investment portfolio has a portion of its risk budget allocated to commodities, for example, then a large oil producer partially owned by a foreign government could actually offer better relative value than, say, a U.S. oilfield services company.
The EM space also offers opportunities to incrementally add to returns over shorter-term time horizons while waiting for better market entry points. As an example, we recently purchased short-term local debt from an EM sovereign issuer set to mature within 12 months, hedging the currency risk at the time of purchase. Because this debt was issued under local law, it offered a significant premium relative to U.S. dollar–denominated paper without additional currency risk. Depending on the country of issuance, local law debt often carries greater risks than comparable instruments issued under UK or U.S. law, which highlights the importance of having a deep bench of emerging markets expertise to evaluate country-specific risk.
We continue to scour the globe for opportunities to capture low-risk carry and position portfolios for capital appreciation.
Q: How should investors think about allocating to multi-sector credit in the current environment?
Sageser: The optimal approach to multi-sector credit will vary depending on an investor’s objectives. While a portfolio can be managed to different benchmarks and performance objectives, our starting point for global, multi-sector credit exposure includes high yield, investment grade and EM debt indexes, but with ample flexibility for shifting among different credit sectors based on our relative value views. This kind of broad strategy may provide a good starting point for investors who desire a tactical approach to the broad spectrum of global credit sectors.
Many institutional investors seeking access to the multi-sector credit space opt for customized solutions aligned with their objectives, risk tolerance and – importantly – their existing portfolio allocations. Benchmark construction is typically a key part of this process, although investors have increasingly begun to look at more benchmark-agnostic approaches, such as absolute return or yield-based objectives. Liquidity preference is also important, since many investors do not necessarily require daily or even monthly liquidity. This opens up the opportunity set even further, and allows investors to consider less liquid credit or private funds that offer more niche approaches. In addition, many investors have paired their multi-sector credit allocations with overlay strategies designed to mitigate tail risk.