(Riflessioni strategiche) Uncovering ‘Diamonds in the Rough’ in Today’s Credit Markets (Mark R. Kiesel, PIMCO, febbraio 2013)
24.02.2013 08:36
The credit markets have had a strong run since the market bottomed in 2009. Many investors searching for income have moved into riskier assets.
- A "diamond in the rough" is a credit that is under-covered, or not actively followed or researched by many investors. At PIMCO, we identify these opportunities through our top-down and bottom-up investment process.
- We’ve identified a number of sectors that appear poised for above-average growth. Housing is at the top of the list, and one of the few bright spots in the U.S. economy. Energy is another industry in which we’re seeing opportunity, and we are also bullish on select credits in emerging economies.
Credit strategies have traditionally served as an attractive source of potential income generation as well as a steady anchor in many investors’ portfolios – roles that have become increasingly meaningful in the low yield environment. Mark Kiesel, head of PIMCO’s global corporate desk and Morningstar’s 2012 Fixed Income Fund Manager of the Year, discusses the state of today’s credit markets and how PIMCO seeks value.
Q: Is there still opportunity for investors, given the strong appreciation in the credit markets?
Kiesel: The credit markets have had a strong run since the market bottomed in
2009. This is largely the result of the Fed’s unconventional monetary policies to stimulate growth, measures which have repressed Treasury yields to near historic lows. Investors searching for income have moved into riskier assets, notably to high yield bond funds, which saw inflows of more than $45 billion in the past two years, according to AMG Data. This demand has pushed yields below 6%, making valuations less compelling.
That’s not to say there aren’t good opportunities for yield and total return in the credit markets, but there has been a shift in where and how investors can find them. The market has moved from a “beta” environment, in which making the right sector call was sufficient, to one in which security selection – pinpointing those “diamonds in the rough” – will matter most. That means active management and smart security selection will be essential. Fortunately, this type of environment should be well matched to PIMCO’s skill set.
Q: Is there still opportunity for investors, given the strong appreciation in the credit markets?
Kiesel: The credit markets have had a strong run since the market bottomed in
2009. This is largely the result of the Fed’s unconventional monetary policies to stimulate growth, measures which have repressed Treasury yields to near historic lows. Investors searching for income have moved into riskier assets, notably to high yield bond funds, which saw inflows of more than $45 billion in the past two years, according to AMG Data. This demand has pushed yields below 6%, making valuations less compelling.
That’s not to say there aren’t good opportunities for yield and total return in the credit markets, but there has been a shift in where and how investors can find them. The market has moved from a “beta” environment, in which making the right sector call was sufficient, to one in which security selection – pinpointing those “diamonds in the rough” – will matter most. That means active management and smart security selection will be essential. Fortunately, this type of environment should be well matched to PIMCO’s skill set.
Q: What makes a company a “diamond in the rough”?
Kiesel: A "diamond in the rough" is a credit that is under-covered, or not actively followed or researched by many investors. It can also be a company where few see near-term upside. At PIMCO, we identify these opportunities through our top-down and bottom-up investment process. We drill down, looking for countries, industries and companies with above-average growth potential. We ask ourselves: What’s driving a country’s growth? Is that growth sustainable? Which industries are poised to grow faster than their overall economies? And finally, which companies are likely to be the fastest growers within their industries? In a low-growth environment, we’re looking for companies that grow free cash flow to pay down debt.
That’s where our credit research plays a key role. We have 47 credit analysts who do hands-on research around the globe. Portfolio managers and analysts visit companies together, examine the company's assets and meet with management, customers, competitors and suppliers. We believe PIMCO’s size and prominence offer an advantage in that they may open doors for us, giving us unique access to industry, academic and political experts unavailable to most investors. Our resources also allow us to maintain coverage on a global basis, which we feel provides us a clearer view of the industry dynamics affecting the subject company. Finally, we travel extensively every year to do bottom-up, face-to-face research with managements of companies all over the world. We aim to put these advantages to work for our clients.
That’s where our credit research plays a key role. We have 47 credit analysts who do hands-on research around the globe. Portfolio managers and analysts visit companies together, examine the company's assets and meet with management, customers, competitors and suppliers. We believe PIMCO’s size and prominence offer an advantage in that they may open doors for us, giving us unique access to industry, academic and political experts unavailable to most investors. Our resources also allow us to maintain coverage on a global basis, which we feel provides us a clearer view of the industry dynamics affecting the subject company. Finally, we travel extensively every year to do bottom-up, face-to-face research with managements of companies all over the world. We aim to put these advantages to work for our clients.
Q: Where are you finding attractive credits in the current market?
Kiesel: We’ve identified a number of sectors that appear poised for above-average growth. Housing is at the top of the list, and one of the few bright spots in the U.S. economy. We anticipate that home inventories, which are good forward-looking indicators of prices, may continue to come down faster than many expect; we also believe that household formation should pick up. Our analysis leads us to believe that housing and housing-related sectors have strong potential to expand even in an economy that’s expected to grow only 2%. So we are looking to take advantage of credits we believe will benefit the most from the rebuild and remodel cycles, such as building materials, lumber and appliance makers – as well as companies that should benefit from a gradual improvement in housing activity, sales and prices.
Energy is another industry in which we’re seeing opportunity, particularly in so-called midstream MLPs (master limited partnerships). These are the “tollbooth” companies that gather, process and fractionate natural gas or oil from the wellhead. As production of oil and gas ramps up across the shale regions including the Bakken, Eagle Ford and Marcellus, midstream MLPs should benefit from increased volumes, demand for new pipeline capacity and favorable pricing trends. And finally, we are bullish on select credits in emerging economies, where PIMCO has a strong market presence and direct access to companies’ high-level executives. Within EM, we’re favoring gaming and gas distribution companies as well as select Latin American banks.
Kiesel: We’ve identified a number of sectors that appear poised for above-average growth. Housing is at the top of the list, and one of the few bright spots in the U.S. economy. We anticipate that home inventories, which are good forward-looking indicators of prices, may continue to come down faster than many expect; we also believe that household formation should pick up. Our analysis leads us to believe that housing and housing-related sectors have strong potential to expand even in an economy that’s expected to grow only 2%. So we are looking to take advantage of credits we believe will benefit the most from the rebuild and remodel cycles, such as building materials, lumber and appliance makers – as well as companies that should benefit from a gradual improvement in housing activity, sales and prices.
Energy is another industry in which we’re seeing opportunity, particularly in so-called midstream MLPs (master limited partnerships). These are the “tollbooth” companies that gather, process and fractionate natural gas or oil from the wellhead. As production of oil and gas ramps up across the shale regions including the Bakken, Eagle Ford and Marcellus, midstream MLPs should benefit from increased volumes, demand for new pipeline capacity and favorable pricing trends. And finally, we are bullish on select credits in emerging economies, where PIMCO has a strong market presence and direct access to companies’ high-level executives. Within EM, we’re favoring gaming and gas distribution companies as well as select Latin American banks.
Q: The low yield environment has made many bond investors concerned about the prospect of both more shareholder-friendly activities and rising rates. How do you look to protect your portfolios?
Kiesel: Let me say first that we don’t believe rates are going to rise meaningfully in the near term due to subpar growth and the Fed’s commitment to easy monetary policy. However, inflation and rising rates are a medium-term concern, particularly as the Fed begins to reverse course and over time reduce its balance sheet. Leveraged buyouts (LBOs), increased share buybacks and rising dividends to equity holders are additional concerns, as some companies re-lever with the help of easy financial conditions. We have been reducing interest rate sensitivity in our portfolios by focusing on intermediate- term securities and by owning floating rate bank loans, which adjust to prevailing rates. We have also been reducing exposure in industries we feel are most at risk of corporate re-leveraging events.
It’s also important to understand that not all bonds decline in price when rates rise. For example, credits that are experiencing rapid deleveraging may see spreads compress significantly enough to compensate for the negative effects of rising rates. We’re always looking for these types of bonds, particularly “rising stars” – below- investment-grade companies with improving credit fundamentals that we believe are likely to be upgraded. Because these securities are rated “junk,” they provide an attractive yield, with the potential for price appreciation as spreads tighten. These types of turnarounds can occur irrespective of the rate environment.
Q: Can you explain more about how you invest in rising stars?
Kiesel: We leverage PIMCO’s independent research to find rising stars, or companies that we feel are misrated and which have the potential to be upgraded. We don’t rely on third-party ratings agencies or research reports. Instead, our credit team does the groundwork, creates valuation models and maintains a proprietary internal credit ratings system. We then frame their analysis in the context of our macro views. As a result, our reading of a company’s risk/reward profile often differs markedly from that of the broader markets: Of the 12,000 securities we rated last year, we independently rated 38% higher and 33% lower than Moody’s and S&P.
We use this intelligence to help us minimize the default risk in our portfolios while also capturing opportunities overlooked by most investors. A good example of this is the auto and auto finance sector, which struggled during the recession, leading to broad credit downgrades by the agencies. We are more bullish on the macro trends affecting the auto industry, anticipating that pent-up demand – the average car on the road is 11 years old – and relatively easy financing may boost sales faster than the market has priced in. Our credit team has identified specific auto and auto finance companies that we believe could be upgraded, offering the potential for capital appreciation.
This type of strategy also requires patience. We invest in many companies one to two years before we believe an upgrade will occur, and then continue to hold them for a while afterward before selling – with the aim of capturing additional gains as passive, index-linked funds buy these credits. That’s a potential edge only active management can provide.
Q: What strategies can investors use to maximize diamonds-in-the-rough opportunities while avoiding those parts of the credit markets that don’t offer as much value?
Kiesel: It’s important for investors to recognize the risks inherent in passive or very traditional credit strategies that tightly track a benchmark. Most credit indexes are market-cap-weighted, which means they have the greatest exposures to companies with the greatest debt outstanding. There are fundamentally better ways to allocate capital, taking into consideration, among other factors, earnings growth, debt-to-enterprise value trends and visibility of earnings, all of which may lead to better long-term performance. The indexes also may limit managers with respect to credit quality, forcing them to accept third-party agency ratings – which may be outdated or based on preconceived notions – rather than determining for themselves what is risky or safe. At PIMCO, we take a long-term approach and try to focus on fundamentals. A great example of an area that is misunderstood from a credit risk perspective is emerging market companies, many of which are multinational powerhouses. Their public and private sector balance sheets are also often more fundamentally sound than their developed market counterparts. Our global corporate bond portfolio management and credit analyst teams travel the globe to find diamonds in the rough in these areas, where many smaller investment management firms don't have the global research platform to thoroughly analyze many of these opportunities.
We believe that broadening portfolio guidelines or taking an absolute return approach by removing benchmarks altogether allow managers like PIMCO to employ our deep global resources to focus on the best risk-adjusted opportunities in the market – regardless of how they are classified – while staying away from those that we feel are less attractive. That flexibility can be an important benefit for our clients. In summary, the global depth of our resources, combined with our longer-term secular approach, allows us to go anywhere to find what we believe are the most attractive investments in the global credit markets.
Kiesel: Let me say first that we don’t believe rates are going to rise meaningfully in the near term due to subpar growth and the Fed’s commitment to easy monetary policy. However, inflation and rising rates are a medium-term concern, particularly as the Fed begins to reverse course and over time reduce its balance sheet. Leveraged buyouts (LBOs), increased share buybacks and rising dividends to equity holders are additional concerns, as some companies re-lever with the help of easy financial conditions. We have been reducing interest rate sensitivity in our portfolios by focusing on intermediate- term securities and by owning floating rate bank loans, which adjust to prevailing rates. We have also been reducing exposure in industries we feel are most at risk of corporate re-leveraging events.
It’s also important to understand that not all bonds decline in price when rates rise. For example, credits that are experiencing rapid deleveraging may see spreads compress significantly enough to compensate for the negative effects of rising rates. We’re always looking for these types of bonds, particularly “rising stars” – below- investment-grade companies with improving credit fundamentals that we believe are likely to be upgraded. Because these securities are rated “junk,” they provide an attractive yield, with the potential for price appreciation as spreads tighten. These types of turnarounds can occur irrespective of the rate environment.
Q: Can you explain more about how you invest in rising stars?
Kiesel: We leverage PIMCO’s independent research to find rising stars, or companies that we feel are misrated and which have the potential to be upgraded. We don’t rely on third-party ratings agencies or research reports. Instead, our credit team does the groundwork, creates valuation models and maintains a proprietary internal credit ratings system. We then frame their analysis in the context of our macro views. As a result, our reading of a company’s risk/reward profile often differs markedly from that of the broader markets: Of the 12,000 securities we rated last year, we independently rated 38% higher and 33% lower than Moody’s and S&P.
We use this intelligence to help us minimize the default risk in our portfolios while also capturing opportunities overlooked by most investors. A good example of this is the auto and auto finance sector, which struggled during the recession, leading to broad credit downgrades by the agencies. We are more bullish on the macro trends affecting the auto industry, anticipating that pent-up demand – the average car on the road is 11 years old – and relatively easy financing may boost sales faster than the market has priced in. Our credit team has identified specific auto and auto finance companies that we believe could be upgraded, offering the potential for capital appreciation.
This type of strategy also requires patience. We invest in many companies one to two years before we believe an upgrade will occur, and then continue to hold them for a while afterward before selling – with the aim of capturing additional gains as passive, index-linked funds buy these credits. That’s a potential edge only active management can provide.
Q: What strategies can investors use to maximize diamonds-in-the-rough opportunities while avoiding those parts of the credit markets that don’t offer as much value?
Kiesel: It’s important for investors to recognize the risks inherent in passive or very traditional credit strategies that tightly track a benchmark. Most credit indexes are market-cap-weighted, which means they have the greatest exposures to companies with the greatest debt outstanding. There are fundamentally better ways to allocate capital, taking into consideration, among other factors, earnings growth, debt-to-enterprise value trends and visibility of earnings, all of which may lead to better long-term performance. The indexes also may limit managers with respect to credit quality, forcing them to accept third-party agency ratings – which may be outdated or based on preconceived notions – rather than determining for themselves what is risky or safe. At PIMCO, we take a long-term approach and try to focus on fundamentals. A great example of an area that is misunderstood from a credit risk perspective is emerging market companies, many of which are multinational powerhouses. Their public and private sector balance sheets are also often more fundamentally sound than their developed market counterparts. Our global corporate bond portfolio management and credit analyst teams travel the globe to find diamonds in the rough in these areas, where many smaller investment management firms don't have the global research platform to thoroughly analyze many of these opportunities.
We believe that broadening portfolio guidelines or taking an absolute return approach by removing benchmarks altogether allow managers like PIMCO to employ our deep global resources to focus on the best risk-adjusted opportunities in the market – regardless of how they are classified – while staying away from those that we feel are less attractive. That flexibility can be an important benefit for our clients. In summary, the global depth of our resources, combined with our longer-term secular approach, allows us to go anywhere to find what we believe are the most attractive investments in the global credit markets.