Picking the Investment Winners In 2010

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What will be the investment winners in 2010? A number of corporate bonds are likely to be winners: They should outperform Treasuries in 2010 due to improving credit fundamentals and strongly supportive credit market technicals, in which demand should exceed supply, causing credit spreads for many higher-quality corporate bonds to tighten versus Treasuries. Within the credit market, select banking and financial sector bonds stand out as potential winners due to an improved outlook for asset quality and profits; healthier balance sheets; continued government, policy and regulatory support and attractive relative valuations.The search for yield, which we claimed would lead to strong relative performance in the credit market in 2009 (see the December 2008 U.S. Credit Perspectives: "Credit Now, Equities Later"), will likely continue to influence investment returns in 2010. While investments in the credit market have performed well in the past year, corporate bonds, particularly those in certain banks and financials, remain attractive relative to other fixed income sectors such as mortgages and Treasuries. The corporate sector has demonstrated remarkable discipline, cutting costs and spending to increase free cash flow while strengthening balance sheets by terming out near-term debt maturities with longer-maturity new bond issues and by raising new equity capital. Credit fundamentals should improve as the economy gradually recovers, and market technicals appear highly supportive for corporate bonds, particularly relative to Treasuries. Credit Fundamentals ImprovingCorporate credit fundamentals have improved with the return of private capital and management's desire for less aggressive business and financial profiles. Rising cash balances, stronger balance sheets, an improving economy and easier credit conditions are all helping to support corporations. One reason corporate fundamentals and balance sheets are improving is the return of animal spirits and private sector risk capital in both the equity and debt markets. Low short-term interest rates combined with a gradual economic recovery have caused investors to venture farther out the risk spectrum over the past year. According to a December report from JPMorgan, U.S. companies in 2009 were able to raise $529 billion of new equity: a 42% increase over 2008's total of $372 billion. In addition to raising equity capital, investment grade and high yield companies raised $1.18 trillion through the new issue corporate bond market in 2009, according to CreditSights. Amazingly, issuance increased significantly across all rating categories from AAA-rated to CCC-rated credits, allowing both high-quality and low-quality companies to refinance near-term debt maturities with longer-maturity debt, push out the average maturity profile, reduce liquidity risk and strengthen balance sheets. This improvement in corporate credit fundamentals has materially improved the outlook for default risk, particularly in the high yield market, and increased balance sheet strength and financial flexibility for corporations. As a result, Standard & Poor's is now upgrading more companies than it is downgrading (Chart 1).

Corporate executives' confidence has increased with the improvements in balance sheets, credit availability and credit fundamentals, along with the gradual strengthening of the global economy. Nevertheless, management remains conservative on the outlook for sustainable economic growth, as government and monetary stimulus may fade throughout 2010. The longer-term economic outlook remains unclear, causing management to remain highly cautious about hiring and capital spending. This explains why companies are hoarding cash: According to JPMorgan, non-financial corporations, which from 2004"“2008 held roughly $500 billion of cash on their balance sheets, increased their total cash holdings to $708 billion by the end of the third quarter of 2009.

Although corporations remain conservatively managed, corporate profits are increasing with the moderate economic recovery (Chart 2). And, because hiring and capital spending are restrained, U.S. corporate free cash flow is improving significantly. As a result of cost cutting and aggressive expense control, non-financial corporations are now generating free cash flow equal to 29% of EBITDA (earnings before interest, taxes, depreciation and amortization), the highest level in a decade according to a December report from Goldman Sachs. In addition, corporate profits should continue to improve as credit conditions ease (Chart 3). A December global survey by McKinsey suggests that increased availability of credit is leading to a more bullish outlook and greater confidence in companies' strategic planning and budgeting processes. If so, increased hiring and spending may be on the horizon, which could help improve the outlook for a sustainable economic recovery and a continued improvement in credit fundamentals.

The outlook for positive credit fundamentals is not without risks. The economy is highly dependant on monetary and fiscal stimulus, as both consumers and businesses are continuing to delever. Private sector final demand needs to strengthen before a sustainable recovery can establish itself. While near-term inflationary pressure appears under control, the Federal Reserve may have to tighten monetary policy should inflationary expectations rise. Aggressive Fed tightening would slow economic growth and be a negative for risk assets, including investment grade corporate bonds, high yield bonds and equities. Finally, the surge in cash on corporate balance sheets may be directed toward more shareholder-friendly initiatives such as increased dividends or share buybacks. Mergers and acquisitions (M&A) will likely rise in 2010, and bondholders will need to be on the lookout for management teams who appear likely to make changes to benefit shareholders. Corporate Bond Market Technicals SupportiveBoth financial and non-financial debt growth is now declining on a year-over-year basis, while the federal government's debt growth is rising by 30% year-over-year (Chart 4). Non-financial corporates need less capital because cash on their balance sheets is rising: According to JPMorgan, their cash levels increased by $113 billion in the third quarter of 2009, as cash flow significantly exceeded capital spending. As the corporate sector delevers while the federal government re-levers, bond market technicals should increasingly turn positive for corporate bonds and negative for Treasuries. This will probably be the single largest factor in credit spreads tightening this year for a lot of companies.

Who's buying Treasuries? Despite rising issuance, almost half of the increase in Treasury supply of $1.89 trillion over the past 12 months, or $889 billion, was purchased by non-U.S. investors. Will foreign investment continue to support the Treasury market to the same degree in 2010 in the face of rising issuance? The answer remains unclear, particularly given the low level of Treasury yields and upcoming surge in government borrowing.Net fixed-rate Treasury issuance this year should approach 10% of nominal GDP. By comparison, net non-financial corporate bond issuance will likely be less than 1% of nominal GDP (Chart 5). The amount of Treasury issuance is rising sharply as the government levers up its balance sheet, while the amount of non-financial corporate debt issuance is falling as companies delever. The Treasury is also set to lengthen the maturity profile of its debt. Rising deficits are causing heightened concern over the sovereign credit risk of the U.S. government. These trends should support corporate bonds relative to Treasuries in 2010, particularly given that the Federal Reserve is set to end its quantitative-easing Treasury and mortgage purchase program in March 2010. Finally, corporate America's rising cash balances and diminished leverage should support credit technicals due to lower corporate issuance needs, helping to tighten credit spreads versus Treasuries for the stronger companies this year.

Bank Bonds Likely to Be Winners in 2010 Within the credit market, the banking sector stands out as a likely winner. Banks should see a gradual slowing in the growth of problem loans as well as improving balance sheet strength and profit growth. Banks are delevering their balance sheets, raising more loss-absorbing equity capital and facing increasing regulatory oversight. In addition, bank and financial companies should benefit from reduced issuance needs in the bond market, providing for supportive market technicals. All these factors should support bondholders and lead to strong relative performance.Banks' asset quality, while still deteriorating, is benefiting from government efforts to support housing. While commercial real estate likely has more downside risk, there is increasing evidence that lower-priced housing is starting to stabilize due to low mortgage rates, government efforts to increase credit availability to homebuyers and improved affordability. As residential real estate prices stabilize and other asset price declines moderate, the pace of write-downs on banks' balance sheets should slow. This will likely improve bank asset quality and earnings and lessen the need for banks to raise more capital.Banks' balance sheet strength and equity capitalization have improved significantly over the past year. The Troubled Asset Relief Program (TARP) allowed banks to raise equity capital when the capital markets were frozen in autumn 2008. However, starting in the fourth quarter of 2008, private investors gradually became more comfortable taking both subordinated debt and equity risk in banks and financial companies. JPMorgan, Goldman Sachs, Bank of America and Wells Fargo have all been able to sell stock to the private sector to help raise money to pay back the government. Just two weeks ago, Citigroup was able to raise $17 billion in common equity. The return of private capital has been a significant positive for the sector. Today, over half of the government's $245 billion TARP capital has been repaid with private sector capital, and in the past 15 months, the over $1 trillion raised across the worldwide financial system has significantly exceeded write downs or losses of $743 billion (Chart 6), according to Bloomberg. As a result of recent equity issuance, several of the largest U.S. financial firms saw their Tier 1 common equity ratios recently climb above 7%, according to PIMCO credit research.

Increased regulation in the banking industry will likely mean less leverage and lower returns on equity. Policymakers and regulators are likely to ensure banks maintain adequate levels of loss-absorbing equity capital. This is positive for bonds, which are at the top of the capital structure, but less so for equity, which potentially could see further dilution if economic growth and asset prices deteriorate, leading to loan losses and additional write-downs. However, should the economy continue to improve, banks' profit growth could rebound more sharply than expected. Finally, the steep yield curve is a positive for economic growth and specifically for banks (Chart 7), as net interest margins tend to widen, which helps boost banks' profits.

Bank bonds continue to offer attractive relative value (Chart 8) within the overall corporate bond market. In addition to attractive valuations, bank bonds benefit from considerably strengthened balance sheets, the increase in loss-absorbing common equity, and regulatory efforts to help cushion balance sheets and protect bondholders from potential asset quality deterioration. Finally, and most importantly, governments and policymakers remain committed to supporting key banks and financial companies, in order to enable a sustainable economic recovery.

Without a healthy financial sector, capital may not recirculate into the private sector. Governments and central banks will likely want to ensure the banking industry is able to increase lending to the private sector, so government support programs should remain in place until banks heal. The Federal Reserve will likely keep monetary policy highly accommodative to allow banks to increase profits and build equity capital. Investing in banks is not without risks. A weak economy or double-dip recession would be highly negative for both residential and commercial real estate prices, and thus for banks' asset quality. Higher short-term interest rates, which could result from the Federal Reserve increasing the fed funds rate to tame inflationary expectations, would negatively impact banks' net interest margins and profitability. Regulatory and legislative actions could also be negative for bank investments at the bottom of the capital structure; re-regulation and the eventual implementation of Basel III and new capital rules by 2012 may cause banks to raise more equity capital, lowering the potential returns for existing shareholders. While potentially dilutive for bank shareholders, re-regulation and increased capital requirements will likely result in banks that are less risky and less leveraged. These secular trends, while likely negative for equity holders, are positive for bondholders. In fact, both senior and subordinated debt and even some Tier 1 bank capital could benefit "“ such securities are unlikely to be useful for regulators wanting higher loss-absorbing capital. The larger equity cushion for bondholders would likely help tighten credit spreads for bank bonds. Given the current attractiveness of some Tier 1 bank capital credit spreads (Chart 9), a select group of these securities could be relative winners in 2010.

What do market technicals look like for the financial sector in 2010? JPMorgan estimates gross issuance in the sector will decline 38% this year versus 2009, down to $285 billion; net issuance, or gross issuance minus maturities, is estimated to decrease by $17 billion (Chart 10). Why do banks and financial companies need less money? These companies raised substantial equity over the past year, were able to access the Temporary Liquidity Guarantee Program (TLGP) for funding, have now delevered their balance sheets, remain cautious on new loans and, if needed, can tap into their vast deposit bases for cash. The net result is that the supply outlook for banks and financials should be muted this year, providing a positive technical backdrop for bondholders, particularly given the likelihood for continued solid demand for high-quality bonds with attractive relative valuations.

Picking the Winners The corporate sector is delevering at the same time the federal government continues to re-lever. Credit fundamentals are improving for the corporate sector at the same time credit fundamentals are deteriorating for the government. This should lead to tighter credit spreads, particularly for firms with strong credit fundamentals, as the beginning of 2010 sees a lack of high-quality spread alternatives to compete with corporate bonds.A number of bank and financial companies stand out as potential winners this year due to attractive valuations and an improved outlook for asset quality and profitability. The banking and financial sector has been able to recapitalize and delever its balance sheet by raising private equity capital. Due to supportive monetary and fiscal policy combined with the likelihood for increased regulation requiring higher equity capital, bond-holders in a number of key bank and financial companies should benefit as the economy recovers and profit growth allows capital to build, causing banking and financial sector credit fundamentals to improve. Given supportive fundamentals and a positive technical outlook, investors should consider staying overweight select bank and financial bonds and underweight Treasuries in 2010.

Mark KieselManaging Director

Past performance is not a guarantee or a reliable indicator of future performance. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. 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. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.This material contains the current opinions of the author but not necessarily those of PIMCO 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. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2009, PIMCO.