The High Yield Spectrum strategy deploys PIMCO's thorough credit research capabilities across the entire range of global high yield debt to seek enhanced returns and meaningful portfolio diversification, while managing the downside risks associated with speculative grade corporate debt. In this interview, portfolio manager Andrew Jessop discusses the potential benefits and risks involved in high yield investing, the High Yield Spectrum approach and the outlook for high yield markets.
Q: Can you discuss the key considerations for investors seeking exposure to the full spectrum of the global high yield market?Jessop: Most high yield investors are looking to capture the benefits of portfolio diversification and attractive return potential. High yield bonds tend to have a low correlation to most asset classes, especially investment grade fixed income, such as Treasuries or even high grade corporate debt, and are less sensitive to interest rate risks. The inherent yield advantages of speculative grade corporate debt are designed to compensate investors for the increased credit, volatility and liquidity risks.
High yield can also be a defensive substitute for equities, focusing on a similar return profile but with considerably less volatility. Looking back over the last 24 years, from the inception of the Bank of America Merrill Lynch High Yield Master II Index in August 1986 to August 2010, high yield bonds have returned 8.72% per annum, outperforming the 8.59% returns of the S&P 500 Index while experiencing 54% of the equity market volatility.
Depending on an investor's risk tolerance, a high yield approach that includes the full quality range of global high yield securities may offer increased diversification and enhanced return potential. The lower-rated tiers (CCC+/Caa1 and below) constitute a significant part of the broad high yield market, and these securities tend to have even lower correlation to investment grade asset classes and interest rates. Throughout the high yield market, and especially in these lower tiers, analysis of individual companies and the nuances of their business and performance is critical, as is sufficient diversification across companies, regions and sectors.
Broadly speaking, there are a number of reasons a company may be assigned a lower rating, such as CCC. First, rating agencies have a structural bias toward size, so many smaller companies receive lower ratings regardless of their fundamentals. Also, asset-light service companies may receive lower ratings because of the perception they will return less money to investors in the case of bankruptcy. However, these issuers may be attractive opportunities if the company has sound fundamentals and is likely to service its debt. Other companies may have CCC ratings because they are under stress, perhaps in a cyclical sector that is having trouble rebounding from crisis levels. Some of the larger leveraged buyouts that face increased restructuring risks may also receive very low ratings. Again, diligent analysis can uncover attractively priced opportunities, particularly among more stable or defensive businesses.
Q: What is the investment approach underpinning the PIMCO High Yield Spectrum strategy?Jessop: The High Yield Spectrum strategy is dedicated to targeting the best risk-adjusted return opportunities across the entire credit quality range of global high yield markets. While it's an expansive high yield opportunity set, the strategy's guidelines focus on delivering returns derived almost exclusively from the high yield market "“ we think of this as "pure high yield alpha and beta." The strategy intends to focus on pure high yield investments and restrict the use of non-high yield securities. The investment approach focuses on individual security selection driven by PIMCO's thorough, proprietary credit analysis.
Q: How do PIMCO's views on the direction of the global economy shape your outlook for the high yield market?Jessop: PIMCO's secular (longer-term) outlook suggests the global economy will likely be marked by lower growth, an increased likelihood of policy errors, market accidents and government involvement in the markets. The world continues to deleverage, derisk and reregulate, and growth and wealth drivers are shifting from developed to emerging economies. All these evolving dynamics are likely to exert a strong influence on the corporate sector, including high yield.
The cyclical boost "“ due in part to the unprecedented magnitude of fiscal and monetary stimulus "“ has invigorated the U.S. corporate sector. Broadly speaking, many investment grade and high yield firms are in better shape now than they were a year or so ago, with healthier balance sheets and improved earnings and cash flows. Over the secular horizon, however, sovereign risk and other longer-term issues such as increasing taxes, regulatory restrictions and limited final demand may be cause for concern in the corporate sector.
Along this volatile secular journey, high yield bonds may be poised to provide attractive opportunities. The high yield sector does not demand great economic times; most of the weakest companies were cleansed from the market during the crisis and most that remain can function very well and continue to reliably service their debt in a low secular growth environment.
With many high yield bonds trading close to par, we don't expect outsized capital gains over the cyclical horizon. Over the next 12 to 18 months we expect coupon income to provide the bulk of returns. Especially when compared with the volatile equity market, high yield bonds may offer attractive risk-adjusted return potential, thanks in part to the larger contribution from coupon income.
Q: Are factors that have supported the high yield market over the past year or so "“ including issuers' access to capital and low expected default rates "“ likely to continue for an extended period?Jessop: Issuance hit an all-time high of $180 billion in 2009, according to J.P. Morgan, and is currently on pace to break that record this year. Companies now coming to market aren't doing so because they have to "“ there aren't pressing liquidity issues "“ but because they're seeing attractive market conditions and making opportunistic moves. The majority of issuance has been refinancing-related, allowing issuers to benefit from lower rates and push out their debt maturities.
Thanks in part to high yield companies' ability to refinance their debt, default rates "“ running at an annualized rate of 0.2% through the first eight months of the year according to J.P. Morgan "“ are likely to remain low in 2011 and into 2012. Issuance has helped strengthen balance sheets and forestall liquidity events. Beyond our cyclical horizon, some of the more leveraged companies may come under stress as significant bond and loan maturities are due in 2013 and 2014.
Q: Given the unprecedented high yield rally in 2009 and strong performance year-to-date, where are you likely to find attractive valuations?Jessop: It's certainly true that high yield spreads have narrowed from their record wide levels at the beginning of 2009, and returns in the current environment will likely be dominated by coupon income, but most investors are likely to retain most of the extra return provided by today's still attractive spreads because of the low risk of default.
We currently see attractive relative value return characteristics in the upper tiers of the high yield market, higher parts of the corporate capital structure and defensive industries. We also see select opportunities along the middle and lower end of the high yield quality spectrum, primarily in the industrial sector and in companies more likely to benefit from global growth, as opposed to those that are more domestically or consumer focused. We're cautious about companies more sensitive to equity valuations, and those issuers that are too levered relative to their expected earnings power (many independent power producers, for example).
Looking at the global high yield market, we're also seeing attractively priced opportunities in Western Europe. We anticipate continued demand from European issuers, mainly companies looking to refinance outstanding bank loans in the high yield bond market.
Turning to emerging markets, industrial companies with exposure to the fast-growing emerging economies are likely to benefit from the growth and industrialization in those regions. The majority of such companies are larger investment grade multinationals, but some high yield firms are likely to see a piece of the action. One interesting trend we see is emerging market companies acquiring high yield U.S. businesses and generally expanding their global reach and growth potential.
However, exposure to the BRIC countries (Brazil, Russia, India and China) is not always necessarily positive. You need to look at each industry carefully. Steel is plagued by overcapacity and is not particularly attractive. However, natural resource companies have long duration assets and some nations want to secure those assets for a 20- to 30-year period. So even if earnings are disappointing in the short term, these companies have good asset quality backing them. That is true of metals and mining as well; the long-term assets of some of these companies may not be profitable today but could have significant profitability in maybe 10 or 15 years' time.
Q: How does PIMCO's investment process help the High Yield Spectrum strategy target return objectives while managing risk?Jessop: In any market environment, high yield investing is fundamentally about individual company and security selection, and the most successful high yield investors are likely to be those who can conduct their own research "“ independent of the rating agencies "“ into each firm's business model, management and earnings outlook. We've found that rating agencies are slow to react when companies are heading down the credit spectrum, and even slower to react on the way up. Those inefficiencies present challenges for investors with guidelines governed by ratings, but they may benefit a resourceful active high yield investor with a global reach.
PIMCO's 35-plus credit research team helps us find compelling opportunities in the high yield market and our size and reach into the investment grade sector gives us insights into "fallen angel" securities. Furthermore, we believe having credit analysts on the ground in local markets around the globe, speaking the native language, and with expertise on both a regional and industry level is essential to take advantage of global high yield opportunities. The High Yield Spectrum strategy's pure high yield alpha approach relies on these extensive credit research capabilities.
Thank you, Andrew.
Past performance is not a guarantee or reliable indicator of future returns. 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. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally backed by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. 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. Diversification does not ensure against loss.
The credit quality of a particular security or group of securities does not ensure the stability or safety of an overall portfolio. The Quality ratings of individual issues/issuers are provided to indicate the credit worthiness of such issues/issuer and generally range from AAA, Aaa, or AAA (highest) to D, C, or D (lowest) for S&P and Moody's respectively.
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 and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. 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. ©2010, PIMCO.
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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. ©2010, PIMCO.
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