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Investing and golf both share the concept of risk and reward. Investors have to consider valuations, fundamentals and technical factors before deciding how much risk to take. Similarly, golfers analyze a number of variables when making a shot. A narrow fairway requires a golfer to hit more conservatively to maximize accuracy, whereas a wider fairway allows for a more aggressive strategy. Wind will interfere with the trajectory of the ball toward the green, and the pin position, or exact placement of the hole, will influence how the shot should ultimately approach the green.

During the early part of 2009, as global markets started to stabilize, the fairway was wide open for credit investors. With credit spreads near record wide levels and fiscal and monetary stimulus flooding in, many investors who swung aggressively into credit were rewarded well for the risk they took. But at this point, the fairway has become narrower, and while there remain opportunities in credit, it’s time to reassess the game.

As we look at opportunities in the credit markets for the remainder of the year, we’ll need to analyze the wind (technicals), width of the fairway (valuations) and the pin position (fundamentals).

Technicals
Credit markets have the wind at their back thanks to accommodative fiscal and monetary policy from global central banks, which has pushed shorter-term interest rates down near zero at the front end of the yield curve. As the economy stabilized, many investors sought higher returns by reducing cash and money market positions (Chart 1) and increasing risk by moving out the yield curve and into riskier asset classes.

A large portion of this year’s outflows from money market funds has moved into the bond market, increasing demand for both investment grade (IG) and high yield (HY) corporate bonds as investors reached for more income (Chart 2). While some conservative investors have extended duration and increased credit risk, other more traditionally aggressive investors recognized that there is equity beta in credit, and they’ve dialed down risk in their portfolios by using credit as a replacement for equities, with lower volatility and a higher position in the capital structure. Others, such as pension funds, have been attracted to corporate bonds not only for income and lower volatility than equities, but also for the duration of long-dated corporate bonds, which may help match their assets to liabilities.

Taken together, these powerful technicals have increased the demand for credit and helped tighten credit spreads throughout this year.

Many companies have also benefited from this year’s strong demand for credit product by issuing new corporate debt. As “animal spirits” returned to the corporate bond and equity markets, companies have been able to access financing at various levels in their capital structure and term out the debt maturity profile of their balance sheets. Though this hasn’t eliminated medium- to long-term default risks that will stem from subpar economic growth and a wave of debt maturities, it greatly reduced near-term default risk. 

Meanwhile, the economic recovery, due mostly to unprecedented policy support, is helping improve the outlook for risk assets. Global central banks appear likely to keep monetary policy highly accommodative, which is supporting the stock market. However, a primary reason equities have rallied so much is that corporations’ near-term default risk has fallen, encouraging many investors with views of a V-shaped recovery to move down the capital structure and into equities.

While credit market technicals have been positive throughout this year, the supply and demand dynamic is changing. Low interest rates and significantly tighter credit spreads may encourage companies to issue more bonds, and the large and growing new-issue calendar will increase supply and likely pressure spreads wider. Demand for risk assets could also soften due to concern over the sustainability of economic growth.

This outlook for increased supply and softer demand, combined with a significant change in valuations after the large run in stock prices over the past six months, make us cautious about increasing risk at this point in time. While investors will likely continue to reach for higher returns with accommodative policy support and cash positions earning zero percent, we  advise near-term caution because of less favorable technicals.

Valuations
How does the “fairway” look now in the credit markets? It is getting narrower because credit spreads have tightened due to unprecedented global fiscal and monetary policy support, stabilization in the financial system, improvement in the economy, rising equity prices and investors’ appetite for higher yields than cash can offer. Investment grade credit spreads have tightened 301 basis points to stand at 192 basis points today from 493 basis points at the beginning of the year according to Barclays¹. High yield spreads have tightened 1014 basis points to 798 basis points today from 1812 basis points at the beginning of the year  (Chart 3) according to Merrill Lynch².

While the width of the fairways have narrowed, it is also important to look at relative valuations. A comparison between cash and corporate bond yields shows that even following the credit rally this year, corporate bonds continue to offer a significant yield advantage relative to cash and money markets (Chart 4). Investors moving out of cash have the opportunity to pick up an average of 4.5 percentage points by moving into investment grade corporate bonds and 10.3 percentage points by moving into the broad high yield market. It makes perfect sense that these pickups are favorable compared to historical norms, since we believe investors should be well compensated for the risk assumed given today’s more uncertain economic outlook. In terms of absolute yields, the near 5% offered for investment grade corporate bonds and 8-10% offered for select high yield bonds remains high relative to cash.

Credit also looks attractive versus stocks. Following the significant rally in equities this year, mid-to-high single digit expected returns for select credit investments also compares favorably to expected returns in the stock market, particularly for investors who believe the economy will grow at roughly 4% over the next several years. Historically, the long-term real return on equities has been a function of the purchase price (Chart 5). For example, stocks purchased at low price-earnings (P/E) ratios are likely to deliver higher returns over the long run than stocks purchased at high P/E ratios. Valuation matters! Over the past thirty years, nominal economic growth in the U.S. averaged 6% while corporate profits grew at 6.6%³ and dividends on the S&P 500 averaged 2.9%⁴. In the past, ten-year double-digit real annualized returns were possible in the stock market as long as investors paid below-average multiples (less than 16x P/E ratio on the S&P 500), the economy grew at 6% nominal gross domestic product (GDP) and investors captured near 3% dividends.

If long-term corporate earnings growth matches PIMCO’s outlook for roughly 4% economic growth and dividends of approximately 2%, stocks are unlikely to deliver the level of returns that they have in the past. In this environment, which PIMCO has labeled the New Normal, the potential returns on corporate bonds should look compelling relative to equities, particularly because corporate bonds remain senior in the capital structure to equities and have historically had one-third the volatility⁵.

At current levels, we believe corporate bonds with mid- to high-single digit potential returns will offer investors attractive risk-adjusted returns relative to equities.  Nevertheless, spreads have tightened considerably this year, and given current valuations, we don’t believe double-digit returns are likely for most corporate bonds. This warrants an increasingly selective approach to credit investing.

Fundamentals
While weather conditions and the size of fairways are very important in golf, the pin position, or placement of the hole, marks the ultimate goal of the game. Similarly with corporate bond investing, picking the right credits requires pinpointing economic fundamentals and how they will affect individual companies.

Near-term fundamentals are stabilizing for most companies, and even improving for some, due to significant global fiscal and monetary policy support which has helped to stabilize the global economy. Stock prices are up now more than 50% from their lows in March 2009⁶ and have supported the return of risk appetites in the capital markets. Many companies are now able to access both the bond and equity markets for capital, which has created a positive feedback loop in which they have de-leveraged balance sheets. This effect has been particularly pronounced for companies whose final demand is tied to faster economic growth regions such as emerging markets.

Free cash flow, or capital spending less internal funds, has also improved (Chart 6) as companies have been aggressive in controlling costs. Some companies remain cautious in both hiring and capital spending because of weak income growth, elevated consumer debt levels and high unemployment. This is particularly true for companies selling discretionary products primarily to U.S. consumers. With corporate executives continuing to remain cautious, companies are paying down debt, hoarding cash, de-leveraging, and running more conservative balance sheets, all of which should result in improved near-term corporate fundamentals. However, while cash flow has increased due to significant cost cutting, we remain cautious on the sustainability of longer-term corporate profitability and free cash flow generation as the U.S. economy becomes increasingly more dependent on policy support to offset weak final demand and consumer fundamentals.

Lending standards, while still tight, are easing for companies repairing their balance sheets, as the economy recovers and risk appetite gradually increases. Easier lending standards should help to lower the default rate from today’s elevated level (Chart 7). Investors and lenders also appear to be easing lending standards more for companies than they are for individuals. This is evident in more open access to capital markets for companies and may be influenced by the stock market’s recent strong performance relative to housing. Financial conditions are improving for companies faster than for individuals. Nevertheless, lending standards are a function of risk appetite, which is directly related to the level of asset prices. Lenders want to lend when asset prices are rising and don’t want to lend when asset prices are falling. As such, lenders’ willingness to take risk will be closely tied to housing and stock prices and bottom-up credit fundamentals.

With financial conditions, free cash flow and lending standards improving for companies, and with near-term economic growth supported by accommodative fiscal and monetary policy, corporate fundamentals should be stabilizing for most companies and improving for some. This trend should continue in the months to come as a result of improvement in the capital markets and economy due to continued aggressive policy support. However, managing credit risk today requires a thorough bottom-up assessment of each individual company’s fundamentals to identify specific opportunities and get the ball closest to the pin.

What Should Investors Do?
With supportive near-term technicals, decent relative valuations and stabilizing corporate fundamentals, select investments in the credit market remain attractive. However, investors should be cautious given the magnitude of spread tightening so far. Why? The sustainability of the current economic recovery remains a significant source of uncertainty given the risk of weak final demand, particularly in developed economies.

In the U.S., nominal economic growth will likely be weak over the next several years as the consumer remains constrained by a high debt burden, low savings, poor income growth and weak employment prospects. With the weakened consumer comprising 70% of the U.S. economy, nominal economic growth should be subpar over the next several years. This is important because nominal economic growth significantly influences the overall corporate default rate (Chart 8). Though heading down from their peak, corporate defaults will likely stay elevated in an environment of weak nominal economic growth due to poor top-line revenue growth, particularly for highly-leveraged companies.

In the current high yield market, the compression in senior to subordinated notes has probably overextended now in most credits as investors have reached for yield. We favor the senior part of the capital structure and remain selective given the recent rally and spread tightening. Because of the high beta nature of the high yield bond market, the bottom of the capital structure has rallied the most and now, in most circumstances, does not offer enough compensation for the risk.

Club Choice Given the Risk/Reward
Given tighter fairways, we see the most attractive risk/reward mainly in high-quality senior bonds in sectors such as banking, pipelines, energy, metals, telecom, healthcare and cable. As we discussed in Rising Tide to Choppy Waters,⁷ these sectors should outperform on a secular basis due to policy support, stronger relative growth in emerging market countries, aggressive fiscal and monetary efforts to reflate assets, and lower operating and financial leverage, as these industries de-risk and de-lever.

Given the recent rally in spreads, high quality senior bonds, both in select investment grade and high yield companies, appear to be an attractive opportunity. Cash at near 0% has limited appeal and equities are the most subordinated position in a company’s capital structure. The mid-to-high single-digit yields offered in selective investment grade and high yield corporate bonds stand out relative to these alternatives.

Being Selective As Fairways Narrow
PIMCO’s bullish view on the credit markets started roughly a year ago when we published Credit Now, Equities Later.⁸ At the time, credit spreads were near all-time wides, compensating investors well for risk and uncertainty. Like a golfer swinging hard toward the green, we felt that the wind was in the right direction, the fairway was wide and the pin position favorable to warrant an aggressive credit strategy.

We maintained our positive outlook on the credit markets throughout the first half of this year and in our piece titled Opportunities in High Quality Credit,⁹ we highlighted the significant opportunity in the credit markets, specifically in the banking and financial sector. We felt that the wind direction was set to change, particularly for banks, as select companies raised equity and sold assets in order to de-leverage and de-risk balance sheets. Policy support and extremely steep yield curves were set to change the direction of both technicals and fundamentals in the sector, warranting using a driver off the tee in for select banks and financial companies.

While today’s near-term wind direction (technicals) and pin position (fundamentals) remain supportive for the credit markets, the fairways (valuations) have become less favorable as credit spreads have compressed. In this more challenging environment, we are being more selective and advocating a more cautious approach toward credit. This  environment requires stringent analysis of each unique credit, and the associated risks, on a case-by-case basis.

Credit spreads remain wide by historical standards and near-term inflows into the credit markets should remain robust. However, the long-term sustainability of the economic recovery remains uncertain amid weak final demand, flat income growth and high unemployment. In golf terms: a year ago we were hitting driver on a lot of the tees, and six months ago aggressive on select tees, but today we are swinging irons in an effort to take less risk and be more strategic.

Today’s tighter fairways and narrower credit spreads warrant more caution. The consequences of missing the fairways in this economic environment have become more severe after spreads have tightened. For now, we have put away the driver and are focusing on control and accuracy. By keeping the ball in play, we hope to keep our scores low and continue to work towards delivering strong risk-adjusted returns for our clients as the conditions on the course change.

Mark Kiesel
Managing Director

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¹ Barclay’s U.S. Aggregate Credit Index, as of September 18, 2009.
² BofA Merrill Lynch U.S. High Yield Master II Index, as of September 18, 2009.
³ Bureau of Economic Analysis, 1979-2009.
⁴ Standard & Poors, 1979-2009.
⁵ From U.S. Credit Perspectives, “Credit Now, Equities Later,” December 2008. Based on the Bofa Merrill Lynch Investment Grade Index versus the S&P 500 for the 20 year period ending September 30, 2008.
⁶ Standard & Poor’s 500.
⁷ U.S. Credit Perspectives, “Rising Tide to Choppy Waters,” July 2009.
⁸ U.S. Credit Perspectives, “Credit Now, Equities Later,” December 2008.
⁹ U.S. Credit Perspectives, “Opportunities in High Quality Credit,” April 2009.