Guide to Global Investing: Part 2

Most experts expect the global recession to continue throughout 2009, despite aggressive fiscal and monetary stimulus by policy-makers. Despite its somewhat-better fundamentals, Canada’s recession could rival the severity of the downturn in the U.S.—particularly in light of this nation’s dependence on demand from the global economy.

We also believe that when the recovery does arrive, it is unlikely to be very robust. In the “new normal”—the new economic reality resulting from de-leveraging, de-globalization and re-regulation—lower potential growth rates coupled with higher tax rates will continue to challenge corporate earnings.

In this new normal, income-generating instruments will, in many cases, dominate equity when it comes to risk-adjusted returns. Indeed, the same financial turmoil and widespread de-leveraging that have hampered financial markets in the past year have raised some historic opportunities in high-quality corporate bonds for investors who know where to find them.

The outperformance of bonds isn’t a new phenomenon. According to data from Research Affiliates, starting at any point from 1980 through to 2008, an investor in 20-year U.S. treasuries who consistently rolled to the nearest 20-year issue and reinvested the income would have beat an investor in the S&P 500. We haven’t been bullish on corporate credit since yields on these issues widened in 2002 and the federal government dropped interest rates, but three factors have changed our thinking.

First, valuations are attractive for select companies on both an absolute and relative basis. Second, opportunities in key areas of the market should benefit from aggressive policy support. Third, increased global government bond issuance and spending should support selective credit investments in general, as fixed income investors allocate out of government debt and into higher-yielding, high-quality corporate bonds.

Value of Seniority
In terms of valuation, investment-grade credit spreads (yields relative to those on the underlying government issues) are currently near their widest levels in decades. In some sectors, they are approaching the widest levels since the Depression.

This asset class hasn’t been so attractively valued in a long time. Yields at or around 7% on investment-grade corporate debt look particularly compelling compared to equity returns of less than half that amount. Like other observers, we expect corporate profits to grow at roughly the same pace as nominal GDP, which is expected to remain weak and below trend. And stock dividends—currently paying out only a few percentage points—may get further haircuts, rendering the equity market far less attractive than investment-grade corporate bonds.

The implication here is that investors can go up in the capital structure by owning senior bonds and find higher return potential than equity holders are getting at the bottom of the capital structure. Yet corporate bonds, because of their seniority in the capital structure, generally have significantly less risk (and volatility) than equities. Historically, investment-grade bonds have about one-third the volatility of stocks.

Of course, given the sharp decline in equity prices, some plans and other investors are looking to increase their equity allocations. But with yields on high-quality corporate bonds now around 7%, investors have the opportunity to earn equity-like returns with only a fraction of the historical risk seen in stocks. The current default rate for investment-grade credit is about 0.4%. Default rates could climb, but the substantial yield premium that the sector is paying, according to data from Barclays Capital, suggests that the market has already priced in a much more serious default scenario than is ever likely to unfold.

To be sure, not all sectors of the bond market are offering a good trade-off between reward and risk. So-called junk bonds offer enticing yields, but we are still at a point in the business cycle where defaults on these issues look likely to increase significantly, and recovery rates for investors are going to be very poor. A lot of the companies offering such securities went through the last leveraged buyout wave with a tremendous amount of bank debt, so there is senior secured bank debt that has the first claim on the company’s assets.

Considering Corporates
Turning to specific corporate credits, we prefer investment-grade issuers in sectors that are non-cyclical, defensive and most likely to benefit from ongoing government support. Within the financial sector, we believe that a select group of companies is mission-critical for a sustained economic recovery. Specifically, select “national champion” banks receiving policy support are the linchpin of efforts to start circulating credit again.

We also like other select investments in government-supported and regulated sectors, such as pipelines and utilities. These are companies with hard assets and infrastructure that are vital for the country. Debt from non-cyclical industries—such as telecom, healthcare, pharmaceuticals, cable and tobacco—also have the potential to outperform in an environment of below-trend growth.

Additionally, there is a lot of interest in high-quality 30-year corporate debt. Part of the demand is driven by the attractiveness of historically wide spread levels. With central banks engaged in quantitative easing by printing money to lower rates, investors are rightly concerned about re-inflation—thus the interest in longer-dated high-quality corporate issues rather than government issues offering paltry yields.

As a result of significant demand from liability-driven investors such as pension plans and a limited supply of high-quality, long-maturity corporate bonds, spreads for long corporates could tighten to a greater degree than for intermediate corporates. For example, recent large 30-year issues from major American pharmaceutical companies were met with significant demand from international investors, and their prices subsequently rallied. With only a relatively limited number of higher-quality issuers able to raise money in the current environment, we expect the demand and supply imbalance in the 30-year part of the market to persist in the near term.

The bottom line remains: after experiencing the disastrous effects of the global equity sell-off, many long-term investors are wedded to the twin goals of principal preservation and stable income. Plan sponsors are also looking to match long-term liabilities with low-risk, long-duration assets. The combined effects of these trends should continue to support long-maturity, high-quality credit assets.

Mark Kiesel is managing director and global head of PIMCO’s corporate bond portfolio management team.
mark.kiesel@pimco.com

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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the July 2009 edition of BENEFITS CANADA magazine.