16 OCT, 2023
By Constanza Ramos
Credit markets are where companies go to borrow money to help finance their activities. This can include selling bonds to investors in public markets and getting loans from banks. Increasingly, asset managers are also providing loans and alternative financing directly to companies through private channels.
Looking at credit markets today, we see a tremendous opportunity for investors to potentially achieve near-equity-like returns in high-quality corporate bonds, which tend to have much lower volatility than stocks. Starting yield levels – historically strongly correlated with returns – are the highest they’ve been in more than a decade.
Focusing on individual sectors allows investors to build portfolios that can seek to take advantage of today’s surprisingly resilient economy while still guarding against recessionary scenarios. Additionally, as banks have become less willing to lend, we see a growing long-term opportunity to provide financing solutions through private markets. The increase in private credit available to companies may even be a tailwind to the broader economy.
In the following Q&A, two of PIMCO’s top experts discuss the credit outlook and the interplay between public and private markets. Mark Kiesel is chief investment officer for global credit and a member of PIMCO’s Investment Committee. Jamie Weinstein leads corporate special situations, focusing on opportunistic and alternative strategies within corporate credit.
Kiesel: Nominal and inflation-adjusted yields haven’t been this high in about 15 years. Investors have an opportunity to potentially earn near-equity-like returns in high-quality bonds, which have historically had one-third to half the volatility of equities. We see this as a very attractive time to move out of equities and into high-quality bonds.
When yields reach these levels, you tend to get a lot more demand from pension funds and insurance companies to get those near-equity-like returns. At the same time, you see fewer companies interested in issuing debt at these yields and therefore less new supply. That creates a favorable technical backdrop.
The credit quality of investment-grade companies has been holding up well. Many companies within the investment grade can continue to generate excess cash flow even in a recession. Companies’ balance sheets have been improving – even as public sector debt has grown – and corporate credit rating upgrades have far outnumbered downgrades.
Even when we look at the traditionally riskier high-yield bond market, overall credit quality has improved dramatically over the past decade. Companies that have issued high-yield bonds have been higher in credit quality than in previous market cycles, while there has also been more issuance of secured bonds. Rising stars – or companies getting upgraded to investment grade – have also supported high-yield market technicals.
Weinstein: You can construct portfolios of attractive and defensive credits that have upside potential through spread tightening and debt repayment. And at the same time, our pipeline for private capital solutions and balance-sheet repair deals is building. That leads to different types of portfolio construction depending on our client’s needs.
Public markets tend to reprice more quickly, and private market pricing lagged last year, particularly for existing deals. More recently, there has been an effective repricing for new deals, coming at higher yields and with reduced leverage. To some extent, quite recently we have seen that pricing peak and start to compress a little. Within the capital solutions category, however, it’s still a buyer’s market, so you’re seeing much wider spreads and higher yields.
Kiesel: You can have a recession in certain sectors but still have expansion in many others. Not all companies are growing at the same pace as nominal GDP. I love credit because it’s not just about the economy. It’s so much more complex, and there are always investment opportunities if you examine the underlying driving forces.
For example, recently you’ve seen people spend less on goods but more on things like vacations and travel and concerts. We’ve been positioned for a rebound in tourism, so right now we’re focused on “fun” sectors. That includes airlines, hotels, gaming, vacation rental properties, theme parks, and concert venues. Many investors are under-invested in those areas.
Airlines are generating double-digit profit growth. Many companies are using almost all of their excess cash flow to pay debt down. We are finding opportunities in secured debt, which helps to provide downside protection. A similar dynamic is also happening in the gaming industry. These sectors are booming at a time when bondholders are the primary beneficiaries.
Weinstein: Credit almost always comes down to the sector level. If you think of sectors facing challenges, you can look at healthcare services, where labor cost issues have hurt profitability. Pricing is slow to react, so you’ve seen margin compression and some challenged capital structures for lower-rated, more highly leveraged companies.
Another is technology, a sector in which debt issuance grew a lot in the non-investment-grade area, particularly businesses that were issuing leveraged loans. Those capital structures were almost all predicated on growth. Now growth has slowed, and those floating-rate loans are imposing big interest-rate increases on the companies that borrowed in that format. This is against a backdrop of other sectors that are doing really well.
Weinstein: We have a large team of credit research analysts who are deeply familiar with companies and industries, up and down the capital structure and across the quality spectrum. We have different portfolio managers who focus on portfolio construction. That information and those perspectives get shared whenever possible.
Our alternative credit analysts are generalists but have expertise in capital structures, in restructuring, in bankruptcies. So when we see companies start to encounter challenges, we will couple the industry experience from the credit research analysts with the skill set from the alternative team that can really go deep on a specific situation. That can determine whether we take on a trade in the secondary market, or whether we pivot toward a more customized private solution.
In non-investment-grade credit, there’s been more blurring of the lines between what’s public and what’s private as companies and financial sponsors look at all available tools. Borrowers are playing the two sides of these markets off each other. Because PIMCO operates on both sides, we can take advantage when we see relative value shift from one side to the other. Today, you see multibillion-dollar deal sizes in private markets, which you would not have seen before, but it’s typically not one fund taking on all of that risk.
Kiesel: So much money has been raised by private credit funds that it prolongs the economic expansion. That is going to be a buffer and a tailwind to the economy because there is more liquidity in the system. The probability of a soft landing type of scenario has gone up, and the economy has proven a lot more resilient than expected, and that supports credit.
Our credit analysts around the globe give us readings on the ground that inform our macro view. Today, companies’ pricing power and ability to pass higher costs on to customers appears close to peaking. That ability is still fairly strong in travel and tourism, which is why we still favor that sector. Elsewhere, we’re seeing improvement in supply chains and incremental improvement in labor sourcing. That gives us comfort that not only is inflation peaking, but that yields at these levels are increasingly attractive.
But we’re always watching new incoming data, and we always want to ensure we stay flexible in our approach. That’s why we aim to incorporate different views in our investment process, and why our firm-wide views are based on a broad range of inputs, both internal and external.
By Generali Investments