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U.S. Corporate Bonds: Crossing the Atlantic to Find Value

As the European Central Bank and Bank of England continue to experiment with unconventional monetary policy – including the direct purchase of corporate bonds - European investors may find better value across the Atlantic in U.S. credit.

PIMCO recently introduced PIMCO GIS US Investment Grade Corporate Bond Fund, a bottom-up approach to credit investing, with a focus on U.S. dollar-denominated investment grade corporate bonds.

In the following interview, Global Credit CIO Mark Kiesel, and product manager Anna Dragesic, discuss why European investors should consider investing in U.S. corporate bonds, the process behind PIMCO’s GIS US Investment Grade Corporate Bond Fund, and how the strategy fits within a broader asset allocation framework.

Q: Why should European investors invest in U.S. dollar-denominated corporate bonds?

Mark Kiesel: The European Central Bank and Bank of England have embarked on a set of increasingly unconventional monetary policies, including the direct purchase of corporate bonds. These actions are making it ever more challenging for European investors to find income in their home markets, where government and corporate bond yields are hitting historic lows, and in some cases, are even negative. In contrast, the Federal Reserve is not buying corporate assets or subsidizing these bonds. This makes the U.S. corporate bond market more attractive than European domestic markets right now, in our view.

Of course, for European investors looking abroad, it’s not as simple as comparing a yield on a bond denominated in euros or British pounds, to one denominated in U.S. dollars, due to potential currency fluctuations. Instead, euro or sterling-based investors need to look at currency-hedged yields to make an apples-to-apples comparison.

Figure 1 shows the hedged yield of U.S. corporate bonds for euro based investors. Though the yield on Treasuries is now basically zero after hedging costs, it is a different story when it comes to the corporate bond market.

Indeed, the U.S. corporate bond market still remains the most attractive credit market, even after adjusting for currency hedging costs. Generally, the spread on U.S dollar-denominated corporate bonds hedged to the euro remains wider than the spread on euro- denominated corporate bonds for intermediate-to long-dated bonds and for lower quality investment grade credit bonds (such as BBB- rated bonds). In our credit portfolios we’ve aimed to take advantage of this; by focusing on intermediate bonds, where curves in the U.S. are much steeper than in Europe, and by taking more credit risk than the benchmark, with a focus on BBB-rated bonds.

In addition, the U.S. credit market benefits from a stronger economic backdrop and remains the most diverse and liquid credit market globally, as shown in Figure 2 below.

Q: What is PIMCO GIS US Investment Grade Corporate Bond Fund?

Anna Dragesic: PIMCO GIS US Investment Grade Corporate Bond Fund is a portfolio consisting primarily of high quality U.S. dollar-denominated corporate bonds diversified broadly across industries and issuers. The fund is actively managed to maximize total return potential while minimizing risk relative to the benchmark, the Barclays U.S. Credit Index. Given a backdrop of historically low bond yields, the fund may act as an alternative to government bonds or domestic corporate bonds, providing investors the potential for higher yields and enhanced portfolio diversification. It also offers embedded flexibility to allocate across industries and issuers, based on PIMCO’s assessment of risks and relative value.

Q: How does it differ from PIMCO GIS Global Investment Grade Credit Fund?

Dragesic: The strategy is similar to PIMCO’s GIS Global Investment Grade Credit Fund, and benefits from the same team and investment process that was awarded Morningstar’s 2012 Fixed Income Fund Manager of the Year in the U.S. However, as it is managed against a U.S. dollar-denominated benchmark, it is more focused on U.S. companies. Though the benchmark includes only U.S. dollar-denominated bonds, it remains a global strategy as many European and UK domiciled companies issue bonds in U.S. dollars. Roughly 30% of the index includes bonds issued by entities domiciled outside of the U.S.

As with GIS Global Investment Grade Credit Fund, PIMCO’s macroeconomic outlook, which forecasts forces likely to impact fixed income markets over the short- and long-term will help drive duration and the level of overall credit risk, while PIMCO’s deep and experienced credit research and portfolio management teams will drive the selection of individual credits and instruments. Bottom-up credit and instrument selection are expected to be the main drivers of outperformance relative to the index.

Q: Has PIMCO managed similar strategies before?

Dragesic: Yes. PIMCO has been managing U.S. investment grade credit strategies since 2000, and has delivered over 175 basis points of outperformance relative to the index, before fees, since inception (see Figure 3 below). This demonstrates a proven track record of managing the strategy across multiple credit cycles.

Q: How does PIMCO’s investment process inform this strategy?

Kiesel: PIMCO’s investment process involves a three-step process in which we evaluate top- down considerations, bottom-up fundamentals, and valuations. Through this process, we aim to identify companies that are operating in industries experiencing above average growth rates, thereby offering the potential to pay down their debt through solid cash flow generation and reward investors with above-market returns. The process is anchored by PIMCO’s secular and cyclical forum process, which provides the framework for regional and industry allocations. In addition, our global investment team, staffed with more than 50 credit analysts and 50+ credit portfolio managers, gives us the ability to perform bottom-up credit research which helps to reduce default risk and avoid overvalued credits.

Q: The corporate bond market has rallied significantly in 2016, is there still value?

Kiesel: Yes. Even after this year’s rally, credit remains one of the more appealing sources of income in the financial markets. Credit is especially attractive as an alternative to government bonds. There is demand around the world for high quality income-producing assets, and credit markets can offer that income. With highly supportive technicals in the U.S. credit markets and healthy fundamentals, U.S. credit stands to outperform. Low positive growth in the U.S. tends to be the sweet spot for corporate bonds, as it is not ‘too hot’ to lead to excessive leverage and not ‘too cold’ to lead to a significant pick-up in defaults. The positive outlook for the U.S. bodes well for credit assets in industries and sectors supported by high barriers to entry, above- trend growth and pricing power, in addition to companies with management teams that act in the best interest of bondholders.

Even amid the significant demand for high quality income-producing assets, credit spreads remain wider than their historical average relationship, based on fundamentals.

Q: What sectors do you currently favor?

Kiesel: Our investment strategy is to focus on companies exhibiting five key characteristics: (1) high barriers to entry, (2) strong cyclical/secular growth, (3) pricing power, (4) solid asset coverage and (5) management teams favoring bondholders over shareholders. Consequently we see opportunities in housing and housing-related sectors such as building materials and non-agency mortgages. In addition, consumer-related sectors such as cable, telecom and gaming should also perform well if our base case outlook for U.S. growth holds. And even though there’s been a lot of pressure on global banks this year, U.S., UK and select European bank bonds are actually very attractive. In the commodity- producing sector, pipelines are attractive at current valuations, but we remain cautious on many industrial metals companies.

Though we continue to favor credit risk, fundamentals remain weak in certain sectors around the globe due to industry-specific dynamics such as pricing, competitive pressures and risks of product obsolescence. As a result, we remain cautious on many companies in the technology, food & beverage and metals & mining sectors.

Q: How could PIMCO GIS US Investment Grade Corporate Bond Fund feature within an investor’s asset allocation?

Dragesic: The fund is designed for investors who desire a high-quality fixed income alternative that is well positioned to benefit from areas where PIMCO sees strength. The strategy allows investors to take a portion of their domestic credit exposure in either the euro or sterling credit markets, and enhance their overall yield by allocating to the U.S. corporate bond market.

PIMCO GIS US Investment Grade Corporate Bond Fund also offers many of the benefits of a core government bond investment, including the potential to provide capital preservation and portfolio diversification. And because credit sectors typically offer a yield premium above government bonds, the fund offers higher income potential.

The Author

Mark R. Kiesel

CIO Global Credit

Anna Dragesic

Head of Global Credit Product Strategies

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