Opportunities inHigh-quality U.S. Credit
IN PRINT ARCHIVE CIR Fall 2009
Opportunities in High-quality U.S. Credit
By Mark Kiesel, managing director, PIMCO.
In this new era that we are calling the New Normal, income-generating instruments will in many cases dominate equity in terms of risk-adjusted returns. Indeed, the same financial turmoil and widespread deleveraging 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 look for them. In fact, the outperformance of bonds isn’t a new phenomenon. According to data from Research Affiliates, starting at any point from 1980 through 2008, an investor in 20-year U.S. Treasuries (that consistently rolls to the nearest 20-year issue and reinvests the income) beats an investor in the S&P 500.
I haven’t been bullish on corporate credit since yields on these issues widened out in 2002 and the U.S. Federal Reserve dropped interest rates. Why? 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 credit investments in general as fixed-income investors allocate out of government debt and into higher-yielding, high-quality corporate bonds.
In terms of valuation, investment-grade credit spreads (yields relative to those on underlying government issues) are near their widest levels in decades, and in some sectors they are approaching the widest since the Great Depression. This asset class has not been so attractively valued in a very 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, I expect corporate profits to grow at roughly the same pace as nominal gross domestic product (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.
Turning to specific corporate credits, I prefer investment-grade issuers in sectors that are non-cyclical, defensive and most likely to benefit from ongoing government support. Within financials, a select group of companies are mission-critical for a sustained economic recovery. Specifically, select “national champion” banks receiving policy support are the linchpins of efforts to start circulating credit again. Other select investments in government-supported and regulated sectors like pipelines and utilities are looking positive. These are companies with hard assets and infrastructure vital for the country.
Finally, high-quality 30-year corporate debt is seeing a lot of interest. Part of the demand is simply driven by the attractiveness of historically wide spread levels. With some central banks engaged in so-called quantitative easing by printing money to lower rates, investors are rightly concerned about reflation. This explains the interest in longer-dated high-quality corporate issues rather than government issues offering paltry yields.