Navigating Credit Markets Today – A Q&A With Mark Kiesel and Jamie Weinstein

Q: How does the outlook for credit markets today compare with what you’ve seen at other times during your careers?

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 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 clients’ 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.

Q: The economic backdrop – including housing and consumer spending – has been surprisingly resilient despite the sharp rise in interest rates, and a recession looks less certain than it once did. How does that affect the corporate credit outlook?

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 property, 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 health-care 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 levered 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.

Q: The sharp rise in interest rates set off turmoil in the banking sector earlier this year, particularly for U.S. regional banks. How has that affected PIMCO’s approach to banks and to credit more broadly?

Kiesel: Banks are cyclical in nature. Monetary policy is becoming quite restrictive, and ultimately we think it will cause an economic slowdown, if not a mild recession. Usually, you’re better off buying banks coming out of a recession, not going into one.

That being said, we find the largest U.S. banks are resilient, very profitable, and under most economic conditions we expect they will continue to make a lot of money. Banks have rallied since the regional bank problems, and so we’ve reduced our overweight a bit as credit spreads have compressed.

As we’ve reduced exposure to banks and financials, we’ve been increasing in noncyclical sectors such as utilities, high quality health care, telecom, and defense and aerospace, which tend to generate significant free cash flow even in recessions.

We’re also looking at other areas in the credit and fixed income markets to ensure we’re getting our best ideas into our portfolios. Areas like agency mortgage-backed securities and securitized credit can provide attractive value and downside resilience, in our view.

Weinstein: Even before the regional bank crisis, there was a reduction in risk-taking by banks due to tighter regulations. Banks are making and holding fewer non-investment-grade corporate loans, which is one reason behind the rapid growth of the private corporate credit market.

In other areas of private credit, such as asset-based finance, regional banks remained active when they were flush with deposits and cheap funding. Banks have since retrenched and have looked to sell certain portfolios. So we’re seeing a lot of opportunities in asset-based finance – things like aircraft leasing, equipment financing, inventory finance, auto loans, consumer loans, and credit card portfolios. In our structured product areas, we’re actively involved in these assets. We can combine our underlying credit analysis tools with an extensive understanding of these specific structures. Those areas of analysis have long been linked, but that kind of collaboration is happening way more lately.

Q: How exactly do credit analysts look at investments across both public and private markets?

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.

Q: Any closing thoughts?

Weinstein: We have been through multiple market cycles and have gained meaningful experience in navigating different environments. The market opportunity right now in credit is pretty bifurcated, and it requires a flexible approach to create the best outcomes for investors.

There is an opportunity now investing in the liquid credit of companies that have resilient businesses and capital structures. Investors can capture yields that are much higher than markets have offered in recent years and that approach longer-term public equity-like returns.

Separately, for companies facing pressure from elevated interest rates and some uneven outcomes in the broader economy, we see opportunities to invest in customized situations with structural downside risk mitigation that offer returns similar to what private equity deals might offer, but with lower risk.

Kiesel: It’s worth emphasizing that not all countries’ economies are in the same place in terms of growth and inflation. We see significant global differentiation by sector and industry, and that gets us excited about active management in global credit markets. Having on-the-ground resources and analysts around the world helps give us an edge.

DISCLOSURES

Past performance is not a guarantee or a reliable indicator of future results.

Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Private credit involves an investment in non-publically traded securities which may be subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Structured products such as collateralized debt obligations are also highly complex instruments, typically involving a high degree of risk; use of these instruments may involve derivative instruments that could lose more than the principal amount invested.

Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.

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