Thu, 26 Jan 2012
The PIMCO Investment Grade Corporate Bond says a growth slowdown and resultant move by central banks have made the team more optimistic on duration. Plus he explains the fund's focus on bank bonds.
Miriam Sjoblom: Hi, I am Miriam Sjoblom, associate director of fund analysis at Morningstar.
I am here today with Mark Kiesel, who is portfolio manager of PIMCO Investment Grade Corporate Bond.
Thanks for joining us. Mark.
Mark Kiesel: Thank you.
Sjoblom: The way PIMCO looks at credit and corporates is a little bit different I think from some of your competitors, in that you start with the top-down macroeconomic view, and we've just gotten some news, yesterday, the Fed came out and said they are going to be hold through 2014, and maybe you could talk a little bit about PIMCO's macro view.
Kiesel: Sure. So, our macro view really is important, because it guides where we want to be in the capital structure in companies, where we want to be on yield curves, what countries we want to invest in, and also what industries.
Yesterday with the Fed keeping rates really low, and the ECB doing the LTROs, there is a very expansionary central bank. Central banks are now, their balance sheets are 20%, 30% of GDP, and what we think this leads to is reflation, which causes us to believe that the front end of curves are going to be anchored, and therefore we want to be out the curve in the 5 to 10-year part benefiting from roll down, as well as in some industries which may benefit from reflation, owning hard assets like pipeline companies and even oil companies.
Sjoblom: There was a sort of a shift last year in PIMCO's view. Can you talk a little bit about that and what that meant for the portfolio?
Kiesel: Sure. So we started last year off, and we were basically underweight duration on the view that we thought that the economy would be growing at or above trend. Recall, a year ago, the U.S. economy was growing at 3%-3.5%, emerging markets were booming, and then all of a sudden Europe came into the equation and really what became a situation where policymakers couldn't get ahead of the crisis. And so Europe really scared a lot of people and really impacted risk appetite and, I think, business and consumer confidence. And when businesses and consumers pull back like they did, that caused the economy to really take a nosedive, and so as a result, central banks had to come in and basically get much more aggressive. And therefore, because of that, the downgrade in the global growth expectations and the acknowledgment that central banks would really hold short rates down for a considerably longer period caused us to get more optimistic on duration.
The final piece of the puzzle is that emerging markets last year were tightening 12 months ago, and now we're seeing emerging-market countries ease. So, we think all of that leads to a more bullish duration position in portfolios.
Sjoblom: So, the duration positioning is a change, but when you look at the industry breakdown in the fund, there weren't drastic changes. You don't tend to make drastic changes to the exposures of the fund. Can you talk a little bit about how the macroeconomic view, even though it has changed somewhat, impacts what kinds of industries you want to be in?
Kiesel: Sure. That's a really good question, because PIMCO is different from some managers, in that we tend to take a very long view, secular view. We do that in terms of our credit investing as well. For example, the banks--the banks went through a very difficult time. But what has changed is the fact that regulation, we think, is actually a positive for banks, at least if you're in the top of the capital structure, because regulators are trying to make banks safer. So, basically what's happening is, a lot of this organic capital that banks are making through net income, it's not going out to shareholders. They are not buying their stock back, they are not paying it out in dividends. Regulators are trapping it inside the bank and also trying to restrict what banks can do going forward.
What this means is that the earnings volatility won't be what we've seen; you'll see a little bit slower earnings growth, more pressure on margins, but the positive news is that the banks are actually still very profitable and a lot of that capital will be retained inside the bank, which means that balance sheets will get much stronger. That's a long-term trend that we're going to be seeing, and that is a trend, which is very favorable for debt. So, even though last year the economy was somewhat weak, it didn't change the fact that over the next three to five years, banks are going to be safer, and bondholders should benefit in that secular trend, so we want to stick with that senior bank overweight.
Sjoblom: So, banks obviously struggled a bit this year, but you're sticking with it, maybe you could talk a little bit about from the bottom-up level, what you have been doing in the bank segment of the portfolio?
Kiesel: Well, I think what failed to realize is that bank capital has doubled in basically three years, and that's because the housing prices are no longer declining at the same rate. While they are still declining, you're actually seeing some signs of strength. In fact, in a couple cities, you've actually seen housing prices go up, like in Texas, New York, Washington. So what's happening is, we've gone through this crisis that started in 2006 with housing prices peaking. We're almost six years into it, and so now banks are actually organically starting to earn their way out of this.
The balance sheets are very strong right now in terms of Tier 1 capital, if you look at the major banks around the globe. The U.S. banks are probably going to get the Basel III faster than any other banks outside of Swiss banks, who are already there.
In addition, the liquidity is far improved from two to three years ago. So, banks are sitting on basically a war chest of cash right now. So, there's no refinancing issues. And finally, banks are issuing a lot less debt because their balance sheets are shrinking, so there's not the supply of debt outstanding.
Finally, the valuations are as compelling as they've been in a long time, so the fundamentals, technicals, and valuations all suggest that this is a sector that even though it did underperform last year, will probably do pretty well this year.
Sjoblom: Even there were things you were doing within the bank segment of the portfolio to upgrade quality.
Kiesel: Yes. So, the two things we did do last year is we did reduce our subordinated debt position, and that was just in recognition of the fact that Europe is obviously going to be an overhang on the overall market.
The second thing we did is we were very underweight European banks, which turned out to be a very good call, and really focusing more on the U.S. senior part of the capital structure.
So, right now, we are sticking with staying relatively senior in the capital structure because we do think that if the situation were to unfold in Europe more negatively, you could actually go down a path where some of these banks in Europe could potentially be nationalized, and that could lead to the subordinated part of the capital structure taking significant hits. So, we are obviously pretty cautious on that.
But in the U.S., very different situation. They have relatively low exposure to Europe, and higher profitability, better capital, better liquidity, and, quite frankly, even better valuations on the senior part of the debt. So, U.S. stands out relative to Europe in the banking sector.
Sjoblom: Shifting gears a little bit. I know energy has been an area of focus for you as well. Can you talk a little bit about some of the issues that you're looking at?
Kiesel: We are looking at oil trading basically 40 times higher in price than nat gas. You've got $100 oil, you got $2.50 gas. I mean, that's really unprecedented, and it speaks to the fact that oil is globally traded, whereas nat gas is very regional. They haven't figured out how to ship gas across the ocean yet. The U.S., because of the shale play and the unprecedented amount of drilling activity that’s occurred over the last two years, now there's a surplus of gas. Too many rigs, they are going to be pulling rigs over the next couple of years. A lot of these natural gas company stocks have been under significant pressure this year. Whereas some of the oil plays, the exact opposite is happening, because Iran and the geopolitical factors are impacting oil.
So one of the things that we are looking at is, obviously, we are favoring oil over nat gas, but we are starting to look at some of these natural gas companies, because what people also underestimate is the fact that these companies are very asset rich, and they have flexibility to rein in capital spending. So, I think, one of the things you will see over the next couple of years is a lot less drilling in terms of the rig count.
Sjoblom: Where do you not want to be in the corporate space?
Kiesel: Well, you don't want to be where companies are basically rewarding stockholders and not bondholders. So, a lot of what we think about is, where do you want to invest, where this company is managing in the best interest of your clients, meaning the bondholder, and when you are in situation where the regulators are trapping money inside the bank and forcing the banks to be less risky and to delever, you want to be a bondholder in that company--the bank. You don't necessarily want to be an equity holder, unless you believe that the macro trends have completely bottomed and have turned.
There are a couple industries where managements are getting more aggressive and rewarding shareholders at the expense of bondholders. We've seen pharmaceutical companies do large bond deals, both here in the U.S. and in Europe, and give that money out to shareholders.
We're seeing M&A activity pickup, and we're also seeing companies start to increase dividends, and also reward more equityholders. So, these are industries like pharmaceutical, they are industries like cable, also you're seeing homebuilders get more aggressive and that could lead to more M&A, as well as potentially acquisitions down the road. So, these are industries that you want to be a little bit more cautious on.
Finally, technology, I think, is clearly an equity sector. So the bondholder never benefits in technology, the equityholder is always usually the winner. So there I think, if you're going to own tech companies, own the stocks.
Sjoblom: All right. One more question just about your outlook for credit in general. Bill Gross recently sounded a more cautious note on credit in the Total Return Fund and more diversified type offerings. Given that you are running a credit fund, how does that view translate into your fund?
Kiesel: So, basically, around the world, you want to favor the strongest countries, and the countries which have the least debt which can delever and grow strongest, because those companies should do the best, so we're favoring some emerging markets. U.S. is clearly outperforming Europe, where we're favoring the U.S. We like Canada, we like Australia. Companies in all those regions, emerging markets, U.S., Canada, Australia are doing quite well.
In addition, we're favoring the senior parts of capital structure, so we're taking a relatively conservative posture given the fact that the global economy is still pretty fragile, and we're also favoring defensive industries like pipelines, like utilities, like some energy companies, the oil companies where this monetary reflation is leading to higher prices, which is allowing the companies to actually throw off all kinds of free cash flow.
Finally, we're favoring those industries again, where the regulators are forcing the companies to be safer and to delever and to reward bondholders, like the banks.
Sjoblom: Well, thanks very much for being with us today, Mark, and sharing your insights.
Kiesel: Thank you. Appreciate it.