Still Some Pockets of Compelling Value in Corporates

Eric Jacoboson, our director of fixed-income research, recently visited the offices of MetWest TCW, and sat down with Laird Landmann, a generalist portfolio manager at Metropolitan West, to discuss the credit markets and the valuations he's seeing today.

Eric Jacobson: Laird, thank you very much for being with us today.

Laird Landmann: It's a pleasure.

Jacobson: So I want to talk a little bit about the credit markets. Do me a favor, if you would, and tell us where you guys stand right now in terms of your thinking on valuation. Obviously a lot of money has moved in to credit sectors as people have been chasing yield.

Landmann: Well, first maybe address the money coming in. I think the money is driven by the stage of the cycle that we currently find ourselves in, and the lax state of federal reserve policy. I think that will continue to drive money into the sector. So, it's an interesting conundrum.

As you know, Metropolitan West-TCW is a value manager, and given that when you look at the valuations from a relative value standpoint, a historical value standpoint in corporates, I think what you're finding right now is you find that valuations are near the median for most of the sectors. So it makes us want to be very much neutral even though it's still early in this stage of the cycle.

So, broadly as it relates to corporates, we find ourselves in a fairly neutral position, but there are some pockets of very compelling value out there. In investment grades, I certainly think you have to look and realize that the financial sector is still dislocated from what happened in 2008 and 2009. Basically, the credit fundamentals in that sector are still positive. The trends are still positive. You're still seeing deleveraging, increases in capital in that sector, and we expect that that will continue for several years, and that over that time period you'll see the premium or the spread premium that financials are currently trading at, that will deteriorate over time, and they will converge to the other sectors of the marketplace. So there is still some value out there.

We're expressing that with money center banks, your Citi's, your BofA's, the normal sort of areas that are out there. These systemically critical financial institutions will, A) have the backstop of the U.S. government and the Federal Reserve behind them for several more years. That stops at your downside somewhat. But in addition to that, they also have the scrutiny of the policymakers, and they'll continue to have to build capital and treat the bondholders preferentially versus the equityholders.

In other sectors of the corporate bond market, I think it's very likely that you'll see in industrials and maybe a little bit in utilities, but not as much, you'll see basically that the policymakers there will be a little laxer, and you'll begin to see preferential treatment for equityholders as we move through this stage of the cycle and away from the bondholders, and we'd like to avoid that.

Jacobson: If I could go back to banks for a second: Is the implication that investors are overestimating the risk involved with the systemically important banks even beyond the federal government backstopping and what have you?

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Landmann: I think that that's certainly the case, and I think that it's also the case that it's a natural process in the marketplace. We've often observed that, it's a little topical, that volatility is very much like radiation. It has a half life. I think that the financial area of the market became radioactive in 2008 and certainly deserved to be. It received a tremendous amount of attention.

You might remember towards the end of 2008, the Nobel Laureate Joseph Stiglitz was consistently making comments about shutting the major banks down and starting over again, going through a cleansing process. Thank goodness the actual policymakers decided that wasn't really feasible. Theoretically, it sounded very good.

I think once they made that commitment, and they have gone really 80 of the 100 yards necessary on that commitment, they are not going to back away at this point. So, I think you really do have a great opportunity to benefit from the fact that the volatility impact is still there in the pricing, as I talked about, but in reality the risk is quite less than many of the other sectors of the marketplace.

Jacobson: So, we've had some conversations with your colleagues, including Tad Rivelle. We've talked a little bit about the firm's expectations for future interest rate policy and interest rate markets in general, and the broad theme being that rates eventually are probably going to rise, the curve is going to shift.

What are the implications both for the corporate market, really starting with the investment-grade market, in terms of what we would call, as you know, spread widening where they would be sort of kicked up by that effect of rising rates, and the implication not only for the broad market but also the sectors that you are most heavily invested in.

Landmann: Well, obviously, the Federal Reserve--and I am sure Tad brought this out pretty thoroughly--won't begin to tighten policy until they really see a self-sustaining growth cycle. They have invested a great deal in getting us to where we are today, which is what I describe as almost a self-sustaining growth cycle. So, I don't think they are going to cut and run too early here. So, in the interim, I think corporate bonds, particularly financials, will do quite well.

As we see that, and as you know from our value style, our approach will be, as this excess liquidity the Fed is driving into the marketplace pushes spreads tighter, pushes them through their long-term averages, makes valuations eventually expensive in these sectors, we'll begin to cost average out of those sectors, and our goal would be as we are sitting on the precipice of the next Fed tightening cycle, would be a couple of things:

One would be obviously to have the portfolios duration continue to be less than that of the benchmark to help absorb some of that risk, and have a lot of our risk positions also be closer to neutral, because it's very hard to know what will shake loose in that point in the cycle.

If spreads are very compressed at that point in time, what's likely to happen is that there will be a high correlation between corporates and Treasuries. So, you may not get as much cushioning as people often associate in terms of a move interest rates in corporates versus Treasuries as you got at some points in the cycle. So, I think we would like to see ourselves be close to home and maybe a little bit conservative as we approach that point in the cycle.

Jacobson: So, going back to current positioning, we talked for a minute about the banks, what are some of the other sectors that you've identified that you're in right now that you liked based on the fundamentals and their valuations?

Landmann: Well, our director of credit, Jamie Farnham always likes to emphasize having secured credit in the portfolio, where we can get strong asset coverage. It's a little bit like, you want to do your regular credit analysis, you want to understand that the company you're buying has income, has the ability to repay.

But at the end of the day, in this market things are very stochastic, very random. Companies can find themselves in trouble for a whole variety of reasons, and we, as a lender to that company, want to make sure that we've secured ourselves with some sort of tangible asset to protect us from those eventualities.

Those sort of assets can be enhanced equipment trust certificates, more commonly called EETCs in the marketplace, which are secured issuances from airlines and railroads. We typically look at the airlines, they will have very modern aircrafts backing them, and we'll buy the first lien position. So, we'll generally buy a bond that has well over enough value in terms of its aircraft to back it.

Those tend to still be higher yielding because of the research premium; they take a lot of research to understand the structures, and obviously a lot of people like to avoid the airline sector because of its volatility. These securities tend to be a lot less volatile and have showed very, very limited downside in some of the more economically challenging periods.

So, we still like that area of the marketplace. Some of the utility bonds fit well into that, particularly where we can get a bond that's backed by an individual gas-fired power plant; that tends to be in area of the market we like a lot. Gas-fired plants, as we're all seeing because of current events, are becoming a lot more popular. People are looking to gas potentially as one of the future sources of clean energy, and we think that that area of the market will do quite well.

Jacobson: Great. Thanks so much for being with us today.

Landmann: It's been a real pleasure. Thank you, Eric.