Where to Find the Best High-Yield Value

Michelle Canavan: I'm Michelle Canavan, mutual fund analyst at Morningstar. I'm here today with Andrew Jessop, lead manager of PIMCO High Yield and PIMCO High Yield Spectrum.

Thanks for joining us today.

Andrew Jessop: Thank you.

Canavan: 2012 has so far been a strong year for the high-yield market with the average high-yield bond fund returning around 12%. Can you discuss some of the dynamics that have been fueling these types of returns?

Jessop: Well, I think 2012 has surprised everybody by the strength of the CCC sector in high yield, which is up about 16%, but more surprisingly it has been the rebound of the European high-yield market. I think if we were here a year ago and I say to you what was going to be the best-performing subsector of high yield, most people would look in disbelief if I said it was going to be European high yield. That market is up almost 23% this year, in part because of an oversold position during the panic of 2011. But more importantly, as we've also seen support from the European Central Bank and authorities, that has then fueled further gains, particularly in the finance sector, and that's also benefited the broader U.S. high-yield market as a whole.

Canavan: Given the runup in these prices, how do you feel about current valuations?

Jessop: Valuations in high yield, unfortunately, it's a fixed-income instrument. There's limited upside, particularly given all the different call options embedded in high yield. So, where we are today, the exceptional returns this year means that future returns will be at lower levels. In fact, most investors should only consider high yield as more of a carry instrument as we look into 2013 and beyond.

Canavan: With both your funds, you have the flexibility to invest globally. Given the recession in Europe and the sovereign debt crisis, what are you avoiding, but also where are you finding the opportunities?

Jessop: I think the best value opportunities are actually still within the European high-yield market. There is still tremendous pressure from companies to reduce their reliance on bank debt. Banks are contracting in Europe. They are shrinking their balance sheets. This is in stark contrast to the U.S. where banks are lending again to well-positioned high-yield borrowers. And therefore, we do have the opportunity to negotiate transactions often on a secured basis as some of the more challenged European companies need to term out their capital structures. Many European high-yield issuers had total reliance on banks for their financing needs. And as their bank loan is approaching maturities, they need to now term out that debt profile, and they are terming to the deeper pools of capital available here in the U.S. markets to find ways to term out their borrowing.

Canavan: In that space is there anywhere that you're not comfortable taking risk in Europe?

Jessop: I think it's a little more challenging in some of the peripheral countries if the companies themselves do not have global operations. Most of our European exposure we take in our funds is either in companies which are operating in some of the stronger economies, be it Germany, Switzerland, other parts of Northern Europe. Where we're looking at some of the peripheral risk, that's perhaps where some of the greatest borrowing needs are. But I think today, the value opportunity there is certainly less obvious to investors than it would have been, say, at the beginning of the year. European yields relative to the U.S. high-yield markets started the year at about 350 basis points more. Today, it's barely 30 basis points more. So if anything, there are perhaps fewer opportunities among some of the better-positioned European companies, and now we're sort of perhaps focusing our attention better on some of the thorough opportunities we are seeing here in the U.S.

Canavan: Switching gears a little bit. Health care is one of the largest overweights in both of your funds. Can you maybe talk a little bit about what you like about that space?

Jessop: I think the nice thing about the health-care market is it's not just one industry. There are multiple different ways that you can invest in there. There are hospital providers desperate on the U.S. industry given the funding nature, whereas in Europe most of health care is provided by the state or onto the state. So, then you also have medical-products companies; you have pharmaceutical companies. All of these provide interesting varied ways of taking exposure both on a U.S. basis and also on a global basis. These are cash-generative companies, particularly in the pharmaceutical side, and therefore, our biggest concern is sometimes about the investment appetite the companies have either making acquisitions or returning capital to shareholders. But at the same time, we know that these companies can very quickly pay down debt, if they do decide to pay out special dividends or they do decide to make acquisitions. So, we like the sector, we like its defensive qualities. We are dealing with aging populations, and therefore that naturally means that there's a demand or increased demand for health-care services.

Canavan: Great. Well, thank you, Andrew, for joining us today and sharing your thoughts.

Jessop: You're welcome.