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Credit Markets Set to Be Alpha Generator

PIMCO’s Mark Kiesel thinks a near-term recession is unlikely and that other factors like slowing corporate issuance should lead to strong returns in the credit market in the next year.

Sumit Desai: So, the flows seemed to have stabilized within the fund. Is that similar to what you've been seeing going forward, as you have a little bit more insight into what may happen a few months out? 

Mark Kiesel: Sure. We actually think that as the Fed lifts off, which we think will likely happen in December, that's our base case, you're going to see gradual rise in rates. A lot of bond buyers have been on the sidelines. In fact, flows as you've seen, not just for PIMCO but for the overall market, you saw a lot of inflows. This year those flows have come down. People are worried about Fed lift-off. They're worried about higher interest rates. As we get through this process of the Fed starting to normalize rates, and rates, should they back up, demand will come back in. Let's not forget, this has been not only a market where demand has been a little bit weaker, but supply has been robust. So the corporate bond market, this year alone, you're on pace to issue $1.15 trillion dollars of investment-grade corporate bonds. That's going to be a near record.

So, you've got unprecedented supply, less demand, and also you've had $120 billion of fallen angels where you've had traditional investment grade-bonds, like Petrobras, Gazprom fall into high yields. So, really unprecedented times. The important thing is that this sets up for a much more positive market next year. You still have very good supportive fundamentals, relatively benign defaults, technically you're gonna see less supply as rates rise. You're gonna see, we think, demand come into the marketplace particularly at these wider spreads. And the valuations right now, if you look at the credit markets, credit markets are pricing in at near-term recession. We don't see that happening so the reality is, is that if you believe the U.S. economy is gonna grow 2.5% real, 4.5% nominal, this cycle is mid-cycle. Credit markets are gonna be an alpha-generator going forward.

Sumit Desai: You wrote recently, specifically within the credit markets, about this heavy issuance by corporations and the possibility for spreads compressing and returns being pretty strong going forward once the new issuance of bonds declines or goes away. Can you talk about that dynamic and how that plays out in the market? 

Mark Kiesel: Sure. So basically, if you look at the last 40 years, actually since 1972, there's been really six or seven rate cycles where the Fed has raised rates and we've studied those cycles. Six months after the Fed raises rates in every case that we've studied, credit spreads have tightened. And that's normal, because typically if rates are rising and the Fed's raising rates, it's because the economy's doing well, defaults are relatively contained and actually you're dealing with a modestly higher interest-rate environment. That typically tightens spreads, because fundamentals are actually improving. We think the same is true today that actually the consumer, which is 70% of the economy, is doing very well. Outside of energy and metals and mining, the default rate should be relatively benign. And companies, let's not forget, the average investment-grade company is 2.2 times leveraged. Most equity multiples are 10 times in terms of enterprise value to EBITDA, so your minimum four or five times asset coverage in high-quality companies with 30%-40% margins that can organically de-lever half a turn of leverage a year.

Most of corporate America organically throws off tons of free cash flow, so don't let the idiosyncratic events in energy and metals and mining spoil it for the rest of the sector, which is relatively healthy. And that's where the opportunity is, is that the market's gone too far in terms of assuming that defaults are set to pick up materially when the reality is, is the fundamentals of the U.S. economy are quite healthy.