When venturing into these beaten-down bond sectors, investors should target names with fundamentally strong balance sheets, says PIMCO's Mark Kiesel.
Sumit Desai: Another area where the market has really punished investors is in emerging markets. This is an area in which you have some exposure across the various funds that you manage. Can you talk a little bit about your expectations for emerging markets and how they might be similar to or different from the U.S.?
Mark Kiesel: Sure. First of all, as we've spoken about for the last several years, PIMCO was really early on in reducing energy, reducing metals and mining. This year, we reduced a lot of emerging-markets exposure. The reality is that what remaining emerging-markets corporate-credit exposure we have is in what we call "idiosyncratic stories," such as Petrobras, Gazprom, Spiritbank--names like that. This is really a technical issue; what you had was a situation which was really unprecedented. You have a $120 billion this year of fallen angels--that's basically going to be a record. Petrobras was $41 billion; Gazprom was $17 billion. These companies were investment-grade; they were in investment-grade-rated benchmarks. They've now fallen into below investment-grade. High-yield buyers are saying, "I don't know if I want to buy this." You literally went from 5% to 6% on these investments a year ago to now 12% to 15%. They've literally fallen in a vacuum. Some of these bond prices are trading at $0.60 on the dollar.
The reality is if you look at a company like Gazprom, the company is less than one time leveraged. Is Gazprom going to have a default risk? No. Even Petrobras, which is more leveraged than Gazprom, has many tools over the next couple of years to maintain liquidity and to actually survive even if the capital markets shut down. So, the reality is that the widening you've seen in emerging markets--particularly in these quasi-sovereigns, which are 51% or more owned by the government--has been technical. So, what I'm saying is that there's potential for price recovery, particularly in the case of Petrobras where the bonds are now trading at $0.60.
Desai: Do you need to see a catalyst for that to play out? Does it depend on, in the case of Petrobras, oil prices rising or do you think it's more a matter of getting past this volatility and seeing more stabilization in the markets?
Kiesel: Well, oil prices rising would help, but the reality is that what really helps is the sovereign. Petrobras is tied to the sovereign; it is 51% owned by the government. Petrobras has sold off with Brazil. Brazil's [credit default swap] a year a and a half ago was 150 to 200 basis points; Brazil's CDS today is 500 basis points. So, what you have is a downgrade in the sovereign--in fact, one of the three agencies has downgraded Brazil now to below investment-grade. That has affected the whole complex, as well as the quasi-sovereigns. Petrobras is the largest company in Brazil. It employs over two million people. So, this is very much a sovereign issue. Ultimately, what needs to happen is the government needs to come together with a sound fiscal plan; part of that is also a plan for Petrobras in terms of near-term liquidity. But do we think Petrobras has the resources to get through the cycle over the next year or so? We do. Most importantly, we think we're closer to a bottom on oil prices, and a gradual rise in oil prices will not only be good for Petrobras, but also [Treasury Inflation-Protected Securities], which we own, as well as some energy exposure.
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Desai: Your team has actually done a really great job in the past year of navigating through the energy sell-off. You've been underweight that sector. Does this mean that you're now starting to see opportunities in the energy space?
Kiesel: We're still cautious in many areas. We're still not playing what I call "aggressive offense"; we're still playing defense. We actually think the driller sector, in particular, could see some bankruptcies in the next one to two years. Many large drillers, we think, are going to see the potential for what I call "contract renegotiations." I don't think this is priced into the market right now. What I mean by this is that countries and companies--[exploration and production] companies--will go back to these drilling companies and say, "At the current oil prices, these contracts no longer work." I'm not so sure that risk is priced in.
So, I actually think capital is going to become much more challenging for these companies. Bank lines are going to start to tighten; the capital markets will shut, particularly for some of the most risky companies; and ultimately, you could have bankruptcies in the sector. So, in the driller sector, the oil-field-service sector, and with many of the more leveraged E&P companies, we're quite cautious--and we're avoiding them. Where we have started to dip our toe has been in the companies that we think, ultimately, can survive. These are companies that have good liquidity for the next three to four years. These are companies that have the balance sheet to be able to handle low energy prices for the next several years. Also, these are companies that are exposed to [liquefied natural gas]. This is an area where the U.S., flat out, has a cost competitive advantage, so we like that sector. And, finally, we also like the pipelines. We think pipelines are 65% to 70% fully contracted. They are not as exposed as E&P companies to the underlying commodity prices.
What we can say with a lot of confidence is that, in the next 10 to 20 years, more of the growth in gas and oil production will actually come from the United States. I'm pretty confident in that. So, if you believe that volumes over time grow independently of the cyclical commodity-price swings, then you want to have a tollbooth. You want to own the key infrastructure across the country that moves gas and oil, if you believe this is actually going to be a growth engine for America. So, we are strategically owning these long-term pipeline networks, which are mission critical and have enormous barriers to entry. They have long-term contracts in place and good balance sheets. They have good clients. That's where we're playing energy today.
