PIMCO's Kiesel: Credit Market Is Attractive
China, commodities, and Fed uncertainty have driven a topsy-turvy bond market this year, says Mark Kiesel.
Sumit Desai: Hi, I am Sumit Desai, senior analyst in Morningstar's fixed-income manager research team. Joining me today is Mark Kiesel. Mark is CIO of global credit for PIMCO and lead portfolio manager for the PIMCO Investment Grade Corporate Bond Fund, PIMCO Long-Term Credit Fund, and co-portfolio manager for the PIMCO Total Return Fund.
Mark, thank you for joining us today.
Mark Kiesel: Thank you. Nice to be here.
Desai: So, within your role as head of credit for PIMCO, you see a lot of what's going on in the market; it's been pretty wild ride so far for the credit markets. Can you talk a little bit about your experience so far in 2016 and what's been driving a lot of the volatility in credit?
Kiesel: You are right. It's been an interesting year with a lot of ups and downs. We think the market's attractive. Overall, what's been driving the market has been really three things: uncertainty over China, where we've gotten I think near-term uncertainty resolved a little bit with more stability on the currency front. But as we started the year, people were really worried about China and devalue. Second has been commodity prices, violent swings there. We bottomed at 26 on oil in February, now we're in the mid-40s, so that has recovered. And the third thing has been uncertainty over central bank policy and negative rates. The positive news there is that the ECB is de-emphasizing rates now moving toward expanding QE and credit easing. We think that Bank of Japan will follow that. So three of the factors--China, commodities, and central banks--are actually improving, and that's why the market has recovered.
Desai: You mentioned commodities, obviously energy has had a nice little run so far this year. Can you talk a little bit about what you see in that space and how you're playing it?
Kiesel: So back in December the team got together, portfolio managers and analysts and we thought that we are closer to a bottom, we had input from Greg Sharenow, who also is our commodity expert. Our view was that oil would go, by the end of the year, to 50. Back then it didn't look so good. We did a lot of bottom-up research. And in January and February we started buying near the lows fortunately, and we bought a lot of high-quality exploration and production companies. We bought a lot of midstream assets and pipelines. We have seen a big recovery; fortunately we were able to buy close to the lows and that has been a good source of alpha for us this year.
Desai: So one of the questions a lot of investors have is, what to expect? So we've had this volatile year so far. What to expect going forward and also from a long-term perspective about where we really are within the credit cycle. We're a few years--seven or eight years past the financial crisis, a lot of companies have issued debt over that time. So it's interesting to know your views on kind of where we are in that cycle.
Kiesel: Sure. So first thing I'd say is that credit markets are attractive or constructive. We think credit can deliver 4% to 7% returns with half to a third of the volatility and it's really three simple reasons. Fundamentally we don't see a recession. We think the spreads are too wide given the private-sector fundamentals. Secondly, technical is incredibly positive. You've got 30% of the government-bond market in negative yields now, a year ago it was 8%. Investors want income. The third reason is relative value, credit relative to government bonds look attractive. Investors are moving into credit and seeking a 4%, 5% return in investment grade with a third of the volatility equities. We think credit can deliver near-equity returns with much lower volatilities than equities.
Now to your point though, active management is key, because you're right, some, not all companies are acting in bondholder interest, you have seen a lot of issuance. Some of that's M&A, but some of it also is to reward equity holders. You are seeing some companies issue debt, buying your stock back, increasing dividends. Obviously, that's what we as active managers screen for through our qualitative on-the-ground research. There are areas we would avoid right now. We're underweight retail, we're underweight technologies, pharmaceuticals, but at the same time, there's a lot of opportunities in banks, financials and housing, building materials and gaming, in cable, healthcare, telecom. There are many opportunities, but active management is key because you're right, not all companies are being run for bondholders.
Desai: We talked a little bit in the past about this phenomenon of companies that are delevering versus relevering, and it sounds like some of those themes are kind of playing out in your portfolios. Can you expand on that a little bit?
Kiesel: Our big thing is we want our clients to benefit, we want bondholders to benefit. Banks are one of our biggest overweights. We like banks because regulation is forcing more retained earnings in banks, they are building capital organically. Regulators have to approve every year share buyback programs and whether or not the banks can increase dividends. The profitability in U.S. banks is so high that they are in almost all cases building capital, unless you have a major financial crisis or housing crash they are making money, they are building capital organically. That's making bondholders safer. By the way, many businesses are delevering organically. They are realizing that bondholders, we need our ratings and bondholders are going to win because it's important to have strong ratings.
That's hugely important in the energy industry where it's high capex, high capital intensity. The pipeline industry, so that industry is moving more bondholder-friendly. Building materials companies are killing it. Their revenues are up twice what nominal growth is, their EBITDA is up double digits. Guess what, most of these companies are all delevering and paying debt down. At the other extreme, you have some companies that are underlevered, say the technology industry, pharmaceutical company, they are issuing bonds they are relevering. And so that trend is happening across the board, and that's why it's very important to understand what is the credit trajectory of this industry and this company. We are buying companies where the fundamentals are set to improve where the credit trajectory is set to improve, not deteriorate. That's why active management so important today.
Desai: Housing has been a strong kind of a strategic position on your portfolio. Can you talk a little bit about that? You mentioned housing and building materials. What is your view on housing and how are fundamentals kind of supporting that view?
Kiesel: Well, we're still constructive on housing. We do think that the house price appreciation is going to moderate. We have been seeing 4%, 5%, 6% increases. We think it's going to level off to more 2% or 3% increases. The super high end is slowing down, but the broader market, middle market, is still doing very well. And that's because inventories are very low and housing still very affordable, particularly for the average house out there. And, look, the consumer is actually as good as they've been in 10 years. You've got wages up 2.5%, you got employment growth up 1.6%, income proxy the U.S. consumer even with hours worked flat is up 4%.
So savings have been rebuilt, the consumer is healthy, and the housing market will benefit from that. Household formation is picking up. We're underbuilding versus long-term demand, and when you ultimately look at these building materials companies which have been one of our biggest overweight, they are benefiting from a huge remodel cycle. I mean basically a lot of this inventory is old; people are having to buy existing homes and they're remodeling them. And why is that happening? Because when home equity rises, your incentive to remodel rises, and home equity has been building now for four years. So we're really in the sweet spot right now for building materials.
Desai: So everything we've talked today, and you've explicitly said you're fairly positive on the outlook for the U.S. economy. What would change your view? How could that work against it or what could go wrong with that view?
Kiesel: I mean I think what could go wrong--you look at the U.S. economy, it's 69% consumer. If something were to happen that would change the labor market trends. I mean the labor market has been doing very well. If you look at the domestic economy, you think the Fed would be raising rates. The Fed is holding off because of international factors. So I think domestically a lot of it would revolve around political risk factors, rising populism that would really hurt consumer sentiment and cause the consumer to pull back. The three biggest risks we've been watching have been China in terms of what they're doing on the currency front and their growth trajectory. Second is commodity prices--we do believe we've bottomed and oil is heading toward 50. And a policy mistake with central banks. So far it looks like central banks are de-emphasizing negative rates, tilting more toward QE and credit easing, and the Fed is remaining on hold. So central banks are trying to expand this economic cycle, but those three as well as consumer sentiment are going to be things to watch out for.
Desai: So I guess to summarize what we've been talking about today is, it sounds like there are some risks on the horizon, but you've placed a fairly low probability on any of those materializing in a significant way, and you're still very positive on credit going forward.
Kiesel: I would say we're constructive, and the reason is simply that when you look at how, where all assets are priced in the world from cash to government bonds to corporate bonds to equities, corporate bonds today offer the ability to get near-equity returns with half to a third of the volatility. So it really is in the sweet spot. If you're in a 1% to 3% real-growth environment and we think the U.S. economy will be, too, that's the sweet spot for corporate bonds. That's why we are constructive.
Desai: Mark, thank you very much for joining us today.
Kiesel: You bet. Great to be here.
Sumit Desai, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.