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As we enter the second half of 2012, Portfolio Managers David
Weismill-
er, Brian Robertson, and Michael Marzouk discuss Pacific Asset
Manage-
ment’s viewpoints; the macro environment, its impact on credit
markets,
and their outlook going forward.
Start at the top, give us your view on recent market
volatility
Weismiller: For the third summer in a row, we are seeing capital
market volatility rise, primarily due to the debt crisis in Europe.
The lack of clarity and need for structural reform are leaving
market participants with a high degree of anxiety. While the
results of the recent Greek election, which saw a relative
“pro-euro” vote, reduced the short term risk of a destabilizing
event, it does not mean the un-certainty surrounding the structural
problems across the euro-zone are any closer to being resolved.
Robertson: Compounding the political situation in Europe, we
have seen a global slowdown of economic activity. This slowdown has
been fairly widespread with softness in Asia, the U.S., Europe, and
Latin America. The response from investors has been increased
volatility, falling equity prices, and record low bond yields. By
example, the 10-Year U.S. Treasury fell to a generational low yield
of 1.46% in June.
Chart 1: Macro uncertainty continues to drive high yield
spreads
Source: Barclays, Moodys
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1994 1996 1998 2000 2002 2004 2006 2008 2010 2012
Barclays High Yield OAS (LS)
Moody's Global Default Rate (RS)
High Yield vs. Equities
Investors may consider an overweight to high yield bonds as a
“higher quality, lower volatility” equity allocation. Given the
posi-tive fundamental tailwind for credit, high yield bonds may
pro-duce equity like returns in 2012, while providing a relative
degree of downside protection.
A Tactical Case
Source: Barclays, Standard and Poors
A Strategic Case
Source: Barclays, High Yield
JUNE 2012
THE INVESTOR
NAVIGATING THE CREDIT MARKETS
PORTFOLIO MANAGER VIEWPOINTS
The policy risk premium remains prevalent in the spread of high
yield versus default expectations
0%
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1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010
S&P 500
Barclays High Yield Index
Cumulative total returns. Over the past twenty years, high yield
produced equity like returns with lower volatility
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Feb-10 Jun-10 Oct-10 Feb-11 Jun-11 Oct-11 Feb-12 Jun-12
Stock-to-bond ratio
12-month trailing return of the S&P 500 to the Barclays High
Yield Index (3-mo moving average)
S&P 500 outperforming
High Yield outperforming
585%
504%
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How does this summer compare with last August’s volatility?
Weismiller: The credit markets have been much more composed,
with the volatility seen principally in euro-centric sectors and
as-sets. For example, high yield and bank loan spreads are still
im-proved year-to-date, and both sectors should produce positive
quarterly results. This is in contrast to last summer, which saw a
highly correlated move lower in all risk assets, on all continents,
due to a myriad of problems, many of which we still face today;
po-litical divisiveness, economic uncertainty, and a continued lack
of monetary and fiscal policy clarity out of Europe.
What is your view on the European Debt Crisis?
Robertson: European policy makers must implement the struc-tural
reforms necessary for a fiscal union, or risk the breakup of the
European monetary union. Although markets seem to be de-manding
implementation of the solutions over the course of weeks and
months, the length of time needed to implement the structural
reforms is more appropriately measured in years and decades. As the
process is drawn out longer and longer, the risk of increased
capital flight rises and the possibility of a systemic shock grows.
Forecasting political will remains difficult, if not impossible,
espe-cially during a time where there are no easy solutions.
Marzouk: The European Central Bank under Mario Draghi has
responded with bold liquidity programs, leading the ECB balance
sheet to grow larger than that of the Federal Reserve’s. However,
each liquidity injection has the problem of diminishing returns as
Spanish and Italian bond yields reach ‘higher highs’ following each
initiative. The bond market is forcing resolution, and whether
Eu-ropean policy makers can agree to the needed structural reforms,
risk assets will continue to be weighed down.
How has Europe impacted portfolio positioning?
Weismiller: Over the past two years, we have made the strategic
decision to have little-to-no exposure to European Banks and
Fi-nancials. As fundamental credit investors, we believe the
uncer-tainty surrounding bailouts and the potential subordination
of claims, systemic risk, rating downgrades, and lack of balance
sheet transparency lead us to seek risk/reward opportunities
elsewhere.
Robertson: We have also reduced our exposure to companies which
we believe are most impacted by weakness in Europe, and
specifically the southern peripheral. This includes companies
do-miciled in Europe as well as those with meaningful exports to
the euro-zone. With global economic growth stagnating, and systemic
tail risks increasing, we believe more attractive relative value
op-portunities exist with U.S. focused companies and U.S. dollar
based revenue streams.
Turning to the U.S., what macro headwinds are on your radar?
Marzouk: If not for the European debt saga, we would be hearing
of the “fiscal cliff” ad nauseam. In December of 2012, a host of
fis-cal stimulus measures, including Bush Tax Cuts, payroll tax
cuts, and unemployment claims are set to expire. In addition,
automatic cuts required under sequestrations are set to begin at
year end. Estimates of the drag from this contraction on 2013 GDP
are in the range of 3%. Given current GDP growth of sub 3%, this
reduction in stimulus is likely to trigger a 2013 recession if no
action is taken by Congress. While many policy strategists believe
action will be taken, Congress’s ability to act before the 11th
hour is question-able. Given the political brinkmanship seen last
year, coupled with a Presidential election, a general fiscal fog
will likely remain over Washington.
Weismiller: In an uncertain regulatory, tax, and economic
envi-ronment, corporations are reluctant to deploy capital, leading
to corporate conservatism. With an outlook of weak economic growth,
the opportunity cost for corporations to hold high cash balances
and maintain conservative balance sheets remains low. While this
can be a positive for higher quality corporate bonds, it is
hindering our economic recovery, and could impact riskier
assets.
What trends are you seeing within corporate debt issuance?
Marzouk: Liquidity, liquidity, liquidity. Over the past three
years, corporations have primarily used the capital markets for
refinanc-ing versus re-leveraging, as 65% of all new issuance has
been used to refinance debt. By focusing on extending maturities
and delever-aging, corporations are reducing their dependence on
access to the capital markets near term. This, in our view, is a
substantial tail-wind for the default rate to remain low over the
next few years.
As of May, only $19bn of high yield bonds and loans mature in
2012 and only $86bn matures through 2013. That is roughly 20% of
the new issuance seen in 2011, a very manageable number. Also, the
Leveraged Buyouts (LBO) of 2006 and 2007, where we see some risk of
default, have limited maturities over the next 18 months, with 95%
of LBO debt maturing after 2013 (Source: JP Morgan).
What impact have macro headwinds had on corporate credit?
Weismiller: Investment grade U.S. bonds, in particular, U.S.
Cor-porate bonds, continue to show strength as a relative safe
haven for investors. As of June 27th, the Barclays Corporate Index
had re-turned 4.77% YTD. It is no secret U.S. companies are in good
shape, with low operating leverage, record cash balances, and
limited near term maturities, all cushions against an economic
slowdown. Strong investor demand should continue as long as macro
fears re-main, creating a positive technical environment for
companies to refinance at record low yields. Over the past few
weeks we have
PORTFOLIO MANAGER VIEWPOINTSJUNE 2012
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seen 3M, Walt Disney, Procter & Gamble, Target, and
Colgate-Pal-molive all issue record low coupon bond deals.
Have low yields affected the demand for corporate credit?
Robertson: No, and we believe it has to do with the current
relative opportunity set for fixed income investors. The demand for
safe assets globally has continued to increase while their supply
has been shrinking. With strong corporate fundamentals, investment
grade credit provides a relatively insulated opportunity to pick up
incremental yield over Treasuries. The Barclays Corporate Index
yield-to-maturity was 3.22% on June 22nd which compares to the
7-year Treasury on that day of 1.15%. One way to graphically look
at this relative advantage is the ratio of corporate to U.S.
Treasury yields (Chart 2). Over the past ten years, that ratio has
been about 1.2x while today that ratio is 3.2x. Even with today’s
low yields, the yield pickup over Treasuries is substantial for
corporate bonds.
Chart 2: Corporate debt provides substantial yield
advantages
Source: Barclays, St. Louis Federal Reserve
Can yields continue to go lower?
Weismiller: The short answer is “Yes”, but I believe how low is
de-pendent on the asset class. While the primary investors within
the Investment Grade corporate market (insurance companies, banks,
pension funds) may have certain yield bogies for their portfolios,
they typically look at the additional spread they can earn versus
comparable Treasuries. This added spread is the risk premium
demanded by investors, and currently, this risk premium is well
above long term averages and closer to recessionary levels. With
the Fed continuing to pull down rates, growth remaining subdued,
and spreads closer to recessionary levels, lower corporate bond
yields are definitely possible. The great thing about current
In-vestment Grade corporate yields is that you are getting a
healthy spread pick-up relative to Treasuries. Should rates stay
low, an investor is earning more, should rates begin to rise, this
spread should cushion the negative price impact.
Robertson: Within high yield, we believe in a low yield
environ-ment, investors put more emphasis on absolute yield levels
rather than spreads to Treasuries. This is partially because many
high yield buyers have the ability to allocate across asset classes
and thus make relative value determinations while comparing
abso-lute yields. That capital mobility across asset classes means
there is a minimum yield an investor will accept for the liquidity,
volatil-ity, and default risk in high yield bonds. It is difficult
to determine where that floor may be, but over the past year when
the yield-to-worst of the Barclays High Yield Index reached the
mid-to-high 6%, the asset class has been prone to weakness.
Chart 3: Due to the capital mobility of investors, a floor is
like-ly in high yield bonds
Source: Barclays
Has the volatility changed your outlook for High Yield and
Bank Loans?
Robertson: While in the short term, the direction of credit
spreads is heavily influenced by the daily headlines coming from
Europe-an politicians, over a long-term horizon, both asset classes
have displayed solid risk-reward profiles. High current income,
strong corporate fundamentals, and low correlation to Treasuries
bode well for High Yield. Further, with Treasury yields at record
lows and a current spread of 630bps, high yield bonds are well
insulated against both rising rates and an increase in the default
rate.
We currently view BB/B credits as attractive relative to CCC
rated bonds due to CCC bond sensitivities to economic weakness,
poten-tial tightening of lending conditions, and capital market
volatility. BB bonds, which have historically provided the highest
Sharpe Ratio of all fixed income, look attractive based on
fundamentals, excess spreads, and low default expectations.
Further, BB bonds should benefit from the reach for yield by many
investment grade bond investors.
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Barclays Corporate Index YTM as a ratio to the 7-year U.S.
Treasury
PORTFOLIO MANAGER VIEWPOINTSJUNE 2012
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Corporate bonds have substantial yield advantages over
Treasuries even with record low coupons
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Jun-07 Mar-08 Dec-08 Sep-09 Jun-10 Mar-11 Dec-11
Twice in the past two years, yields have reached the mid-6%,
only to move higher at the first sign of capital market
volatility
Barclays High Yield Index Yield-to-Worst (%)
3.2x
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PORTFOLIO MANAGER VIEWPOINTSJUNE 2012
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ABOUT PACIFIC ASSET MANAGEMENTFounded in 2007, Pacific Asset
Management specializes in credit oriented fixed income strategies.
Pacific Asset Management is a division of Pacific Life Fund
Advisors LLC, an SEC registered investment adviser and a wholly
owned subsidiary of Pacific Life Insurance Company (Pacific Life).
Investment professionals at Pacific Asset Management also have
investment responsibilities at Pacific Life. As of March 31, 2012
Pacific Asset Management managed approximately $2.9bn. Assets
managed by Pacific Asset Management includes assets managed at
Pacific Life by the investment professionals of Pacific Asset
Management and assets managed within Pacific Asset Management.
IMPORTANT NOTES AND DISCLOSURESThe opinions expressed are not
intended as an offer or solicitation with respect to the purchase
or sale of any security. The information presented in this material
has been developed internally and/or obtained from sources believed
to be reliable; however Pacific Asset Management does not guarantee
the accuracy, adequacy, or the completeness of such information.
This material has been distributed for informational purposes only
without regard to any particular user’s investment objectives,
financial situation, or means, and Pacific Asset Management is not
solicit-ing any action based upon such information, and should not
be considered as investment advice or a recommendation of any
particular security, strategy or investment product. Statements
concerning financial market trends are based on current market
conditions, which will fluctuate. There is no guarantee that these
investment strategies will work under all market conditions, and
each investor should evaluate their ability to invest for the
long-term. The information provided herein should not be construed
as providing any assurance or guarantee as to returns that may be
realized in the future from investments in any asset or asset class
described herein. Corporate securities involve risk of default on
interest and principal payments or price changes due to changes in
credit quality of the borrower. This material contains
forward-looking statements that speak only as of the date they are
made, Pacific Asset Management assumes no duty to and does not
undertake to update forward-looking statements. Forward-looking
statements are subject to numerous assumptions, risks, and
uncertainties, which change over time. No part of this material may
be reproduced in any form, or referred to in any other publication,
without express written permission. FOR MORE INFORMATIONPacific
Asset Management • 700 Newport Center Drive • Newport Beach, CA
92660 • www.pam.pacificlife.com • [email protected]
Marzouk: For bank loans, we believe the asset class provides a
unique risk/reward proposition in fixed income. In our view, bank
loans are one of the few asset classes where investors do not give
up current income (yields above 6%) to hedge against the potential
for higher rates and inflation. With credit fundamentals sound,
de-fault risk looks to remain low for loan issuers. The 12-month
trail-ing default rate for bank loans was 1.1% through May (Source:
JP Morgan). Further, bank loans may provide superior interest rate
and inflation hedging properties. Historically, bank loans have
been as correlated to inflation as commodities and one of the most
negatively correlated asset classes to Treasuries.
With the current volatility where do you find value?
Weismiller: A couple of investment grade sectors I continue to
view favorably are REITS and Lodging, as both sectors provide above
average yields with strong fundamentals. Investments in the debt of
many Real Estate Investment Trusts (REITS) provide solid covenant
and implied collateral protection, which can protect bond holders.
Improved REIT balance sheets and asset coverage’s have allowed for
excellent access to capital, even in today’s volatile market
environment. I also like Lodging as improving occupancy and
increasing average daily rates make them attractive upgrade
candidates.
Robertson: While our strategies remain principally focused on
U.S. credit, we do find select foreign companies in food &
bever-age, metals & mining, and autos attractive. We hold
overweight’s to global companies domiciled in Brazil, Chile, South
Korea, Australia, and Mexico where an attractive spread can be
earned over their U.S. counterparts. Currently, we only have
exposure to U.S. dollar bonds of these foreign companies.
Summary
The lack of fiscal and monetary policy clarity out of Europe,
com-pounded with weaker global growth forecast has once again led
to increased volatility and market uncertainty. With the
uncertainty in Europe, U.S. Corporate bonds remain a bright spot as
the asset class has been a relative safe haven. Strong company
fundamen-tals and yield advantages over Treasuries look to keep
investment grade fund flows strong. Regarding high yield and bank
loans, while in the short term the direction of credit spreads will
be driv-en by technicals and policy announcements, over a longer
term ho-rizon, both asset classes have displayed solid risk-reward
profiles. High current income, strong corporate fundamentals, and
low cor-relation to Treasuries bode well for high yield. For bank
loans, we believe it is one of the few asset classes where
investors do not give up current income to hedge against the
potential for higher rates and inflation.
We continue to focus on U.S. centric companies, limiting our
expo-sure to European Banks and euro-centric business models. We
do, however, find select foreign companies as attractive
investments with incremental relative value over some of their U.S.
counter-parts.
Pacific Asset ManagementJune 2012
