As risk aversion continues to haunt equity markets, corporate credit risk looks reasonably good. Despite deleveraging and a prolonged economic decline that threatens to take down some companies, investing in corporate bonds might be a worthwhile alternative to equities.
With about 10,000 issuers and an increasing number of emerging markets, European and Asian companies issuing debt, the $1.3 trillion global credit market is large and geographically diversified. In the U.S., credit markets are growing 12% annually, much faster than the overall U.S. economy.
The popularity of the credit market has grown in the last three years, said Mark Kiesel, managing director, PIMCO, at the recent CFA conference in Boston.
“There are two main reasons for institutions and investors to move into credit as an asset class; first, it is a very real alternative to equity. In fact, credit has delivered equity-like returns over the last seven years with a third the volatility.”
The second reason, he said, is the fact that coupon payments are senior in the capital structure and offer stable income. “Dividends are discretionary; the coupon payments on bonds tend to be about two, even three, times higher in some cases, [where as] dividend yields at times can fluctuate.”
Persistent uncertainty and slowing global economic growth has compelled many institutions to invest higher in the capital structure, where most credit vehicles are.
Kiesel stressed the importance of active management in the corporate bond space.
“Corporate bonds need to pass some stress tests in order to get in clients’ portfolios,” he said. “Companies with high cash as a percent and free cash as a percentage of debt maturing are more likely to pass the stress test.”
Another test involves valuations where credit is compared to a wide spectrum of vehicles ranging from Treasuries and global government bonds, to swaps and mortgages and emerging market credit.
Kiesel’s first rule of bond selection is to follow growth. “Even though we know China is about to downgrade its growth to about 6.5% to 7.5% real, [it and other emerging economies] have less debt and they are growing faster. What you want to do is play the higher cyclical growth rate, but you also want to play the secular growth.”
Structurally high debt levels in the private and public sectors lead to weaker growth outlook. “[Emerging] countries don’t have that dilemma; they have a less public and private sector debt which puts them in a more favourable position to grow going forward.”
The other thing to consider is multinational companies which have really embraced the emerging market consumer. Kiesel recommends investing in those multinationals which have strong fundaments and whose “profits have grown 10%, even though nominal GDP has only grown about 5% over the last decade.”
Again, much of that growth among multinationals has been thanks to their exposure to emerging markets growth.
Lastly, Kiesel wants investors to also keep a close eye on volatility, a main component of investing in credit. “We’re going to be in a more volatile world; keep some dry powder [so] you can go in and out of these markets when volatility spikes.”