Pacific Investment Management Co. (PCARX) has been snapping up some of the higher-rated junk bonds dumped by speculative-grade debt managers amid the recent exodus from funds.
In their rush to meet redemptions, high-yield money managers picked the wrong assets to sell and created pricing that’s “quite attractive” for some instruments rated just below investment grade, Mark Kiesel, Pimco’s global head of corporate bond portfolio management, said at a media briefing in Sydney today.
“High-yield managers have been selling, in our opinion, what they shouldn’t be selling,” said Kiesel, who’s also a deputy chief investment officer at the Newport Beach, California-based company. “They’ve been selling the safest part of the high-yield market, the BBs. We’ve been cherry picking many of these assets over the last couple of weeks and buying them because they’re trading at significant discounts to where we think fundamental value is.”
Record withdrawals from junk-bond funds helped push average U.S. speculative-grade yields to 6.3 percent on Aug. 1, the highest in almost six months, according to a Bank of America Merrill Lynch index. The market has since rebounded, with yields easing back to 5.97 percent yesterday. Monthly losses in July were the worst in more than a year.
The attractiveness of some bonds is illustrated by the widening gap between their spread and the credit-default swaps used to insure against their nonpayment, according to Kiesel.
“CDS is really your purest estimate of default risk, so when a bond becomes really, really cheap relative to the true default risk, or the CDS spread, it creates what we call a negative basis opportunity,” he said. Differentials of as much as 150 basis points are as large as they’ve been in about six years, he said.
Kiesel said fund managers should be selling debt at the lower end of the ratings spectrum, around the CCC range, rather than higher-quality notes. While there’s a lack of liquidity when trying to sell these types of assets in some cases, Kiesel said a lot of the traditional junk-bond managers are focused on yield income, rather than capital appreciation.
“You should be buying the BBs, you shouldn’t be buying the 7 percent stuff,” he said. “The people chasing the higher yield are going to end up getting hurt.”
Pimco, which oversees about $2 trillion and runs the world’s biggest bond fund, favors corporate issuers in industries likely to grow at least twice as fast as the broader economy. Its managers also look at whether the companies they’re investing in have the ability to determine prices, whether growth is strong enough to support rising wages, and if they benefit from barriers to entry, according to Kiesel.
Sectors Kiesel likes include midstream energy, hotels, airlines and building materials. Macau’s mass gaming market and Chinese gas distributors also present opportunities, he said.
He also prefers companies with more assets and infrastructure, such as hospitals and mobile-phone tower owners, and tends to shun those with fewer physical assets such as technology companies.
“There are a lot of bottom-up opportunities we can find around the globe, and that’s where we’re going to deliver value,” Kiesel said. “You’re going to see the most credit upgrades in areas with superior growth” and this can provide price appreciation even in a low interest-rate environment, he said.
Pimco predicts global economic growth will remain muted for some time. Federal Reserve Chair Janet Yellen will likely reinforce the message when she speaks at the Jackson Hole Symposium Aug. 22 that “in the U.S., there’s still significant slack, despite the unemployment rate having come down,” Kiesel said. Pimco expects the Fed will start raising its benchmark from near zero in the second half of 2015, and take three or four years to reach a rate of about 2 percent.
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