Pimco's Rate-Rise Bond Strategy: Buy Middle Class Corporates

Good news for bond investors that have the flexibility to cross the line between high-quality and junk-rated debt: securities near the middle of the quality scale will probably be in a sweet spot when the Federal Reserve 
raises rates.

Pacific Investment Management Co. said the so-called crossover bonds perform better and are less correlated to U.S. Treasuries than are their investment-grade counterparts. The segment also offers similar returns with less credit risk than the broad high-yield market, Pimco’s Hozef Arif and Michael Brownell wrote in a post Tuesday.

“With expectations for rates to move higher with the Fed policy expected to be tighter, it’s being sought out by many investors,” Brownell, a Newport Beach, California-based vice president, said by phone. “There are investors that want safety so they’re not looking to go into the full high-yield market.”

The pool of securities to choose from is growing. More than a third of bonds issued by companies this year fall into the crossover universe, according to Pimco. High-grade companies “seem more comfortable” moving down the ratings scale to the BBB level to raise funding for mergers and acquisitions or to funnel money to shareholders, said Arif, a portfolio manager at Pimco.

That’s brought the amount of triple-B and double-B rated issues to about $3 trillion, or about half the outstanding corporate bond market. The crossover segment comprises bonds from the lowest rung of investment grade, those rated BBB+ to BBB-, down to top-rated junk bonds, whose grades range from BB+ to BB-, the Pimco analysts wrote. This year they’ve outperformed the combined and standalone investment-grade and high-yield debt markets on a total return basis, according to Bank of America Merrill Lynch index data.

Because guidelines for many institutional investors prohibit them from owning high-yield bonds, managers are often required to sell securities that are downgraded to junk, “creating valuable opportunities” for investors that aren’t bound by the restrictions, according to the posting. Pimco said most interest in crossover strategies has come from its financial institutions clients whose guidelines let them take exposure to the riskier credits.

“There’s a growing focus on credits that can be upgraded, and also for discrepancies in the views of other investors and rating agencies on issuers,” said David Tesher, a credit analyst at Standard & Poor’s Ratings Services.

Investors also target so-called rising stars: high-yield credits whose ratings are on review for increases that would bring them to investment grade. Standard & Poor’s has upgraded 14 borrowers from junk since this year, just shy of 16 last year. It downgraded 11 high-grade issuers to high yield.

According to 77 percent of economists in a Bloomberg survey taken Aug. 7-12, the Fed will act at the Sept. 16-17 Federal Open Market Committee meeting. The market is less confident, with investors on Wednesday forecasting a 38 percent chance the Fed will tighten next month, based on pricing of federal funds futures contracts. The odds assume the effective rate will rise to 0.375 percent after liftoff.

“In this environment, the market moves very fast,” Arif said. “It’s always good to be more nimble. The good thing is this market sector is where the most liquid deals are. You get a benefit of liquidity as well as more stability.”

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