U.S. CREDIT PERSPECTIVES
Picking the Winners
Mark
Kiesel
January 2010
What will be the investment winners in 2010? A number
of corporate bonds are likely to be winners: They should
outperform Treasuries in 2010 due to improving credit
fundamentals and strongly supportive credit market
technicals, in which demand should exceed supply, causing
credit spreads for many higher-quality corporate bonds to
tighten versus Treasuries. Within the credit market, select banking and financial
sector bonds stand out as potential winners due to an improved outlook for asset
quality and profits; healthier balance sheets; continued government, policy and
regulatory support and attractive relative valuations.
The search for yield, which we claimed would lead to strong relative performance
in the credit market in 2009 (see the December 2008 U.S. Credit Perspectives:
“Credit Now, Equities Later”), will likely continue to influence investment returns
in 2010. While investments in the credit market have performed well in the past
year, corporate bonds, particularly those in certain banks and financials, remain
attractive relative to other fixed income sectors such as mortgages and Treasuries.
The corporate sector has demonstrated remarkable discipline, cutting costs and
spending to increase free cash flow while strengthening balance sheets by terming
out near-term debt maturities with longer-maturity new bond issues and by
raising new equity capital. Credit fundamentals should improve as the economy
gradually recovers, and market technicals appear highly supportive for corporate
bonds, particularly relative to Treasuries.
Credit Fundamentals Improving
Corporate credit fundamentals have improved with the return of private capital
and management’s desire for less aggressive business and financial profiles. Rising
cash balances, stronger balance sheets, an improving economy and easier credit
conditions are all helping to support corporations.
One reason corporate fundamentals and balance sheets are improving is the
return of animal spirits and private sector risk capital in both the equity and debt
U.S. CREDIT PERSPECTIVES
markets. Low short-term interest rates combined Corporate executives’ confidence has increased
with a gradual economic recovery have caused with the improvements in balance sheets, credit
investors to venture farther out the risk spectrum availability and credit fundamentals, along with
over the past year. According to a December report the gradual strengthening of the global economy.
from JPMorgan, U.S. companies in 2009 were able Nevertheless, management remains conservative
to raise $529 billion of new equity: a 42% increase on the outlook for sustainable economic growth,
over 2008’s total of $372 billion. as government and monetary stimulus may
fade throughout 2010. The longer-term economic
In addition to raising equity capital, investment outlook remains unclear, causing management to
grade and high yield companies raised $1.18 trillion remain highly cautious about hiring and capital
through the new issue corporate bond market spending. This explains why companies are
in 2009, according to CreditSights. Amazingly, hoarding cash: According to JPMorgan, non-
issuance increased significantly across all rating financial corporations, which from 2004–2008
categories from AAA-rated to CCC-rated credits, held roughly $500 billion of cash on their balance
allowing both high-quality and low-quality sheets, increased their total cash holdings to
companies to refinance near-term debt maturities $708 billion by the end of the third quarter of 2009.
with longer-maturity debt, push out the average Although corporations remain conservatively
maturity profile, reduce liquidity risk and managed, corporate profits are increasing with the
strengthen balance sheets. moderate economic recovery (Chart 2). And, because
This improvement in corporate credit fundamentals U.S. Corporate Pro ts Improving
1600
has materially improved the outlook for default Non-financial and Financial Corporate Profits
1400
risk, particularly in the high yield market, and 1200 Non-financial
Billions of Dollars
1000 Financial
increased balance sheet strength and financial 800
600
flexibility for corporations. As a result, Standard &
400
Poor’s is now upgrading more companies than it is 200
0
downgrading (Chart 1).
1Q 03
1Q 04
1Q 02
1Q 05
1Q 06
1Q 08
1Q 09
1Q 00
1Q 07
1Q 01
Credit Fundamentals Continue to Improve Source: Bureau of Economic Analysis
(Investment Grade and High Yield Corporate Bonds)
1.4
Chart 2
S&P Upgrade to Downgrade Ratio
1.2
Ratio of Upgrades to Downgrades
1.0 hiring and capital spending are restrained, U.S.
0.8
corporate free cash flow is improving significantly.
0.6
0.4 As a result of cost cutting and aggressive expense
0.2
control, non-financial corporations are now
0.0
generating free cash flow equal to 29% of EBITDA
Q1 99
Q1 00
Q1 02
Q1 03
Q1 04
Q1 05
Q1 06
Q1 07
Q1 08
Q1 09
Q1 01
Source: Standard and Poor’s
(earnings before interest, taxes, depreciation and
Chart 1 amortization), the highest level in a decade
2
according to a December report from Goldman cash on corporate balance sheets may be directed
Sachs. In addition, corporate profits should toward more shareholder-friendly initiatives such
continue to improve as credit conditions ease as increased dividends or share buybacks. Mergers
(Chart 3). A December global survey by McKinsey and acquisitions (M&A) will likely rise in 2010,
and bondholders will need to be on the lookout
Corporate Pro ts Should Improve
for management teams who appear likely to make
as Credit Conditions Ease
Non-financial Profits, Year-Over-Year % Change
60%
Pro ts vs. Lending
-50% changes to benefit shareholders.
50%
% of Banks Tightening Commercial
-25%
and Industrial Loans (Inverted)
40%
30% 0% Corporate Bond Market Technicals
20%
10%
25% Supportive
0% 50%
-10% Both financial and non-financial debt growth is
75%
-20% Non-financial Profits
Banks’ Willingness to Lend now declining on a year-over-year basis, while the
-30% 100%
1Q 90
1Q 92
1Q 94
1Q 96
1Q 98
1Q 00
1Q 02
1Q 04
1Q 06
1Q 08
federal government’s debt growth is rising by 30%
Source: Bureau of Economic Analysis and Federal Reserve year-over-year (Chart 4). Non-financial corporates
Chart 3
Corporate Sector Delevers While
suggests that increased availability of credit is the Federal Government Re-levers
40% 40%
Non-financial, Financial and Federal Government Debt
leading to a more bullish outlook and greater 35% 35%
30% 30%
Year-Over-Year % Change
Year-Over-Year % Change
Non-financial Corporate
confidence in companies’ strategic planning and Financial Corporate
25% 25%
Federal Government
budgeting processes. If so, increased hiring and 20% 20%
15% 15%
spending may be on the horizon, which could 10% 10%
5% 5%
help improve the outlook for a sustainable
0% 0%
economic recovery and a continued improve- -5% -5%
-10% -10%
ment in credit fundamentals.
1Q 87
1Q 89
1Q 91
1Q 99
1Q 01
1Q 03
1Q 05
1Q 85
1Q 95
1Q 09
1Q 93
1Q 07
1Q 97
The outlook for positive credit fundamentals is not Source: Federal Reserve
Chart 4
without risks. The economy is highly dependant on
monetary and fiscal stimulus, as both consumers need less capital because cash on their balance
and businesses are continuing to delever. Private sheets is rising: According to JPMorgan, their cash
sector final demand needs to strengthen before levels increased by $113 billion in the third
a sustainable recovery can establish itself. While quarter of 2009, as cash flow significantly exceeded
near-term inflationary pressure appears under capital spending. As the corporate sector delevers
control, the Federal Reserve may have to tighten while the federal government re-levers, bond
monetary policy should inflationary expectations market technicals should increasingly turn
rise. Aggressive Fed tightening would slow positive for corporate bonds and negative for
economic growth and be a negative for risk assets, Treasuries. This will probably be the single largest
including investment grade corporate bonds, high factor in credit spreads tightening this year for a lot
yield bonds and equities. Finally, the surge in of companies.
3
U.S. CREDIT PERSPECTIVES
Who’s buying Treasuries? Despite rising issuance, Finally, corporate America’s rising cash balances
almost half of the increase in Treasury supply and diminished leverage should support credit
of $1.89 trillion over the past 12 months, or technicals due to lower corporate issuance needs,
$889 billion, was purchased by non-U.S. investors. helping to tighten credit spreads versus Treasuries
Will foreign investment continue to support for the stronger companies this year.
the Treasury market to the same degree in
2010 in the face of rising issuance? The answer Bank Bonds Likely to Be
remains unclear, particularly given the low Winners in 2010
level of Treasury yields and upcoming surge in Within the credit market, the banking sector stands
government borrowing. out as a likely winner. Banks should see a gradual
slowing in the growth of problem loans as well
Net fixed-rate Treasury issuance this year should
as improving balance sheet strength and profit
approach 10% of nominal GDP. By comparison,
growth. Banks are delevering their balance sheets,
net non-financial corporate bond issuance will raising more loss-absorbing equity capital and
likely be less than 1% of nominal GDP (Chart 5). facing increasing regulatory oversight. In addition,
The amount of Treasury issuance is rising sharply bank and financial companies should benefit
as the government levers up its balance sheet, from reduced issuance needs in the bond market,
while the amount of non-financial corporate providing for supportive market technicals. All
debt issuance is falling as companies delever. these factors should support bondholders and lead
The Treasury is also set to lengthen the maturity to strong relative performance.
profile of its debt. Rising deficits are causing
Banks’ asset quality, while still deteriorating, is
heightened concern over the sovereign credit
benefiting from government efforts to support
risk of the U.S. government. These trends should
housing. While commercial real estate likely has
support corporate bonds relative to Treasuries in
more downside risk, there is increasing evidence
2010, particularly given that the Federal Reserve
that lower-priced housing is starting to stabilize
is set to end its quantitative-easing Treasury
due to low mortgage rates, government efforts to
and mortgage purchase program in March 2010.
increase credit availability to homebuyers and
Technicals Favor Corporate improved affordability. As residential real estate
Bonds Over Treasuries prices stabilize and other asset price declines
Net Fixed-Rate Issuance % Nominal GDP
12%
Treasury vs. Corporate Supply
10% moderate, the pace of write-downs on banks’
8% Treasury/GDP
6% Corporate/GDP
balance sheets should slow. This will likely
4% improve bank asset quality and earnings and
2%
lessen the need for banks to raise more capital.
0%
-2%
-4%
Banks’ balance sheet strength and equity
89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F
capitalization have improved significantly over
Source: Barclays and PIMCO
Net fixed-rate issuance is gross fixed-rate issuance minus maturities.
Corporate net issuance is non-financials.
the past year. The Troubled Asset Relief Program
Chart 5 (TARP) allowed banks to raise equity capital
4
when the capital markets were frozen in autumn likely to ensure banks maintain adequate levels
2008. However, starting in the fourth quarter of of loss-absorbing equity capital. This is positive
2008, private investors gradually became more for bonds, which are at the top of the capital
comfortable taking both subordinated debt and structure, but less so for equity, which potentially
equity risk in banks and financial companies. could see further dilution if economic growth
JPMorgan, Goldman Sachs, Bank of America and and asset prices deteriorate, leading to loan
Wells Fargo have all been able to sell stock to the losses and additional write-downs. However,
private sector to help raise money to pay back the should the economy continue to improve, banks’
government. Just two weeks ago, Citigroup was profit growth could rebound more sharply than
able to raise $17 billion in common equity. expected. Finally, the steep yield curve is a positive
The return of private capital has been a significant for economic growth and specifically for banks
positive for the sector. Today, over half of the (Chart 7), as net interest margins tend to widen,
government’s $245 billion TARP capital has been which helps boost banks’ profits.
repaid with private sector capital, and in the past
A Steep Yield Curve Is Positive for Banks
15 months, the over $1 trillion raised across the 500 500
10-Year Treasury - Fed Funds (%)
Yield Curve vs. Bank Stocks
S&P 500 Commercial Bank Index
450
400
worldwide financial system has significantly 400
300 350
exceeded write downs or losses of $743 billion
Yield Curve
200 300
250
(Chart 6), according to Bloomberg. As a result of 100
200
0 150
The Financial Sector is Re-capitalizing -100
Yield Curve
100
50
500 Bank Stocks
Worldwide Financial System Losses and Capital Raised -200 0
450
Jan-90
Jan-92
Jan-98
Jan-00
Jan-08
Dec-09
Jan-06
Jan-94
Jan-02
Jan-96
Jan-04
400 Losses
350 Capital Raised
Billions of Dollars
Source: Bloomberg and S&P
300
250
Chart 7
200
150 Bank bonds continue to offer attractive relative
100
50
value (Chart 8) within the overall corporate bond
0
3Q 07 4Q 07 1Q 08 2Q 08 3Q 08 4Q 08 1Q 09 2Q 09 3Q 09 4Q 09*
market. In addition to attractive valuations, bank
Source: Bloomberg
*Capital raised and losses announced quarter to date. bonds benefit from considerably strengthened
Chart 6 balance sheets, the increase in loss-absorbing
recent equity issuance, several of the largest U.S. common equity, and regulatory efforts to help
financial firms saw their Tier 1 common equity cushion balance sheets and protect bondholders
ratios recently climb above 7%, according to from potential asset quality deterioration.
PIMCO credit research.
Finally, and most importantly, governments and
Increased regulation in the banking industry policymakers remain committed to supporting key
will likely mean less leverage and lower returns banks and financial companies, in order to enable
on equity. Policymakers and regulators are a sustainable economic recovery.
5
U.S. CREDIT PERSPECTIVES
Bank Bonds Continue to will likely result in banks that are less risky
Offer Attractive Relative Value and less leveraged. These secular trends, while
800 800
Option-Adjusted Spread (OAS)
vs. Treasuries, in Basis Points
Option-Adjusted Spread (OAS)
vs. Treasuries, in Basis Points
700 Corporate Spreads 700 likely negative for equity holders, are positive for
600 600
500 500
bondholders. In fact, both senior and subordinated
400 Banks
Corporates
400
debt and even some Tier 1 bank capital could
300 300
200 200 benefit – such securities are unlikely to be useful
100 100
0 0 for regulators wanting higher loss-absorbing
Q1 00
Q1 02
Q1 03
Q1 04
Q1 05
Q1 06
Q1 07
Q1 08
Q1 09
Q1 01
capital. The larger equity cushion for bondholders
Source: Barclays (Sub-sectors of the Barclays U.S. Credit Index)
would likely help tighten credit spreads for bank
Chart 8
bonds. Given the current attractiveness of some
Without a healthy financial sector, capital may not Tier 1 bank capital credit spreads (Chart 9), a select
recirculate into the private sector. Governments group of these securities could be relative winners
and central banks will likely want to ensure the in 2010.
banking industry is able to increase lending to the
private sector, so government support programs Tier 1 Bank Capital Remains Attractive
BofA Merrill Lynch U.S. HY BB-B Index, Option-Adjusted
JPMorgan Bank Capital Index, Option-Adjusted
Spread (OAS) vs. Treasuries (in Basis Points)
Spread (OAS) vs. Treasuries (in Basis Points)
should remain in place until banks heal. The 1800 1800
Bank Capital vs. High Yield
Federal Reserve will likely keep monetary policy 1600 1600
1400 1400
highly accommodative to allow banks to increase 1200 T1 Index 1200
1000 U.S. HY BB-B index 1000
profits and build equity capital. 800 800
600 600
Investing in banks is not without risks. A weak 400 400
200 200
economy or double-dip recession would be highly 0 0
Q1 01
Q1 02
Q1 03
Q1 04
Q1 05
Q1 06
Q1 07
Q1 08
Q1 09
negative for both residential and commercial real
Source: JPMorgan and BofA Merrill Lynch
estate prices, and thus for banks’ asset quality.
Chart 9
Higher short-term interest rates, which could
result from the Federal Reserve increasing the fed What do market technicals look like for the
funds rate to tame inflationary expectations, would financial sector in 2010? JPMorgan estimates gross
negatively impact banks’ net interest margins and issuance in the sector will decline 38% this year
profitability. Regulatory and legislative actions
versus 2009, down to $285 billion; net issuance, or
could also be negative for bank investments at the
gross issuance minus maturities, is estimated to
bottom of the capital structure; re-regulation and
decrease by $17 billion (Chart 10). Why do banks
the eventual implementation of Basel III and new
and financial companies need less money? These
capital rules by 2012 may cause banks to raise more
companies raised substantial equity over the past
equity capital, lowering the potential returns for
year, were able to access the Temporary Liquidity
existing shareholders.
Guarantee Program (TLGP) for funding, have now
While potentially dilutive for bank shareholders, delevered their balance sheets, remain cautious on
re-regulation and increased capital requirements new loans and, if needed, can tap into their vast
6
Technicals for the Financial Sector policy combined with the likelihood for increased
Are Strongly Positive in 2010 regulation requiring higher equity capital, bond-
600
Financial Supply holders in a number of key bank and financial
500
Gross companies should benefit as the economy recovers
400 Net
and profit growth allows capital to build, causing
$ in Billions
300
200
banking and financial sector credit fundamentals
100
to improve. Given supportive fundamentals and
0
a positive technical outlook, investors should
-100 consider staying overweight select bank and
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010F
Source: JPMorgan
financial bonds and underweight Treasuries in 2010.
Net issuance is gross issuance minus maturities.
Chart 10
deposit bases for cash. The net result is that the Mark Kiesel
supply outlook for banks and financials should Managing Director
be muted this year, providing a positive technical
backdrop for bondholders, particularly given the
likelihood for continued solid demand for high-
quality bonds with attractive relative valuations.
Picking the Winners
The corporate sector is delevering at the same
time the federal government continues to re-
lever. Credit fundamentals are improving
for the corporate sector at the same time
credit fundamentals are deteriorating for the
government. This should lead to tighter credit
spreads, particularly for firms with strong credit
fundamentals, as the beginning of 2010 sees a lack
of high-quality spread alternatives to compete with
corporate bonds.
A number of bank and financial companies
stand out as potential winners this year due to
attractive valuations and an improved outlook for
asset quality and profitability. The banking and
financial sector has been able to recapitalize and
delever its balance sheet by raising private equity
capital. Due to supportive monetary and fiscal
7
Past performance is not a guarantee or a reliable indicator of future performance. Investing in the bond market is subject to certain
risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market,
economic, and industry conditions. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S.
Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government;
portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage and asset-backed securities may be sensitive to
changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor
there is no assurance that the guarantor will meet its obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities;
portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Derivatives may involve certain
costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous.
Investing in derivatives could lose more than the amount invested.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice.
This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon
proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment
product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be
reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC,
840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2009, PIMCO.
840 Newport Center Drive
Newport Beach, CA 92660
949.720.6000
PER033-122109