Portfolio manager David Lee shares his thoughts on the changing market environment for corporate bond investing, and offers his outlook on some key opportunities and risks. Among other topics, David discusses his views on:
- Mergers-and-acquisitions (M&A) activity and broader trends in corporate leverage
- Relative value among banks and emerging markets corporates
- Liquidity and transaction costs in today’s credit markets
M&A and corporate leverage are on the rise — especially in the technology-media-telecom (TMT) areas. What do you think is driving this trend?
The U.S. economy is gradually strengthening, so a higher level of M&A activity is to be expected. Meanwhile, the likelihood of a recurrence of some of the major risks of recent years — the continued decline of the U.S. housing market and euro zone crisis — appears to have receded. Consequently, U.S. corporate executives believe that their balance sheets are able to support more debt. Recently, this shift in attitude has been most evident in the TMT industries, with companies issuing a large volume of bonds to help finance share buybacks — Apple, for instance — or acquisitions — Verizon and Comcast, for example. I expect the trend to spread to other sectors.
Cable companies seem to have been the subject of market speculation on further M&A activity. Are there industry-specific reasons for all the deal talk?
While the cable industry’s current profitability is generally sound, its future is more in question. Subscriber growth has been fairly flat because of rising cable subscription prices and the emergence of new competitors such as Netflix, which are disrupting the established industry business model with a cheaper on-demand product.
Strategic acquisitions are one way for a cable firm to try to safeguard its future competitiveness. What’s more, if the target asset is a cash generator, then a deal could offer compelling economics; in a sense, cash flow from the target company could cover some of the debt service costs of the acquirer/issuer.
Recent TMT bond returns have generally lagged the broader market, but does that necessarily mean that M&A deals are negative for bond investors?
Of course, each deal is different. Thorough fundamental credit research is a crucial tool for helping to ascertain the prospective M&A risk associated with a particular issuer, as well as the outlooks for both the acquirer and the target. A large M&A transaction that is debt- financed can cause the bond spreads of the acquirer to overshoot. Bond investors can potentially make money by not owning an acquirer’s debt prior to an announcement and buying bonds as they are issued at wide spreads — if the company is able to handle its increased level of debt.
More broadly, what is your assessment of pricing in the corporate bond market?
Corporate spreads have on average been declining for the last five years as the economy stabilized, then proceeded to grow. It is my expectation that U.S. companies will generally become more leveraged relative to their profits going forward, and this will begin to be reflected in higher spreads.
Clearly, that dynamic creates a more challenging environment in the intermediate timeframe for corporate bond investors. However, over the longer term, it means that money can be invested at higher spreads, which is a good thing.
Corporate Spreads Have Declined for Most of the Past Five Years
As an active credit investor, how do you view the opportunities in 2014 and beyond?
In broad terms, corporate bond spreads may move wider. However, I must emphasize that this is a generalization. Credits spreads for many issues may move wider by varying degrees, while others may even narrow. In other words, spread dispersion should increase.
So as companies in various industries make different choices about their leverage, I would expect to see greater spread dispersion. For an active investor, that shift can be positive. Fundamental research can help identify strong credits whose spreads are less likely to widen, as well as which credits to buy after their spreads have widened. Overall, greater spread dispersion means a broader opportunity set.
Do you tend to take a different approach to valuations depending on the credit market cycle — when spreads are wider versus when spreads are near historically tight levels, as they are now?
When credit spreads are wide we may be willing to take on more risk — given the opportunity to generate outsized returns as risks dissipate. When spreads are tight, we may be more defensive and look for credits that will hold value if and when the market becomes more fairly priced. It may seem counterintuitive, but we are generally willing to take less risk when it appears that fundamentals are very strong. This is because at such times, spreads typically reflect those fundamentals. So in the current economy, which appears to be improving, we are actually leaning toward moving higher in credit quality.
Are there any particular areas where you are seeing relative value in credit?
U.S. banks are an area of interest for me as I think that the risk that their spreads widen substantially is low — relative to what has been the case for the past five years. Recently introduced regulations mean that bank leverage should not climb as it did during similar phases of economic and credit cycles prior to 2008 (though if bank regulations are relaxed at some point, then leverage could begin to build).
Emerging markets are another area of interest. Given some emerging markets are experiencing difficulty, some investors have pulled capital out of developing-country stocks and bonds. Hence, recent volatility has created opportunities to selectively invest in emerging-market corporate and sovereign bonds at attractive valuations, as alternatives to U.S. credit.
Of course, I’m aware that the market’s nervousness around emerging markets means that prices could deteriorate further. But as an investor with access to thorough fundamental and macro research by analysts who spend a lot of time in emerging markets, we have the ability to discern/cut through the short-term noise and focus on the longer term risk-adjusted return potential.
In my view, it’s during times of greater uncertainty or differences of opinion in the market that our proprietary research on an asset is likely to add the most value.
You’ve had a positive view on real estate investment trusts for quite some time. Does that still hold?
We believe the supply/demand outlook for REITs in the commercial real estate sector continues to be favorable on both sides of the equation. Demand is improving and supply is still somewhat constrained. This holds true for most REITs except office complexes, where barriers to entry are relatively low. So yes, we continue to be constructive on many REITs.
What stands out about Capital Group’s approach to credit investing?
We put just as much emphasis as some of our largest competitors do on macro- oriented factors. However, our investment approach emphasizes issuer analysis to a greater degree. Over time, that can lead to strong views on the relative value of one credit versus another, or one security versus another.
A key reason for the robustness of our investment views is that we have tenured, experienced analysts who have typically followed their industries over multiple market environments. Importantly, many of them invest directly in bonds through research portfolios. As our analysts are also investors, they arguably have a deeper understanding of what makes a good corporate bond investment.
Research can help identify the potential for attractive risk-adjusted returns. But isn’t it more difficult to execute an investment idea now because investor demand greatly exceeds supply?
It can be relatively more difficult to invest today, especially if the comparison is the period immediately following the 2008 financial crisis when most investors were selling credit. In my experience, the question about the difficulty of investing in an idea is often posed during periods when demand is greatest — after a market rally when spreads are the least attractive. That said, it is still possible to invest in high-quality, reasonably priced bonds if you are patient and capitalize on market volatility. There have been many such opportunities over the past five years; most recently, the first quarter of 2014.
How would you characterize the liquidity of the corporate bond market?
Tighter banking regulations have diminished liquidity provision by dealers. Consequently bid-ask spreads are typically wider now than they were prior to the most recent U.S. recession, though they have not changed much in the past few years. The difference is that today, buying at a fair price relative to posted prices can, on average, be harder to achieve. Three years ago, we saw the most pronounced deviation from posted prices when selling bonds. In my view, current levels of liquidity are beneficial to the health of bond market.
It’s not often that you hear a bond investor highlight the merits of less liquidity. Care to elaborate?
Overly abundant liquidity may encourage a market environment in which investors aren’t incentivized to think carefully about their capital allocation decisions, because in a sense they can potentially change their minds with minimal financial penalty. When capital is too easy to come by, the result can be an unsustainable expansion of credit as investors focus on short investment horizons and quick gains.
On the other hand, when liquidity is more limited, the effective cost of transacting is higher. Arguably that puts more of an onus on investors to make the right decision straight off, which results in more long-term efficient capital allocation for the broader economy.
Is it fair to say that higher transaction costs should have less of an impact on longer term investors?
To an extent, yes: if you’re not transacting, you’re not bearing transaction costs. However, it cannot be emphasized enough: having a research-based long- term investment outlook is not the same as “buy and hold.” We will look to transact at any point that market prices are inconsistent with our long-term views, as long as the prospective return of making the portfolio adjustment beats the transaction costs we are incurring.
Successful investing in high-quality bonds is notably different to investing in equities, given that bond investors are not residual claimants on a company’s profits. In many cases, bond investors do not benefit directly when a firm successfully executes on its business plan. From a bond investor’s perspective, this outcome would only mean greater certainty that a company will repay the set dollar amount lent to it through bond borrowing. Therefore, any time that a bond trades at a premium it presents an opportunity for an active bond investor to sell and make a gain.
Could you give some examples of strategies that you have pursued in your capacity as a portfolio manager?
Sure. Some strategies may be less familiar. One example brings us back to the notion of market liquidity and its ebb and flow. When the liquidity premium is relatively large, holding off-the-run bonds or issues from smaller companies can be beneficial — and when the premium diminishes, it may be more favorable to hold on-the-run bonds or more widely owned corporates.
Another strategy is to favor longer dated bonds when the credit curve is particularly steep. Overall, we make a deliberate decision about where to invest in an issuer’s bond complex, based on our view of credit curves — both for the market and the issuer.
While fundamentally based credit selection has tended to generate a large part of our excess returns, we do look to generate the best return for our investors using all available tools — including the two strategies just mentioned. This will also entail examining relative value opportunities in sectors that are closely related to corporate bonds, such as emerging markets, municipals and structured assets.