Wednesday, August 15, 2007

U.S. Credit Perspectives / PIMCO

It is always good to hear what one of the biggest players is doing in such critical times. And i have to admit that since i followed the reports they have a really good track record. So i find it interesting to hear that PIMCO is now warming up to the secondary bank loan market ( probably like this one )and that they are still largely avoiding bonds from financials. Click on the headline to read the entire report.

Es kann nicht schaden wenn man zu hören bekommt was einer der größten Spieler im Kredit und Anleihemarkt zu sagen hat. Das gilt besonders dann wenn man wie Pimco in den letzten Jahren ziemlich ein extrem guten Track Record vorweisen kann. Besonders hervorzuheben ist hier das PIMCO wohl sein Engagement im sog. " Secondary Bank Loan Market" ausbauen will ( dieses hier könnte ein gutes Beipsiel sein ) und das Bonds von Finanzunternehmen noch immer extreme Risiken bergen. Klickt bitte auf die Überschrift um den kompletten report zu lesen.

To summarize, our firm’s view was that rising global liquidity was stimulating an aggressive search for yield which, when combined with rapid innovation in the structured credit markets, was leading to excesses that dislodged the fundamental link between the prices of assets and their underlying values in the corporate bond market. We noticed another discouraging trend as a growing number of private equity deals and aggressive corporate managers were piling more debt on balance sheets through leveraged buyouts (LBOs) and increasing shareholder-friendly initiatives such as share buybacks. Finally, the lack of covenant protection and the tight level of credit spreads (Chart 1) relative to history led us to under-weight investment-grade credit risk, and favor other asset classes where we felt returns would be higher and risks lower.

....The second bottom-up opportunity where PIMCO has benefited thanks to significant credit analysis from both our corporate and mortgage team has been our belief that the U.S. housing market would surprise on the downside. We have written extensively on our housing views and our positioning across PIMCO portfolios remains under-weight housing, sub-prime and cyclical credit risks. Rising inventories, tightening lending standards, and significant sub-prime and prime adjustable-rate mortgage (ARM) resets were an early warning sign that prompted us to reduce housing and sub-prime mortgage exposure. Not surprisingly, the relationship between home prices and mortgage rates has changed amid falling prices and tightening credit conditions. The real mortgage rate (Chart 4), or the difference between the current 30-year mortgage rate and the year-over-year change in housing prices, has been rising sharply. Investors who moved into these asset classes without thoroughly analyzing risks are now clearly wishing they had done more bottom-up credit work. Fortunately, PIMCO’s bottom-up investment process prompted us to pro-actively steer our clients away from these risks.

Knowing when to avoid risk and play it conservatively, as in golf, is just as important as knowing when to take risk. At PIMCO, we saw opportunity in the energy sector and risk in the housing and homebuilder sector that markets were not priced to reflect. Fortunately for our clients with credit exposure, these bottom-up decisions have paid off as energy sharply outperformed homebuilders (Chart 5). In golf terms, our corporate bond, mortgage and credit teams have just hit a 3-wood 250 yards right on the green
Our current strategy will be to move a portion of our high-quality investments into more credit risk as opportunities present themselves. One opportunity may be in the bank loan market, which has re-priced significantly, and specifically in the credit default swap market which references bank loans. The loan credit default swap index (LCDX), which references a diversified basket of bank loan credit default swaps (LCDS), has gone from initial spreads of LIBOR+120 to over LIBOR+350 in roughly two months. This has caused the relationship of the spread on the high yield credit default swap index (HY CDX), which references a diversified portfolio of high yield CDS, and LCDX to change dramatically (Chart 6).

Banks hedging bridge loan commitments have likely influenced the move wider in LCDX and its recent underperformance versus HY CDX. Given the significant forward calendar of new issuance lined up to come to market, it is not surprising recent covenant-lite bonds and loans have come under pressure. Despite these near-term negative technical factors, our initial analysis of the putting green suggests bank loans, and specifically LCDX, have cheapened considerably.

Tightening credit conditions have also raised significant uncertainty about whether or not announced LBOs will get funded. Higher financing costs, due to tighter credit conditions and widening credit spreads, should reduce the momentum of future deals. The institutional forward loan calendar has grown significantly (Chart 7) and, as a result, the stock market could face increasing headwinds, with less aggressive private equity support and higher financing costs on future deals. In the bond market, tighter credit conditions, more robust covenant protection, and wider credit spreads are leading to opportunities for our clients. A recent bank loan deal with a spread of LIBOR+400 priced recently at a significant discount. This type of pricing is now giving us the opportunity to potentially earn significant returns on senior secured bank loans over the next several years.
PIMCO will seek to capitalize on selective opportunities in the new issue and secondary bank loan market now that terms are becoming more favorable for bondholders. Bank loans historically recover around 75% in the event of default due to senior positioning in the capital structure. Credit fundamentals remain healthy for a lot of companies, and bank loans are currently experiencing less than 1% default rates (Chart 8). What’s the big picture? At current spreads of roughly LIBOR+400, a diversified portfolio of bank loans would have to default at near 16%, assuming a 75% recovery rate, for an investor to break-even versus LIBOR. While bank loan defaults rose to 8% in 2000, a rise from the current level below 1% to anything remotely approaching 16% is highly unlikely. Clearly, technicals, not fundamentals, are driving spreads in the bank loan market.
Within the credit markets, another area of potential opportunity is in financials, which have sharply underperformed recently, with both banks and broker spreads (Chart 9) moving to levels not seen in over five years. Uncertainty surrounding sub-prime, housing and bridge loan exposure has changed the outlook for the financial sector.

While widening spreads in bank debt, bank capital securities and brokerage paper could represent opportunities, we are being highly selective in our bottom-up credit process to ensure we avoid unnecessary risks.

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Anonymous Anonymous said...

PIMCO selling themselves as "strong hands". If true they may do well... and more power to them.

5:43 AM  
Blogger jmf said...


i think they will have plenty of loans to choose from...... :-)

Should be a good feeling to laugh in the face of Citigroup, Goldman etc....

6:05 AM  
Anonymous philip said...

You know, I don't like how cavalier he was about dismissing 16% defaults as a possibility. I think it is maybe only a 1 in 5 chance, but we've seen how well the hedgies have done with their 1 in 10000 chances. He is basically denying there is a chance this will spin out of control. Wherefore such confidence?

1:49 PM  
Blogger jmf said...

Moin Philip,

good point.

I think the bondholders will benefit from a return of "bondholder value management" ( poor equity folks... no longer any buybacks etc....)

I am just screening the companies here in Germany that have loaded up very high debt levels.

I think they will underperform significantly

10:38 PM  

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