As the global banking sector continues a multi-year process of deleveraging, the market environment remains conducive to the appreciation of subordinated bank bonds. Moreover, increased banking regulation should lead to fewer bank failures due to stronger capital buffers.
Recently, we introduced the PIMCO Capital Securities Strategy, a global approach to subordinated debt instruments issued by banks, insurance companies and other specialty finance companies.
In the following interview, Philippe Bodereau, managing director and head of pan-European credit research in PIMCO’s London office, discusses the PIMCO Capital Securities Strategy’s investment process, the outlook for capital securities and how the strategy seeks a focused expression of PIMCO’s top financial ideas without the constraints of a benchmark index.
Q: What is the PIMCO Capital Securities Strategy?
A: The strategy offers investors a long-term, strategic allocation to the global financial sector through investments primarily in subordinated and contingent convertible bonds (the latter, also called “CoCos”, are a type of bond that can rank anywhere from senior to subordinated in the bank’s capital structure but that can be converted into equity or written down if the issuer’s core capital level – called Core Tier 1 ratio – falls below a certain trigger level). The strategy may act as an alternative to traditional high yield bonds or equities while enhancing overall portfolio diversification. The risk/return profile of this asset class is between equity (higher risk) and high yield (lower risk compared with capital securities). It offers embedded flexibility to allocate across the capital structure, ranging from senior bonds and Tier 1 bonds to CoCos and even equities, based on PIMCO’s assessment of risks and relative value.
At PIMCO, we view this as a highly focused, “top-picks” global financial strategy that ideally will focus on roughly 30 to 40 issuers. The strategy is not constrained by a traditional benchmark that might skew an investor toward overly indebted banks or banks operating within a stressed sovereign environment.
Q: How does the PIMCO Capital Securities Strategy differ from other benchmark-oriented credit strategies?
A: We are aware that traditional investment grade investors may already have exposure to the financial sector, as a typical credit benchmark contains between 20% and 30% in financials. However, these positions are mainly focused on senior bonds, as subordinated debt issued by banks represents only about 5% of a typical credit index. In addition, the modest subordinated exposure within indexes is primarily concentrated in Lower Tier 2 bonds rather than junior subordinated Tier 1 bonds or even CoCos, which are not benchmark-eligible.
The PIMCO Capital Securities Strategy instead focuses primarily on subordinated instruments, including CoCos, issued by banks, insurance companies and other specialty finance companies. Subordinated instruments, although more volatile than senior bonds, offer the potential for higher returns given the more elevated yield levels and active management opportunities within this more complex segment of the market. As such, an allocation to the capital securities market may be viewed as a complement to, rather than substitute for, the financials exposure in a traditional investment grade credit portfolio.
Q: What are the potential benefits of the investment approach of this strategy?
A: The strategy’s embedded flexibility provides the freedom to invest where we see the best opportunities and have the strongest conviction, avoiding those banks that we believe could suffer due to standalone credit problems or linkage to a weak sovereign, such as certain peripheral countries in Europe. Furthermore, the built-in flexibility allows us to allocate across the capital structure based on PIMCO’s assessment of relative value. This is important in instances when we believe Lower Tier 2 bonds are overpriced relative to Tier 1 bonds, enabling us to potentially capitalize on this dislocation and relative value anomalies.
Q: Since the financial crisis, banks have deleveraged and bank bonds have appreciated in price. Where are you seeing value now?
A: While bank bonds have performed well since the financial crisis, this has also been widely true for all risk assets as such assets have benefited from accommodative global central bank monetary policies. This includes capital securities that have also benefited from the continued deleveraging of the financial system and increased regulation, including Basel III, which has bolstered bank balance sheets with a higher capital buffer. The good news for investors in capital securities is that we are still in the middle of this deleveraging journey, with continued signs of capital build-up that is benefitting bondholders.
From a valuation perspective, capital securities still offer an attractive yield. We are seeing a broad spectrum of opportunities today in subordinated bonds, including UK-based issuers of CoCos and UK-based banks with exposure to the faster growing emerging markets. Outside of the UK, we see good value in U.S. specialty finance companies that are benefitting from favourable margin, demand and asset quality dynamics and Tier 1 bonds issued by select continental European banks that offer attractive spread premia relative to more senior bonds. We believe the risk of a “bail-in” that can impair senior bonds is underappreciated by the market – especially for European banks.
Q: How does the PIMCO Capital Securities Strategy navigate risk in this uncertain environment?
A: Although investors in bank bonds must now be aware of the new “bail-in” risks when issuer fundamentals significantly deteriorate, PIMCO’s independent credit research and time-tested macroeconomic analysis and process serve as the first line of defense to help protect against permanent impairment. As part of our overall risk management, we conduct independent stress tests of bank balance sheets across a variety of macroeconomic environments; this is something we have been doing since 2008, and we have worked with official institutions to help them design their banking stress tests. Our approach to navigating risk and investing in capital securities focuses on those issuers where we have a high degree of confidence in the issuer as a going concern. While we are willing to accept lower yields than might be available from more distressed issuers in stressed sovereigns, our approach ultimately seeks to result in a better risk/return profile.
In addition, we have a number of tools at our disposal to actively manage risk in this strategy, ranging from the flexibility to invest in more senior bonds to using credit default swaps (CDS) as hedging instruments. We will use these tools with an eye toward capital protection when we perceive the market to be overheated and not offering investors adequate compensation for the risks they are assuming.
Q: How does PIMCO’s investment process inform this strategy?
A: Now, more than ever, macroeconomic and policy expertise is critical to managing downside risk and identifying the most attractive opportunities for a portfolio of capital securities. PIMCO’s global economic outlook, which is the result of our hallmark cyclical and secular forum process, is an important factor in determining the countries we believe will provide a stable backdrop for their banking sector. The macro environment is critical to the banking system and can have an impact on a number of factors, including regulations and capital requirements; we dedicate significant effort to understanding this aspect of the investment decision. For example, in Europe – where the link between sovereigns and the banking system remains very strong – the Europe Portfolio Committee, one of three dedicated regional portfolio committees complementing PIMCO’s global Investment Committee, focuses on evaluating the European macroeconomic outlook and regulatory developments that will ultimately affect European banks.
Q: How do you select specific financial companies and in which part of the capital structure do you invest?
A: At PIMCO, we combine the macroeconomic analysis described above with a fundamental, bottom-up style of picking individual securities. For capital securities, top-down analysis is used primarily to assess macro risks such as sovereign risk that can have an impact on banks. PIMCO’s bottom-up bond selection process is based on thorough traditional fundamental credit research on financial companies.
PIMCO’s credit research group consists of more than 50 seasoned credit analysts, with more than 10 analysts focused exclusively on researching financials (as of August 2013). All companies considered for purchase are independently researched by one of our analysts and evaluated through a three-step process consisting of top-down considerations, bottom-up fundamentals and valuations.
In financials, particular emphasis is placed on analyzing the structure and security of each issue. PIMCO will analyze pricing across the cash bond and the CDS markets, but also across the relevant investment universe, which includes sovereign, covered, senior, securitized, Lower Tier 2, Upper Tier 2, Tier 1 and contingent convertible bonds.
Investments will then be focused on issuers that pass our top-down test and have been identified as providing the best risk-adjusted yield across the capital structure and in any currency available. Note that currency risk is hedged, so the decision is isolated to the attractiveness of the credit spread of each investment.
Q: How might the Capital Securities Strategy feature within an investor’s asset allocation?
A: The Capital Securities Strategy may fit within an investor’s higher-risk fixed income allocation. The strategy will have more risk and volatility than a traditional core credit allocation; however, investors with exposure to high yield bonds, bank loans or convertibles may consider substituting part of this allocation into capital securities to diversify exposure without necessarily sacrificing yield. Alternatively, this strategy might be used as an equity substitute, as capital securities have historically provided a better risk-adjusted return than financial stocks (based on the Barclays Capital Securities Index versus the S&P 500 Financial Index for the five-year period ending 30 June 2013) even though subordinated debt holders remain more senior in the capital structure than equity holders.