Bond talk: Can credit markets continue to run strong?

This week on Capital Ideas we're taking a deep dive into credit markets and the critical role they play in the global economy. In a wide-ranging interview with my colleague Apu Seekry, Capital Group Portfolio Manager Damian McCann explains why credit markets have remained strong, even in a world of elevated interest rates. He also offers his view on multi-sector portfolios, designed to generate income from a combination of corporate bonds, emerging market bonds and mortgage-backed securities. I'm your host Bill McKenna, let's get into it. Damian, welcome. Thanks for being with us today on this conversation on credit markets. Your area of focus as a portfolio manager is credit market. Before we get to the hearing now, tell us how credit markets have evolved over the last couple of decades. What would they like when you started out and what has changed? There's definitely been an evolution in credit markets over the years. debt markets are much larger today than they were 20 years ago. For example, investment-grade corporates has grown. The high-yield corporate market has grown about two and a half times. A nominal GDP over this period is up about two and a quarter time, so that kind of provides a sense for the pretty rapid growth in these debt markets. But the evolution isn't limited to growth. Investment-grade corporates, we've seen new industries emerge. Farma and tech are now significant issuers. 20 years ago, they were very significant industries with big market caps, but they only started to borrow the significant size more recently, like over the last maybe 10 to 15 years. Today, pharmaceuticals and the investment-grade corporate market is nearly 400 billion in bonds outstanding, about 5% of the market. 20 years ago, it was only about 30 billion, which was less than 2% of the market. I'd say there had been kind of a few reasons why or drivers of the growth in pharmaceutical issuance, and this is really emblematic of why investment-grade corporates overall has grown so much. The first thing I'd point to is acquisitions. So 20 years ago, the largest pharmaceutical issuer was a company called Wyeth. Wyeth no longer exists. They were acquired by Pfizer back in 2009. Pfizer borrowed to make that acquisition, which made Pfizer a significantly larger issuer. We've seen many acquisitions in Pharma over the last 20 years. They are usually funded with a healthy chunk of debt. You can just go down the list, Abbey Amgen, Bristol Myers, Pfizer, Merck, J&J, Gilead, Novartis, Roche, and there are others like these are all pharmaceutical companies that have made significant debt-financed acquisitions over time. The second important driver of the growth is Spinoffs. So there are some entirely new pharmaceutical companies issuing bonds today that didn't exist 20 years ago. An example would be this company called Zoetis. This is a veterinary pharmaceuticals company. Pfizer decided it didn't make strategic sense to keep Zoetis in-house, so it was spun out, became a standalone company, and Zoetis has issued bonds a number of times over the years. Today, the largest issuer in investment-grade pharmaceuticals is a company called Abbey. Abbey is the former pharmaceuticals division of a company called Abbott Labs, which back in 2013 decided to separate its pharmaceuticals and diagnostics businesses into two separate standalone companies. And then the third driver, and this is, I'd say, partially reflected in this acquisition and Spinoff activity that I already mentioned, has been just growing scrutiny over time by equity investors and by extension company management and boardrooms on the concept of value maximizing capital structures. So it's basically more focus on the idea that debt capital is cheaper than equity capital. So if your goal is to maximize value for shareholders, you should have some debt in your capital structure so that you can have less equity there by boosting your return on equity, which benefits shareholders. So for pharmaceutical companies, 20 years ago, the average credit rating was, for those that were investment-grade, was high-single-a, or even numerous examples of double-a. Today, it's primarily an industry that's single-a and triple-b rated. Similarly, across the investment-grade corporate market, there's been this migration away from double-a rated and even single-a rated balance sheets. And many more today are triple-b rated than were triple-b rated 10, 15, 20 years ago. My first experience with this phenomenon of sort of moving away from the quote unquote lazy balance sheet was in the pre-global financial crisis period. After the GFC, this trend of using more leverage became more measured, I'd say, but also more widespread. And the low interest rates we saw after the crisis added fuel to this trend. And by and large, I think you can say that companies that decided to migrate to triple-b from single-a have proven to be generally correct without approach. Meaning that for many companies that are triple-b rated, you can still enjoy pretty easy access to a large fairly reliable and fairly low-cost credit market. So what you're saying, Damien, is that companies have evolved to understand what is the optimal capital structure are comfortable taking it on a little bit more leverage for improving return on equity capital. Is that correct? That's correct. Coming to the near term, can you share with us broadly the state of credit markets today where are you seeing the opportunities and the risks? To simplify, let's look at credit from two primary angles. First credit fundamentals. So this refers to the ability of borrowers to make interest payments and refinance and repaid debt and then how that ability is trending over time. Second is broadly what's what's called technicals, which describes the supply of credit from borrowers and the demand for credit from investors or lenders. For fundamentals, I'm broadly comfortable with the state of credit markets. Backdrop is an improved outlook for economic growth that's fairly broad-based, including developed markets and emerging markets. Economies are on fairly solid footing in the US, Japan, Australia, in emerging markets like India and Indonesia. We see positive growth, but a bit lower and more fragile in geographies such as Europe, the UK, China. If you roll it all up, our economists expect global GDP growth of about 3% in 2024, which is down somewhat from kind of a 4% trend growth rate pre-pandemic, but 3% is still pretty solid, and that decline from 4% to 3% is really attributable primarily to slower growth in China. We also think that inflation is going to gradually come down, and this disinflation, you know, while it's a bit slower than central banks would like, still creates space to eventually begin the process of lowering policy rates. So this backdrop of solid economic growth and rates that no longer seem to be on an upward trajectory and eventually should be on a downward trajectory is a good overall backdrop for credit. You also have corporate and consumer balance sheets that overall aren't excessively levered and fairly stable. And this isn't to say that credit fundamentals are fine everywhere, but I describe the problems as more idiosyncratic specific to certain issuers, you know, whether that be corporate issuers or sovereign issuers. And then that second factor being technicals, I'd say, is also supportive. So big picture now that rates are a lot higher, you have borrowers who aren't as excited about borrowing as they were two to three years ago. It's more expensive to borrow. So on the margin, borrowers will choose to borrow less or will choose to borrow for a shorter period of time. And as an example of this, high yield issuance declined massively in 2022 and 2023 compared to previous years. This was issuers basically stepping back because they didn't want to lock in higher borrowing rates than they needed to. You also have, because rates are higher, more interest in credit from lenders from bond investors such as ourselves. Yields and expected returns are higher for lenders. So we want to buy more bonds. You can see this in the significant inflows into bond funds, for example. This is cash coming off the sidelines coming out of money market funds where investors went to hide in 2022 and rates were rising. So investors are basically recognizing this opportunity to lock in these historically elevated yields for a longer period of time. So stepping back, you have fewer bonds to buy, but more people who want to buy, that's broadly supportive of bond prices and credit spread. So that's kind of the big picture backdrop as I see it. And as a result, I very much view credit as broadly investible today. Now is not the time to have a big credit underweight, for example. And you can counter this line of thinking and say, well, yes, fundamentals and technicals are positive, but spreads are tight. And my reply to that is that based on supportive fundamentals and technicals, it would be quite odd if spreads were much wider than where they are today. And I would say we're in a range of normal when there isn't a crisis. And also, critically, credit isn't just one thing. It's not uniformly tight. Credit markets are enormous, seven trillion in investment grade corporates, one point three trillion in high yield, another two trillion in EM dollar, including sovereigns and corporates, another trillion in securitized credit. So very large, very diverse, quite fragmented, thousands of issuers across these markets. These different sectors and credit have distinct underlying credit drivers, corporate drivers of credit quality aren't the same as sovereign determinants of ability to repay. aren't the same as sub-prime auto-ability to service debt. And as a result, valuations yield spreads. They're not the same across these markets. They don't move around in a perfectly correlated fashion. So as I look at credit markets broadly with the incredible insights provided by these distinct teams of analysts, we have dedicated to each of these different credit sectors. I see the opportunity in investment grade corporates is pretty interesting and securitized credit as well. I see some risk in high yield though in high yield. It's not really a concern about fundamentals. It's more a concern that valuations have become a bit excessive relative to other sectors. Thanks, Damien. So what you're saying is broadly speaking, credit remains well underpinned by strong fundamentals, a strong economy and where you see the risks they tend to be more specific to specific issues. That's right. Coming to a multi-sector income strategy, what's different, Damien, is that different asset managers take different approaches. Why is that and what is your approach to multi-sector income investing? I think it starts with the very nature of the category of the strategy. And you can kind of see it in the name, multi-sector, it's quite undefined. And so different asset managers have their own interpretations of what multi-sector means. The approach each asset manager takes reflects their investing values and philosophy and the research and portfolio management resources that they have access to. Capital Group has incredible depths and breadth of credit research resources across numerous sectors as well as extensive macro research. And philosophically, the firm believes that diversification, balance and flexibility are crucial to generating superior long-term investment results. So we focus on four primary credit sectors for our multi-sector strategy. High-yield corporates, investment grade corporates, emerging market debt and securities credit. We're not over-reliant on any of these. Each sector has unique characteristics that add value to a diversified portfolio over time. None are a silver bullet. The key is to find the right combination. And so we'll vary exposure to each of these sectors over time as markets evolve and our research reveals new investment opportunities in a manner that, on average, over time, delivers an approximate 50/50 blend between investment grade rated and high-yield rated bonds. We also think investors appreciate that we define the flexibility we have to change sector exposure. It's flexibility with card rails. And this ensures a healthy degree of balance. And what's your process for deciding relative value among sectors? If there is a shock event in markets, like what happened with COVID and a sector like high-yield sells off, how do you decide that now is a good time to start building a position or making a switch between sectors? So philosophically, I believe that credit spreads at the sector level, so not at the issuer level necessarily. But at the sector level are both cyclical, meaning credit spreads will go up during certain periods. They'll go wider, and then during other periods, they'll go tighter. And over long periods of time, you can observe multiple periods of spread widening and multiple periods of spread tightening that correlates with an economic cycle. And also that I believe that credit spreads are mean reverting over time, meaning that after a period of spread widening, there will be a tendency for spreads to tighten back to sort of a long-term average. And after a period of spreads being tighter than a long-term average, there will be a tendency for spreads to widen out back toward that long-term average. And so that the cyclical nature of spreads and the strong tendency of mean reversion or reverting back to the long-term average reflects the cyclical nature of economies and markets. So if you take the high yield sector as an example, during periods of strong markets and low volatility, high yield issuers have a tendency which they have exhibited again and again over time to gradually take more risk in how they manage their business. So they'll take more operating risk, more investing risk, more balance sheet risk. Eventually, this risk-taking behavior goes too far. And it's often revealed when there's a slowdown in the economy. And then companies that took too much risk have to course correct. And so you'll see cost-cutting, reduced capital spending, maybe asset sales. Companies look to repay debt as they shore up operations. And this pattern plays out again and again over time, over cycles. And so this cycle feeds into our approach to sector allocation in a multi-sector context. So we take a counter-cyclical approach after periods of spread tightening and strong results in higher yielding more volatile sectors will look to reduce exposure to those sectors. And simultaneously, we'll look to grow exposure to lower yielding higher quality sectors. As market cycles play out over time, we also have a quant model that helps inform this counter-cyclical mean reversion approach. And also look to signals coming out of our portfolio strategy group about the overall attractiveness of credit. And then we take inputs from numerous sector specialist portfolio managers we have and the related analyst teams to help us make those sector allocation decisions. Damien, just coming back to sectors a little bit, financials are a big part of credit markets. And they're also amongst the largest issuers of corporate bonds. Following the brief crisis that we saw related to the collapse of Silicon Valley Bank and then the stress among European banks that led to the UBS Credit Suisse merger, what is the state of the banking industry today? Yes, it's been quite a recovery from the events of March of last year. I mean, the root causes were a combination of factors. Some sort of unique customer concentrations and herd behavior among those customers at certain banks, excessive commercial real estate exposure at certain banks, excessive interest rate sensitivity and treasury holdings at certain banks. And there were other issues as well. In the US, the larger banks in the country were and I think remain very well capitalized and were able to provide support in concert with the Fed to stabilize markets and provide ultimate resolution for the handful of banks that got into trouble. In the aftermath, the Fed will further tighten regulation which follows significant tightening in the aftermath of the global financial crisis years ago. We're still waiting on all of the details but this is likely going to mean banks need to hold more capital than they did before last March. And maintain a more liquid balance sheet. So big picture, that means credit quality for banks is going to go up and their return on equity is going to go down sort of all else equal. So that'll be a relative positive for bond investors and a relative negative for equity investors in banks. And as the Federal Reserve and other central back lower rates, what will that mean for banks? So that should be broadly positive. It should mean that net interest margins which is kind of a key measure of bank profitability should improve as funding costs fall. And then demand for loans could also improve across commercial industrial consumer and including mortgages. And this just goes back to when it's cheaper to borrow businesses and consumers are going to want to borrow more and banks are in the business of extending loans. And then staying on some of the sector opportunities, Damian, in both investment grade and high yielding sectors, where are you seeing some opportunity and where are you being more cautious? As I look across multi-sector, credit spreads are on the tighter side versus the historic range. This is what I'd expect to see given this environment of fairly solid economic growth, decent underlying credit fundamentals, and a Fed that's stopped hiking and is likely to cut in the not too distant future. But spreads aren't uniformly tight. I see the most opportunity in investment grade corporates as well as securitized credit. In investment grade corporates, this is a large and diverse market. Credit rating span, triple B to triple A, the most of the markets, triple B in single A, maturity span three year to 40 year, although most of the markets kind of five-year, 10-year, and 30-year, there are a thousand issuers in investment grade corporates, and that's coming from more than 50 industries. If you just take triple B corporates, which is arguably the core of the investment grade corporate market, spreads here aren't at the tights. We're finding value in select pharmaceutical companies, going back to the trends in higher pharmaceutical debt that I mentioned earlier. There are some situations where there's been debt-financed, acquisitions, and those pharmaceutical companies that made debt-financed acquisitions are now going to use pre-cash flow to repay debt. Pharmaceuticals tends to be a very good business with demand that's not sensitive to the economy and generate strong cash flow. So we see opportunities for spreads to tighten in some of these, which could provide returns that in some cases are competitive with many of the opportunities that we find in the high yield market, but with a significantly lower risk profile for giving the investment grade balance sheets of these pharma companies. We're also finding value in certain utilities that are facing elevated wildfire rates. risk, but have credible plans to harden their distribution systems thereby reducing wild fire risk going forward. And we think this should also be a tailwind for spreads to tighten as those plans are implemented. And then in a securitized credit, I'd highlight subprime auto. This is a shorter maturity three to five year where a strong job market supports debt service. And we also like the structures which de-leverage naturally over time and in this context, you know, six to eight percent yields are quite attractive areas where we are cautious. At the sector level, I'll mention high yield, but importantly, I feel pretty good about underlying credit fundamentals here. I'm cautious because of ultra tight spreads for many high yield issuers, tighter relative to history within high yield. I'm being very selective in telecom, cable, and satellite. There are a number of companies here that are simply too levered for the more competitive environment that has emerged in those industries. That was a great overview, Damien. Tell us about your own journey. How did you get to capital? So I joined capital right out of undergrad. I went to Cal State Northridge, which is right up the freeway from our Los Angeles offices. Capital Group didn't recruit from Cal State Northridge. So I had to do something different to be noticed. And this was in late '99, early 2000, if you recall, during that period, AOL or American online would regularly blanket every home in the U.S. with these CD-ROMs that would come in the mail, delivered in dual cases, and it would be the latest version of the AOL browser that they wanted you to load onto your computer. Well, in a previous job, I had done some limited website development. I sort of knew enough to be dangerous. So I decided to turn my regular paper resume into basically a website that was loaded onto a web browser. I burned it on a CD, I packaged it in a dual case, and I sent it to capital group. In a dual case? Just like AOL. It was an interactive resume. So you took the CD out of it, you put it in the CD-ROM drive, opened the web browser, and you saw my resume and it was sort of you'd click here to see my education, you'd click here to see my work experience. I had a little picture of Warren Buffett and Benjamin Graham up in the corner to sort of demonstrate my interest in fundamental investing and my creativity, and that ended up being enough to get me an interview. That's great. And you started as an equities research associate and then transitioned to fixed income? Yeah, that's right. I joined capital initially as an equity research associate. I was incredibly fortunate to work alongside three of our equity analysts. All of them were incredibly generous with their time. Made it a point to really help me develop as an investor. Aaron Larson had joined capital in 1962 and had covered some of the same companies such as Coca-Cola for something like 40 years. So pretty incredible to be able to work alongside Karen. And then after working in equities as a research associate for five years, I joined fixed income as a corporate analyst in 2005. What was it in your equity's experience that helped you in fixed income, Damien? Looking back, having that prior experience in equities made me, I think, a more effective fixed income analyst in the sense that I was very comfortable looking at companies with an equity perspective and then developed comfort looking at companies with a credit hat on. And so I was able to, I think, just develop a more holistic view and honestly for investors and corporate bonds, I think it's really important to pay attention to the motivations of equity investors, which is often quite similar to the motivations of management who are trying to maximize the value of the company's equity. Sometimes equity interests are aligned with fixed income interests and sometimes equity interests diverge. And fixed income investors need to know where they stand in the priority list of management and owners. So this kind of gets into, you know, being able to evaluate and motivations of management regarding capital allocation, balance sheet policy, dividend policy, all of which are critical to figuring out the direction of credit quality and ultimately how much the bonds are worth. What would you say is your favorite part of the job? Gosh, where do I start? There's a lot about this job that I love. As a multi-sector credit investor, there is incredible breadth to the investment opportunities I'm given, the privilege and responsibility of evaluating on behalf of investors. The flexibility I have to pivot from one sector to another as markets and opportunities change is really quite exciting. The credit markets are so large and diverse, there's always something interesting to focus on. Or, you know, the many different ways the fixed income markets provide to express an investment view. And this is, I think, an interesting contrast to equities. So let's say I want to invest in JP Morgan in equities. It's pretty straightforward. You buy the stock. But in bonds, there's actually a bunch of options. There's senior and secured bonds. There's subordinated bonds. There's perfirds. And then a bunch of different maturity options for each of these and each offers something different. Each plays a different role in the portfolio and trying to figure out that puzzle is a lot of fun. The fact that I can work with so many incredible analysts who are true experts on the underlying issuers, that's an incredible privilege. I also really enjoy the over-the-counter nature of fixed income. So bonds, they don't trade on exchanges. And so you have to work with these teams of professional bond traders that we have and figure out liquidity isn't always straightforward, whether you're buying or selling. And so to find liquidity at the right price is sort of a whole other part of fixed income investing that is a lot of fun. And being able to do this at Capital Group, which is so client-focused and managed for the long term, is the icing on the cake. OK, there you have it. Special thanks to Damien McCann and Aflu's secret for coming on the ship. Capital Ideas is brought to you by Capital Group, one of the world's largest and most experienced active investment managers. If you like what you heard today, please follow us on your favorite podcast platform. Thanks for listening. We'll see you next week. Bond ratings, which typically range from triple A, A-A-A, highest to B, lowest, are assigned by credit rating agencies such as Standard Imports, Moody's, and/or Fitch as an indication of an issuer's creditworthiness. Investment grade refers to bonds rated triple B and above. References to fixed income sectors are in the context of US bond markets. 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