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Will McKenna: 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 Sikri, Capital Group portfolio manager Damien 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 markets bonds and mortgage-backed securities.

I’m your host, Will McKenna. Let’s get into it.

Apu Sikri: Damien, welcome to the podcast. Thanks for being with us today and this conversation on credit markets.

Your area of focus as a portfolio manager is credit markets. Before we get to the here and now, tell us how credit markets have evolved over the last couple of decades. What were they like when you started out and what has changed?

Damien McCann: Sure. So, I mean, 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 have grown about five times in 20 years. The high-yield corporate market has grown about two and a half times nominal GDP over this period is up about two and a quarter times. So that kind of provides a sense for the pretty rapid growth in these debt markets.

But the evolution isn't limited to growth. In investment-grade corporates, we've seen new industries emerge. You know, pharma and tech are now significant issuers than they were 20 years ago. They were very significant industries with big market caps, but they only started to borrow in significant size more recently, like over the last, maybe, 10 to 15 years.

Today, pharmaceuticals in the investment-grade corporate market is nearly $400 billion in bonds outstanding, about five percent of the market. Twenty years ago, it was only about 30 billion, which was less than two percent of the market.

I'd say there have been kind of a few you reason 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 issuer in bonds was a pharmaceutical, or 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. And you can just go down the list: AbbVie, Amgen, Bristol Myers, Pfizer, Merck, J&J, Gilead, Novartis, Roche, and there are others. These are all pharmaceutical companies that have made significant debt financed acquisitions over time.

A second important driver of the growth is spin offs. 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. Zoetis was formerly a division of Pfizer. 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 AbbVie. AbbVie 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 managements 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, thereby boosting your return on equity, which benefits shareholders.

So, for pharmaceutical companies, 20 years ago, the average credit rating was — and 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 corporates 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 there 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 lowest 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 with that 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.

Apu Sikri: So, what you're saying, Damian, is that companies have evolved to understand what is the optimal capital structure, are comfortable taking on a little bit more leverage for improving return on equity capital. Is that correct?

Damien McCann: That's correct.

Apu Sikri: 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?

Damien McCann: So, 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 repay debt, and then how that ability is trending over time.

Second is broadly 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. It's fairly broad based, including developed markets and emerging markets. Economies are on fairly solid footing in the U.S., 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 percent in 2024, which is down somewhat from kind of a 4 percent trend growth rate pre pandemic. But 3 percent is still pretty solid, and that decline from, 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, ascribed 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 when 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 know, 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, that's kind of the big-picture backdrop as I see it. And as a result, I very much view credit as broadly investable 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, you know, critically, credit isn't just one thing. It's not uniformly tight. Credit markets are enormous. Seven trillion in investment-grade corporates. 1.3 trillion in high yield, another 2 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 in 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 subprime auto’s ability to service debt. And as a result, valuations, yields, 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.

Apu Sikri: Thanks, Damian. So, what you're saying is the broad, 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 issuers?

Damien McCann: That's right.

Apu Sikri: Coming to a multisector income strategy, what's different, Damian, is that different asset managers take different approaches. Why is that? And what is your approach to multisector income investing?                                                                           

Damien McCann: I think it starts with the very nature of the category or the strategy, and you can you kind of see it in the name multisector. It's quite undefined, and so different asset managers have their own interpretations of what multisector 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 depth and breadth of credit-research resources across numerous sectors as well as extensive mass 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 multisector strategy: high-yield corporates, investment-grade corporates, emerging-market debt and securitized 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 guardrails. And this ensures a healthy degree of balance in all market environments.

Apu Sikri: And what's your process for deciding relative value among sectors? So, 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?

Damien McCann: So philosophically, I believe that credit spreads act 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, 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, 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 behaviour 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 multisector context. So, you know, we take a counter cyclical approach after periods of spread, tightening and strong results in, in higher yielding, more volatile sectors, we'll 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.

Apu Sikri: Great. Damian, just coming back to sectors a little bit, financials are a big part of credit markets and they're also amongst the largest issues 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?

Damien McCann: 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 behaviour among those customers at certain banks, excessive commercial real estate exposure at certain banks, excessive interest rate sensitivity in treasury holdings at certain banks.

And, you know, there were other issues as well. In the U.S., 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.

Apu Sikri: And as the Federal Reserve and other central bank lower rates, what will that mean for banks?

Damien McCann: 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 banks funding costs fall.

And then demand for loans could also improve across commercial, industrial, consumer, 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.

Apu Sikri: Great. 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?

Damien McCann: Sure. So, as I look across multisector, credit spreads are on the tighter side versus the historic range. This is what I'd expect to see, given this environment of crisis. 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 ratings span triple B to triple A, though most of the markets triple B and single A. Maturities span three-year to forty-year, although most of the markets, kind of five-year, ten-year, and thirty-year. There are, you know, a thousand issuers in investment-grade corporates, and that's coming from more than fifty 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. So, you know, 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 free cash flow to repay debt.

Pharmaceuticals tends to be a very good business with demand that's, you know, not sensitive to the economy and generates 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, given the investment-grade balance sheets of these pharma companies. We're also finding value in certain utilities that are facing elevated wildfire risk, but have credible plans to harden their distribution systems, thereby reducing wildfire risk going forward.

And we think this should also be a tailwind for spreads to tighten as those plans are implemented. And then, in securitized credit, I'd highlight subprime auto. This is a shorter maturity — kind of three to five year — where a strong job market supports debt service. And we also like the structures which deleverage naturally over time. In this context, you know, 6 to 8 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.

Apu Sikri: That was a great overview, Damian.

We're always trying to get better. So, if you have any feedback, including topics you'd like to see addressed in future episodes, send us an email at CapitalIdeasPodcastAustralia@capgroup.com. And if you like what you've heard today, please follow us on your favourite podcast platform for Capital Ideas. This is Matt Reynolds reminding you that the most valuable asset is a long-term perspective.

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