A gainst a backdrop of low volatility and tight spreads, 2014 turned out to be a challenging year for many alternative investors as they watched their trades become crowded, and reverse quickly when expected returns were not realized. One such example was the positioning among investors in advance of the European Central Bank’s (ECB) Asset Quality Review announcement; many had increased their exposure in anticipation of a tightening of European bank-related securities. Despite the relatively market-friendly news, securities of European credit institutions actually sold off as there were few remaining new buyers.
Given these market dynamics, the key to credit investing in 2014 was avoiding the big mistakes while navigating the fourth quarter volatility. Over the course of 2014, the continued rally in credit resulted in a shift to less liquid investments, regardless of portfolio structure. For strategies with a credit focus, a disconnect emerged between the vehicle structure and the liquidity of the underlying investments.
So far, 2015 is shaping up to be very different. Europe is facing multiple potential catalysts, ranging from accelerated bank delevering and negative interest rates across the region to political uncertainty in Europe’s periphery. Outside of Europe, emerging markets face ongoing volatility and the U.S. Federal Reserve (Fed) is expected to begin raising interest rates later this year. Finally, drastically lower oil prices and the potential for high yield defaults only add to what could easily be an incredibly exciting environment for investing in alternatives.
Currently, dislocations abound and relative value is shifting continuously. Given the ample liquidity provided by global central banks, many assets are arguably unattractive or will likely offer relatively low returns over the coming years. Thus, in an environment characterized by volatility while also littered with potentially overpriced assets, we believe adhering to the following important key themes will prove critical to successfully navigating the markets in 2015.
1. Have a high hurdle for investing away from the U.S., or UK to a lesser degree
PIMCO’s secular view maintains that the U.S. and UK economies should both experience steady growth for the next few years. Depending on the asset class, the premium investors may earn from investing outside these countries has narrowed, if not inverted, particularly across the developed world. Dependent upon the investment, the expected steady growth of the U.S. and the UK economies, combined with better liquidity, transparency, legal structure and sanctity of contracts, the premium offered ‒ or lack thereof ‒ often does not justify the risk for investing outside these jurisdictions. More importantly, given the size of the U.S. economy, combined with the lingering overhang of the financial crisis and evolving regulatory burdens, there are still ample attractive opportunities where current market prices imply conservative assumptions relative to base case expectations.
2. Peripheral Europe: do not underestimate the upside
While it could seem potentially contradictory with the first theme, peripheral Europe may be on the beginning of a long-term secular upswing, and an attractive place to deploy capital. This region still has numerous risks including high unemployment, weak growth, a debt overhang and geopolitical uncertainty. Moreover, many banks within these countries continue to need to raise capital and shed non-performing assets. However, positive developments, such as reforms that are taking place (albeit slowly), adjusted labor costs, incredibly low interest rates and an elongated timetable due to the ECB’s latest quantitative easing (QE) announcement on 22 January 2015, provide support to peripheral countries. While a return to robust growth is not anticipated for the foreseeable future, this region could experience a steady recovery over a five- to 10-year time horizon, making select investments relatively attractive, particularly relative to the rest of the developed world. In particular, while not without substantial risk and mark-to-market volatility, select investments in Greece potentially offer attractive risk-adjusted returns as the current pricing provides for marked upside should a recovery ensue and limited downside even in a Greek exit from the eurozone.
3. Understand deleveraging trends in European banks: they are going to do something eventually
The importance of understanding where the European banks are in the credit cycle should not be underestimated. While many of these institutions are still in balance sheet repair mode, over time we expect more of them to shift to the offensive. In order to maintain/increase their net-interest-margin (NIM), they will eventually ramp up lending activity or buy off-the-run securities (see Figure 1).
Whether they decide to drive funding costs lower on prime mortgage loans or expand the credit box for small- and medium-sized enterprise (SME) loans will have important implications to where one allocates capital now.
4. Accommodative central banks will pull off-the-run credit assets tighter
QE in Europe, combined with continued accommodative monetary policy from many other central banks globally (30+ central banks lowered interest rates as of March 2015), and a dearth of higher-yield, high quality short-weighted, average-life fixed income securities will continue to shift investor behavior given the global search for yield. As has been highlighted in the financial press, there is an estimated €2 trillion of negative yielding bonds across Europe.
We believe this shift will continue despite the eventual removal of partial accommodation from the Fed. While an extension of duration could be one investor shift, we believe well-bounded credit assets, such as investment grade securities, non-agency mortgage-backed securities and off-the-run senior investment-grade-rated European structured products will be important beneficiaries of this phenomenon.
Similarly, improving funding markets could continue to lower the discount rate on numerous real assets. In the U.S., this is most pertinent for housing-related investments. Arguably, commercial real estate, especially in the U.S., has benefited from this dynamic through lower cap rates. Across Europe, numerous asset classes, in particular distressed peripheral collateral, could still experience price appreciation through a reduced discount rate should their underlying funding improve.
5. Stay long the U.S. housing market: it will have an asymmetric profile over PIMCO’s secular horizon
PIMCO’s home price appreciation (HPA) forecast remains relatively benign over the coming 24 months at 3%–4% nominally in each of the next two years. While we acknowledge that the sharp HPA recovery is behind us, we do expect a steady rise in HPA over our secular horizon, with variations across local geographies.
Among other factors, favorable demographics, under-building, attractive price and rental yields and improving credit standards should buffer housing-related investments over the coming 12 months, which should limit the downside risk. As such, we believe that many U.S. housing-related investments have an asymmetric upside investment profile.
6. Greater return potential through origination and aggregation of high single digit loss-adjusted-yielding collateral
In many instances, the return gap between public and private opportunities has widened significantly, particularly relative to the embedded credit risk. In the alternative landscape, finding high single digit loss-adjusted-yielding collateral and employing light leverage in efforts to achieve double-digit returns is an important trend. Arguably, it is the same concept, whether the underlying collateral is subprime auto, middle market loans, non-qualified mortgages or peer-to-peer lending. Sourcing these assets will have the benefit of ongoing European bank deleveraging as this is often the profile of the loans/collateral being sold.
In order to be successful in this type of investment, we believe the funding terms and/or investment vehicle need to allow investors to navigate difficult market environments; the collateral must be able to truly provide a loss-adjusted return in the high single digits, and the overhang of any platform investment must outweigh the benefit of getting access to potential collateral.
7. Do not forget the value of being senior and secured
The longer interest rates stay low, the more likely we are to see bouts of irresponsible lending and leverage. The value of being senior and secured in the security structure is that during periods of economic volatility, or if one is wrong on the underlying investment, we believe the senior secured nature of the investment should help mitigate the downside risk. More importantly, by avoiding outsized losses during periods of market stress, it helps enable investors to go on the offensive. This theme could prove instrumental in energy-related investments over the coming years.
8. Be prepared for overshooting: the cost of being early, but still “fundamentally right,” can be very painful
Clearly, the street’s willingness to facilitate trading/disintermediating risk has waned. For illiquid assets, we spend significant time focusing on the next buyer analysis, i.e., if someone “has” to sell an asset in a liquidity event, at what level will new buyers emerge assuming the street does not disintermediate (see Figure 3). This effect is amplified by a heightened regulatory environment, which has increased buyer segmentation for various assets. We seek to avoid positions where we believe the alternative community is overly represented, as reversals could be volatile.
While ample global central bank liquidity will drive asset inflation in certain markets, we believe the current investment environment provides extensive opportunities for alternative investors able to navigate market volatility. Having the correct structure to hold these complex investments will be critical.