Bentley is a London-based v.p. at PIMCO Europe and is responsible for its U.K. investment-grade credit portfolios. PIMCO manages £10 billion in total out of London, with £6 billion in government bonds and £4 billion in credit.
How attractive is European investment-grade credit?
Overall European credit is looking expensive on a historical basis and it's hard to see how spreads can tighten from here. At the same time, the tightening we've seen over the past few years is justified from the point of view of both fundamentals and technicals, and we do not see an imminent breakdown in either of these which would justify significant widening. Fundamentally, companies have improved their balance sheets and liquidity positions, default rates are at all time lows and credit quality is high.
And from a technical perspective, these strong fundamentals mean that supply will remain constrained. Many companies have pre-funded and don't need to turn to the market for financing at this point, so supply isn't going to be strong enough to offset strong investor demand.
What is driving investor demand in Europe?
Aside from the strong credit fundamentals described above, there are a number of technical factors contributing to heightened demand for credit including the introduction of standardized credit derivatives, synthetic collateralized debt obligations and indexed products. These all make it easier for European investors to gain exposure to the credit markets now and have helped generate new demand for the asset class.
Does PIMCO use derivatives in its investment-grade portfolios?
We do use both credit and interest-rate derivatives in portfolios where mandates allow for their use and use them on an un-leveraged, cash-backed basis unless a client explicitly requests otherwise. We started using credit derivatives in Europe in mid-2004 and were ahead of the game in terms of setting up the necessary confirmation and settlement systems and getting the swap counterparty agreements in place.
Using interest-rate futures and swaps allows us to separate the credit decision from the interest-rate decision, which means we can buy corporate bonds offering the best value, regardless of currency or maturity. We can then use interest-rate derivatives to make sure the portfolio's overall duration, curve structure and market allocation structure are all in-line with PIMCO's macro view.
As for credit derivatives, we use both credit default swaps on individual names and credit derivative index products. For example, there are derivative products that allow us to get exposure to particular parts of the credit market as an overlay to the portfolio. We implement a number of credit strategies by buying or selling protection on various iBOXX index products.
Where do you see value in the sterling market?
Areas where we see value in sterling include subordinated bank paper, telecommunications and whole business securitizations. In tier one paper, we've moved into higher quality banks, since lower quality banks now offer little yield premium relative to higher quality ones. We like the telecommunications sector since telecoms have been de-leveraging and seem to be locking in the credit quality they've achieved; selected names offer value here. Lastly, with regard to whole business securitizations, these are deals which require a lot of credit work but you get paid to do it given the returns available.
What strategies are you focusing on outside of sterling?
One approach we employ is to rotate in U.K. names that offer bonds in multiple currencies. For example, major U.K. clearing banks issue in sterling, dollars and euros. In early 2004, the euro-denominated bonds were the cheapest on the back of certain investors not buying tier-one in that market since it was considered an equity-like investment-so we were long euro-denominated bonds at that time. Then we rotated into dollars in the fall of 2004 when these were cheaper, based on lack of name recognition of these banks in the U.S. In this way we are able to make money without taking on incremental credit risk.
The telecommunications sector is another example of a place where we see better value in bonds issued in euros versus bonds issued in sterling.