Mark Kiesel

U . S . C R E D I T P E R S P E C T I V E S

January 2010

Picking the Winners

What will be the investment winners in 2010? A number

of corporate bonds are likely to be winners: They should

outperform Treasuries in 2010 due to improving credit

fundamentals and strongly supportive credit market

technicals, in which demand should exceed supply, causing

credit spreads for many higher-quality corporate bonds to

tighten versus Treasuries. Within the credit market, select banking and financial

sector bonds stand out as potential winners due to an improved outlook for asset

quality and profits; healthier balance sheets; continued government, policy and

regulatory support and attractive relative valuations.

The search for yield, which we claimed would lead to strong relative performance

in the credit market in 2009 (see the December 2008 US Credit Perspectives:

“Credit Now, Equities Later”), will likely continue to influence investment returns

in 2010. While investments in the credit market have performed well in the past

year, corporate bonds, particularly those in certain banks and financials, remain

attractive relative to other fixed income sectors such as mortgages and Treasuries.

The corporate sector has demonstrated remarkable discipline, cutting costs

and spending to increase free cash flow while strengthening balance sheets by

terming out near-term debt maturities with longer-maturity new bond issues

and by raising new equity capital. Credit fundamentals should improve as the

economy gradually recovers, and market technicals appear highly supportive for

corporate bonds, particularly relative to Treasuries.

Credit Fundamentals Improving

Corporate credit fundamentals have improved with the return of private capital

and management’s desire for less aggressive business and financial profiles.

Rising cash balances, stronger balance sheets, an improving economy and easier

credit conditions are all helping to support corporations.

One reason corporate fundamentals and balance sheets are improving is the

return of animal spirits and private sector risk capital in both the equity and debt

2

U . S . C R E D I T P E R S P E C T I V E S

markets. Low short-term interest rates combined

with a gradual economic recovery have caused

investors to venture farther out the risk spectrum

over the past year. According to a December report

from JPMorgan, US companies in 2009 were able

to raise $529 billion of new equity: a 42% increase

over 2008’s total of $372 billion.

In addition to raising equity capital, investment

grade and high yield companies raised $1.18 trillion

through the new issue corporate bond market

in 2009, according to CreditSights. Amazingly,

issuance increased significantly across all rating

categories from AAA-rated to CCC-rated credits,

allowing both high-quality and low-quality

companies to refinance near-term debt maturities

with longer-maturity debt, push out the average

maturity profile, reduce liquidity risk and

strengthen balance sheets.

This improvement in corporate credit fundamentals

has materially improved the outlook for default

risk, particularly in the high yield market, and

increased balance sheet strength and financial

flexibility for corporations. As a result, Standard &

Poor’s is now upgrading more companies than it is

downgrading (Chart 1).

Corporate executives’ confidence has increased

with the improvements in balance sheets, credit

availability and credit fundamentals, along with

the gradual strengthening of the global economy.

Nevertheless, management remains conservative

on the outlook for sustainable economic growth,

as government and monetary stimulus may

fade throughout 2010. The longer-term economic

outlook remains unclear, causing management to

remain highly cautious about hiring and capital

spending. This explains why companies are

hoarding cash: According to JPMorgan, non-

financial corporations, which from 2004–2008

held roughly $500 billion of cash on their balance

sheets, increased their total cash holdings to

$708 billion by the end of the third quarter of 2009.

Although corporations remain conservatively

managed, corporate profits are increasing with the

moderate economic recovery (Chart 2). And, because

US Corporate Pro�ts Improving

Bill

ions

of D

olla

rs

Source: Bureau of Economic Analysis

Chart 2

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Rat

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rade

and

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ield

Cor

pora

te B

onds

) Credit Fundamentals Continue to Improve

Source: Standard and Poor’s

Chart 1

S&P Upgrade to Downgrade Ratio

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hiring and capital spending are restrained, US

corporate free cash flow is improving significantly.

As a result of cost cutting and aggressive expense

control, non-financial corporations are now

generating free cash flow equal to 29% of EBITDA

(earnings before interest, taxes, depreciation and

amortization), the highest level in a decade

3

according to a December report from Goldman

Sachs. In addition, corporate profits should

continue to improve as credit conditions ease

(Chart 3). A December global survey by McKinsey

cash on corporate balance sheets may be directed

toward more shareholder-friendly initiatives such

as increased dividends or share buybacks. Mergers

and acquisitions (M&A) will likely rise in 2010,

and bondholders will need to be on the lookout

for management teams who appear likely to make

changes to benefit shareholders.

Corporate Bond Market Technicals Supportive

Both financial and non-financial debt growth is

now declining on a year-over-year basis, while the

federal government’s debt growth is rising by 30%

year-over-year (Chart 4). Non-financial corporates

Corporate Pro�ts Should Improve as Credit Conditions Ease

Source: Bureau of Economic Analysis and Federal Reserve

Chart 3

Non

-fin

anci

al P

rofit

s, Y

ear-

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ar %

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ight

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omm

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Inve

rted

)

Pro�ts vs Lending

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Non-financial ProfitsBanks’ Willingness to Lend

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-Ove

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Corporate Sector Delevers While the Federal Government Re-levers

Source: Federal Reserve

Chart 4

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Non-financial CorporateFinancial CorporateFederal Government

Non-financial, Financial and Federal Government Debt

need less capital because cash on their balance

sheets is rising: According to JPMorgan, their cash

levels increased by $113 billion in the third

quarter of 2009, as cash flow significantly exceeded

capital spending. As the corporate sector delevers

while the federal government re-levers, bond

market technicals should increasingly turn

positive for corporate bonds and negative for

Treasuries. This will probably be the single largest

factor in credit spreads tightening this year for a lot

of companies.

suggests that increased availability of credit is

leading to a more bullish outlook and greater

confidence in companies’ strategic planning and

budgeting processes. If so, increased hiring and

spending may be on the horizon, which could

help improve the outlook for a sustainable

economic recovery and a continued improve-

ment in credit fundamentals.

The outlook for positive credit fundamentals is not

without risks. The economy is highly dependant on

monetary and fiscal stimulus, as both consumers

and businesses are continuing to delever. Private

sector final demand needs to strengthen before

a sustainable recovery can establish itself. While

near-term inflationary pressure appears under

control, the Federal Reserve may have to tighten

monetary policy should inflationary expectations

rise. Aggressive Fed tightening would slow

economic growth and be a negative for risk assets,

including investment grade corporate bonds, high

yield bonds and equities. Finally, the surge in

4

U . S . C R E D I T P E R S P E C T I V E S

Who’s buying Treasuries? Despite rising issuance,

almost half of the increase in Treasury supply

of $1.89 trillion over the past 12 months, or

$889 billion, was purchased by non-US investors.

Will foreign investment continue to support

the Treasury market to the same degree in

2010 in the face of rising issuance? The answer

remains unclear, particularly given the low

level of Treasury yields and upcoming surge in

government borrowing.

Net fixed-rate Treasury issuance this year should

approach 10% of nominal GDP. By comparison,

net non-financial corporate bond issuance will

likely be less than 1% of nominal GDP (Chart 5).

The amount of Treasury issuance is rising sharply

as the government levers up its balance sheet,

while the amount of non-financial corporate

debt issuance is falling as companies delever.

The Treasury is also set to lengthen the maturity

profile of its debt. Rising deficits are causing

heightened concern over the sovereign credit

risk of the US government. These trends should

support corporate bonds relative to Treasuries in

2010, particularly given that the Federal Reserve

is set to end its quantitative-easing Treasury

and mortgage purchase program in March 2010.

Finally, corporate America’s rising cash balances

and diminished leverage should support credit

technicals due to lower corporate issuance needs,

helping to tighten credit spreads versus Treasuries

for the stronger companies this year.

Bank Bonds Likely to Be Winners in 2010

Within the credit market, the banking sector stands

out as a likely winner. Banks should see a gradual

slowing in the growth of problem loans as well

as improving balance sheet strength and profit

growth. Banks are delevering their balance sheets,

raising more loss-absorbing equity capital and

facing increasing regulatory oversight. In addition,

bank and financial companies should benefit

from reduced issuance needs in the bond market,

providing for supportive market technicals. All

these factors should support bondholders and lead

to strong relative performance.

Banks’ asset quality, while still deteriorating, is

benefiting from government efforts to support

housing. While commercial real estate likely has

more downside risk, there is increasing evidence

that lower-priced housing is starting to stabilise

due to low mortgage rates, government efforts to

increase credit availability to homebuyers and

improved affordability. As residential real estate

prices stabilise and other asset price declines

moderate, the pace of write-downs on banks’

balance sheets should slow. This will likely

improve bank asset quality and earnings and

lessen the need for banks to raise more capital.

Banks’ balance sheet strength and equity

capitalisation have improved significantly over

the past year. The Troubled Asset Relief Program

(TARP) allowed banks to raise equity capital

Technicals Favor CorporateBonds Over Treasuries

Net

Fix

ed-R

ate

Issu

ance

% N

omin

al G

DP

Source: Barclays and PIMCONet fixed-rate issuance is gross fixed-rate issuance minus maturities. Corporate net issuance is non-financials.

Chart 5

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89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10F

Treasury/GDPCorporate/GDP

Treasury vs Corporate Supply

5

when the capital markets were frozen in autumn

2008. However, starting in the fourth quarter of

2008, private investors gradually became more

comfortable taking both subordinated debt and

equity risk in banks and financial companies.

JPMorgan, Goldman Sachs, Bank of America and

Wells Fargo have all been able to sell stock to the

private sector to help raise money to pay back the

government. Just two weeks ago, Citigroup was

able to raise $17 billion in common equity.

The return of private capital has been a significant

positive for the sector. Today, over half of the

government’s $245 billion TARP capital has been

repaid with private sector capital, and in the past

15 months, the over $1 trillion raised across the

worldwide financial system has significantly

exceeded write downs or losses of $743 billion

(Chart 6), according to Bloomberg. As a result of

likely to ensure banks maintain adequate levels

of loss-absorbing equity capital. This is positive

for bonds, which are at the top of the capital

structure, but less so for equity, which potentially

could see further dilution if economic growth

and asset prices deteriorate, leading to loan

losses and additional write-downs. However,

should the economy continue to improve, banks’

profit growth could rebound more sharply than

expected. Finally, the steep yield curve is a positive

for economic growth and specifically for banks

(Chart 7), as net interest margins tend to widen,

which helps boost banks’ profits.

Chart 6*Capital raised and losses announced quarter to date.Source: Bloomberg

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LossesCapital Raised

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The Financial Sector is Re-capitalisingWorldwide Financial System Losses and Capital Raised

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Chart 7Source: Bloomberg and S&P

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Yield CurveBank Stocks

Yield Curve vs Bank Stocks

Bank bonds continue to offer attractive relative

value (Chart 8) within the overall corporate bond

market. In addition to attractive valuations, bank

bonds benefit from considerably strengthened

balance sheets, the increase in loss-absorbing

common equity, and regulatory efforts to help

cushion balance sheets and protect bondholders

from potential asset quality deterioration.

Finally, and most importantly, governments and

policymakers remain committed to supporting key

banks and financial companies, in order to enable

a sustainable economic recovery.

recent equity issuance, several of the largest US

financial firms saw their Tier 1 common equity

ratios recently climb above 7%, according to

PIMCO credit research.

Increased regulation in the banking industry

will likely mean less leverage and lower returns

on equity. Policymakers and regulators are

6

U . S . C R E D I T P E R S P E C T I V E S

What do market technicals look like for the

financial sector in 2010? JPMorgan estimates gross

issuance in the sector will decline 38% this year

versus 2009, down to $285 billion; net issuance, or

gross issuance minus maturities, is estimated to

decrease by $17 billion (Chart 10). Why do banks

and financial companies need less money? These

companies raised substantial equity over the past

year, were able to access the Temporary Liquidity

Guarantee Program (TLGP) for funding, have now

delevered their balance sheets, remain cautious on

new loans and, if needed, can tap into their vast

Without a healthy financial sector, capital may not

recirculate into the private sector. Governments

and central banks will likely want to ensure the

banking industry is able to increase lending to the

private sector, so government support programs

should remain in place until banks heal. The

Federal Reserve will likely keep monetary policy

highly accommodative to allow banks to increase

profits and build equity capital.

Investing in banks is not without risks. A weak

economy or double-dip recession would be highly

negative for both residential and commercial real

estate prices, and thus for banks’ asset quality.

Higher short-term interest rates, which could

result from the Federal Reserve increasing the fed

funds rate to tame inflationary expectations, would

negatively impact banks’ net interest margins and

profitability. Regulatory and legislative actions

could also be negative for bank investments at the

bottom of the capital structure; re-regulation and

the eventual implementation of Basel III and new

capital rules by 2012 may cause banks to raise more

equity capital, lowering the potential returns for

existing shareholders.

While potentially dilutive for bank shareholders,

re-regulation and increased capital requirements

will likely result in banks that are less risky

and less leveraged. These secular trends, while

likely negative for equity holders, are positive for

bondholders. In fact, both senior and subordinated

debt and even some Tier 1 bank capital could

benefit – such securities are unlikely to be useful

for regulators wanting higher loss-absorbing

capital. The larger equity cushion for bondholders

would likely help tighten credit spreads for bank

bonds. Given the current attractiveness of some

Tier 1 bank capital credit spreads (Chart 9), a select

group of these securities could be relative winners

in 2010.

Opt

ion-

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uste

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prea

d (O

AS

) vs

. Tre

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in B

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nts

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nts

Chart 8

BanksCorporates

Source: Barclays (Sub-sectors of the Barclays US Credit Index)

Bank Bonds Continue to Offer Attractive Relative Value

Corporate Spreads

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Chart 9Source: JPMorgan and BofA Merrill Lynch

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Tier 1 Bank Capital Remains Attractive

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Bank Capital vs High Yield

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7

regulation requiring higher equity capital, bond-

holders in a number of key bank and financial

companies should benefit as the economy recovers

and profit growth allows capital to build, causing

banking and financial sector credit fundamentals

to improve. Given supportive fundamentals and

a positive technical outlook, investors should

consider staying overweight select bank and

financial bonds and underweight Treasuries in 2010.

Mark Kiesel

Managing Director

Chart 10

Source: JPMorgan

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2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010F

$ in

Bill

ions

Gross Net

Net issuance is gross issuance minus maturities.

Financial Supply

Technicals for the Financial Sector Are Strongly Positive in 2010

deposit bases for cash. The net result is that the

supply outlook for banks and financials should

be muted this year, providing a positive technical

backdrop for bondholders, particularly given the

likelihood for continued solid demand for high-

quality bonds with attractive relative valuations.

Picking the Winners

The corporate sector is delevering at the same

time the federal government continues to re-

lever. Credit fundamentals are improving

for the corporate sector at the same time

credit fundamentals are deteriorating for the

government. This should lead to tighter credit

spreads, particularly for firms with strong credit

fundamentals, as the beginning of 2010 sees a lack

of high-quality spread alternatives to compete with

corporate bonds.

A number of bank and financial companies

stand out as potential winners this year due to

attractive valuations and an improved outlook for

asset quality and profitability. The banking and

financial sector has been able to recapitalise and

delever its balance sheet by raising private equity

capital. Due to supportive monetary and fiscal

policy combined with the likelihood for increased

PIMCO Australia Pty Ltd ABN 54 084 280 508 AFS Licence 246862 Level 19, 363 George Street Sydney, NSW 2000 Australia 612-9279-1771

The services and products provided by PIMCO Australia Pty Ltd are only available in Australia to persons who come within the category of wholesale clients as defined in the Corporations Act 2001. They are not available to persons who are retail clients, who should not rely on this communication. Investors should obtain relevant and specific professional advice before making any investment decision. The information contained herein does not take into account the investment objectives, financial situation or needs of any particular investor. Before making an investment decision investors should consider, with or without the assistance of a securities advisor, whether the information contained herein is appropriate in light of their particular investment needs, objectives and financial circumstances.

Past performance is not a guarantee or a reliable indicator of future performance. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. Certain U.S. Government securities are backed by the full faith of the government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Mortgage and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor there is no assurance that the guarantor will meet its obligations. High-yield, lower-rated, securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested.

This material contains the current opinions of the author but not necessarily those of the PIMCO Group and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2009, PIMCO.

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