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| Steve Kellner |
Kellner is managing director and head of credit portfolios at Prudential Investment Management in Newark, N.J. He oversees Prudential's emerging market, bank loan and high-yield areas but spends most of his time managing high-grade portfolios. Prudential has around $56 billion in high-grade corporates and about $144 billion in fixed income.
What sectors are attractive right now?
Current levels of spreads are very tight; there's been a tremendous amount of spread compression. It's turned into a bottom-up market, meaning it's not as much sector-oriented as individual security selection. But with that in mind, we are overweight telecom because spreads are attractive. In addition, we like technology and improving credits there like Computer Associates.
We're also overweight electric utilities with the reason being managements have found religion and are managing their businesses like a standard traditional utility. Spreads are tight, but not much issuance provides for strong technicals. The utilities had gotten more aggressive with their finance companies and then energy trading and got into trouble. But the last couple of years, they have been focusing on their core transmission and generation businesses and not exploring other strategies. They're stable credits and it's more of a defensive strategy in an environment where spreads are tight.
With telecom, it's for the spread. You can get high triple-Bs at a considerable discount. The reasons for the yield opportunities with that are competitive pressures and M&A activity has been putting pressure on spreads. And new technology has some uncertainty with it. [Even with all of the M&A activity such as] SBC Communications and AT&T Corp., management will still pursue conservative financial strategies over the course of the next year. I expect management to pay down debt and the environment to be favorable for corporate bonds.
Do you expect the bid for crossover credits to continue?
Yes. Crossovers have been a big strategy of ours. There are still plenty of companies whose priority is to get back to investment grade. Some of those, we're pursuing actively. Credits like Lubrisol, D.R. Horton, The Gap, Computer Associates and Enterprise Products are moving their way back toward investment grade and should be able to make it there over the next 12-18 months. That's one of the few areas where there's less event risk than the market in general because management is focusing on improving credit quality, because an event has often already happened to make them lever up their balance sheets. It's one of the few areas where there's still upside.
We use a variety of benchmarks including Lehman Brothers' and had already been trying to anticipate rating upgrades. The Fitch Ratings incorporation accelerated some of the price appreciation in the market. But it doesn't change anything in our approach to the market; we still have a large group that we're focusing on.
What are you doing with new cash?
We're allocating to certain areas like triple-A mortgage-backed securities, which look attractive relative to high-quality corporates. We've also been making some commercial mortgage-backed securities allocations and we've been buying some higher-quality home equity asset-backeds. We've selectively found a few that offer as much as LIBOR plus 50 basis points.
Are you concerned about the corporate trend to favor shareholders over bondholders?
That is a trend that is completely in place. We've been noticing with fourth quarter earnings, there's a trend associated with share buybacks and corporate America shifting away from focusing on balance sheets.
This puts higher-quality single-As and double-As at risk. They're looking more to grow their businesses. Although economic growth is at 3-4%, which doesn't represent huge top-line growth, they're looking to make acquisitions and build their businesses. The higher-quality names are more at risk because they have more room on their balance sheets. Companies are thinking it makes sense to run their businesses as a mid-to-high-triple B. An example would be Viacom Inc., which might be increasing debt to buy back their stock aggressively, which would let the single-A rating go. It's more of a credit risk to the higher-quality names because with triple-Bs, most want to stay investment grade. The HCA Inc. descent [to high-yield] was not a typical event, more of a one-off event. I expect triple-Bs to be outperforming single- and double-As.
What other credit trends do you expect to see in coming months?
One trend we've been seeing is a big drop in volatility. The VIX, which measures the volatility of the Standard & Poor's 500, has come down quite a bit. What has dropped volatility is the increased usage of [credit derivatives indices] and credit-default swaps. When hedge funds want to move, they used to have more impact [on volatility] by selling blocks of bonds and on the less liquid stuff they'd have a profound impact. Now, they buy and sell protection on the index. The CDS markets are deep and the bid-offer spreads are thin. The CDS indices have reduced volatility.
We expect volatility to remain reasonably well behaved. We don't see anything that will cause a spike like the economy heating up more than expected or the [Federal Reserve] adopting a more aggressive stance. If the yield curve continues to flatten and we see an inversion, that could push out spreads. We do expect it to flatten, but not an inversion, which would pressure 10- to 30-year corporates. If the Fed raises rates with a measured approach, economic growth is well-behaved and core-inflation is well-behaved, we should see relatively low volatility.
With companies flush with cash, what do you expect them to do going forward?
We're in an incredibly liquid environment right now with record cash balances. They'll drop with share buybacks and the purchases of other companies. We're seeing some big demand for loans in the bank market right now; it's a very liquid market for the corporate bond market. It's very easy to tap the market. Lower quality, shorter maturity, higher yielding credits can easily tap the market and go ahead with refinancings. It's completely the opposite of 2001-2002. The [commercial paper] and bank markets are now completely open to issuers, which is helping to increase liquidity.
Capital expansion is picking up but it's still behind the rate of growth. It should pick up quite a bit this year, but I still think management is going to be relatively responsible--the 2001-2002 years are still not forgotten. But with the earnings announcements, we saw in addition to share buybacks, management is looking for the opportunity to grow.