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Where to Find Future Winners in Corporate Bonds

Morningstar 2012 Fixed-Income Fund Manager of the Year Mark Kiesel says housing and energy sector bets proved positive last year, and he sees multiyear growth potential in these and other areas.

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Miriam Sjoblom: Hi. I am Miriam Sjoblom, associate director of fund research at Morningstar. I am here today with Mark Kiesel, who is the portfolio manager of PIMCO Investment Grade Corporate Bond and winner of Morningstar's Fixed-Income Manager of the Year for 2012. Congratulations, Mark.

Mark Kiesel: Thank you.

Sjoblom: Well, thank you for joining us. Now, you've had a long track record at this fund, posting very good returns, but let's talk about 2012 specifically. And coming into 2012, can you talk a little bit about what your outlook was at the beginning of the year and how the fund was positioned?

Kiesel: Sure. Well, we were somewhat cautious on the overall economy as we started last year, but we did have a couple of contrarian views. One was banks, which not a lot of people wanted to own, and we held that position through 2011. And then in 2012 it turned out to be a very strong performer, one of the strongest performers in the investment-grade market.

Also last year, we embraced the recovery in housing probably sooner than some, and our exposure in building-materials credits, lumber companies, title insurance companies, and appliance companies proved to be very good for the fund.

And then finally, we also embraced the energy revolution earlier than some. And so we took advantage of companies that are growing earnings significantly faster than the overall economy and some of these midstream master limited partnership companies. So, it's really a combination of riding through the storm with the banks as well as really embracing the housing recovery and energy revolution maybe earlier than some other managers.

Sjoblom: You talked about being positive on housing early. Can you talk a little bit about your thesis and how you were able to get more comfortable sooner?

Kiesel: Sure. We spend a lot of time--obviously everyone's familiar with PIMCO's top-down macro. And on the macro front, I think what became very obvious was the inventories were coming down much faster than people thought. Right now today existing-home inventories of just over 2 million are at 11-year lows, and the new-home inventories are basically near 50-year lows. So, a lot of inventories have been absorbed into the market. The other thing is that household formation is picking up faster than what some people may have thought, given the decline in the unemployment rate.

And then what's happened is that prices for housing literally fell 35% from the peak. It's a combination of the fact that America has very, very cheap real estate--housing--and that supply and demand is changing. I think the biggest change came out of our bottom-up research, which we started doing over a year ago when we met with the homebuilders and building-materials companies. What became very clear was that consumer psychology at the margin was changing.

Specifically, people finally felt about nine months ago that housing would no longer go down in price. And that once you change that momentum, you would get demand to pick up, and that's actually what's happened. And so, our investment in the banks, in the building-materials companies, the lumber companies, like Weyerhaeuser, title insurance companies, appliance manufacturer Whirlpool, all those investments have paid off.


Sjoblom: One really good-performing area of the market would be the homebuilders last year. But can you talk a bit about why homebuilders didn't really factor into your portfolio too significantly?

Kiesel: Sure. Well, as with investing, sometimes you get things right and wrong, and I think in hindsight we probably should have bought more homebuilders. I think what got us concerned there was that basically homebuilder supply--it takes a while to get this inventory actually on line for the builders. They actually need a lot of land, and so the land was still in shortage.

And in fact, when you look at the early recovery, well the equities of the homebuilders went up significantly and were one of the top-performing equity markets. The bonds actually didn't do nearly as well as the building-materials companies'. So, we felt a better way to play it, particularly given our investment philosophy which is a longer-term approach, was to play the building-materials companies which can have sustained strong returns for several years. Whereas the builders would see that initial equity pop, but it wouldn't accrue over a longer-term investment horizon, which is more consistent with how PIMCO approaches the market.

Sjoblom: Some investors are talking, after this great year for credit in 2012, about shifting course, that maybe a lot of the value is now gone from the corporate-bond market. What's your view?

Kiesel: Well, I think, overall, yields are definitely low, but they were low last year, as well. The spreads have tightened. But I think in this market, people are still going to embrace the global credit markets. I think you are going to have to be more selective. You're going to have to find what we call diamonds in the rough. And our strategy is really to focus on the faster-growth areas. We still think the global credit markets have significant opportunity.

Housing and energy are multi-year-recovery investments. What that means is that this isn't just a play over a quarter or even two quarters. It's a multiyear investment cycle. So, housing and companies related to the recovery in housing should do well in 2013. There are many companies in the energy industry, specifically the midstream MLP sector, which are said to grow very fast in 2013--10% to 15% potential earnings growth.

And then we also are probably rotating somewhat out of our bank overweight into more emerging markets, specifically in China gas distribution, also in gaming which we started to build up a bigger position in last year, and then finally some of the emerging-markets banks, which now that the U.S. banks have significantly outperformed, we see increasing opportunity in the emerging markets to buy banks there.

Sjoblom: Some of the same themes that worked for the fund last year you expect are setting the fund up for good returns in the future, as well?

Kiesel: Yes. And just to kind of boil this down into why that is, if you look at housing starts--housing is a sector that we're bullish on and we're bullish on it all throughout this year. And because the market was so depressed--if you think about it over the last 50 years, housing starts typically average about 1.5 million, but we're currently only at 900,000--this is a market over the next one to two years that can grow 15%-20% easily.

And more exciting is we hope we can find companies that will grow even faster than that. Similarly, the U.S. economy is producing now about 8%-12% growth in the production of crude oil and gas. Yet, within the energy industry, certain subsectors grow even faster than that, like the gathering and processing and transportation parts of the energy industry, specifically the midstream MLPs--companies like Highland Partners, companies like MarkWest Energy, companies like Targa Resources. All three of those companies we think you're going to see 15% to 20% earnings growth this year and also be sustained. MarkWest, for example, is going to literally double its takeaway capacity in the Marcellus shale over the next two years. So, there are certain companies in this energy revolution in America that are really going to benefit we think, and so we're optimistic that we can hopefully find those good companies, those diamonds in the rough in that sector.

Sjoblom: Your fund is a corporate-bond fund. What would you tell investors who are maybe looking to benefit from these growth opportunities that you're mentioning as far as what is the better place to do it: in stocks or bonds?

Kiesel: I think, in general in gaming there is value in both the debt and the equity. Gaming is an industry that's growing very rapidly because of the growth in Asia, companies like Las Vegas Sands, companies like Wynn, and even MGM. These are companies that will likely see earnings and EBITDA growth above 10% in 2013. They're also trading at reasonable multiples. If you look at the MLP sector, those companies' equities are trading about 10 to 11 times enterprise value to EBITDA, and they're paying distribution yields of 5% to 8%. Yet their top-line cash flow is growing at 10% to 15%, and the distribution yield can grow.

These are exciting businesses across the entire capital structure, the gaming industry, particularly because of the growth in Macau and Asia [and also] the master limited partnerships. So, growth can be good for bonds, it can be good for equities, as well. And the multiples on those MLPs are still, I think, quite attractive.

Sjoblom: You sound pretty optimistic overall. Is there any area that you're concerned about?

Kiesel: Sure. We're very concerned about obviously, the fiscal cliff and well, they were able to get the vote through the House of Representatives, and we have near-term resolution. The debt ceiling will be ongoing volatility for the markets over the next one month to two months, and quite frankly Congress hasn't really done anything to address entitlement reform or the longer-term structural issues. So politics and political uncertainty will be a huge issue particularly in the first quarter. That could cause risk assets to suffer, the equity market, consumer confidence, et cetera.

So we are more concerned about that. We're looking at growth below trend. We're looking at 1% to 1.5% real growth, with the fiscal cliff hitting growth probably 1% to 1.5% for 2013. So, while we can potentially hopefully avoid a recession, this is going to be a relatively low-growth environment. And so because of that, the strategy again is to favor these sectors that are multiyear winners, [that have] multiyear growth potential. And I think focusing on these housing and building-materials companies, the MLPs, the emerging-markets growth opportunities, gas distribution, the gaming sector, and some of the selective banks, that's the way you really have to play it given this environment.

Sjoblom: Mark, thank you for joining us and sharing your insights, and congratulations again.

Kiesel: Thank you so much. Appreciate it.

Miriam Sjoblom does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.