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A new taxonomy

Market dislocation and unpredictable government interventions have re-ordered the natural environment of credit. Joseph Mariathasan asks if the old taxonomies are still fit for purpose

Investors are surveying a new specimen box that looks very different from the old one. While global equity markets have dropped 50% or so from their highs in 2007, a widespread view is that they still do not  offer the best risk/reward trade-off compared with the credit markets.

Ric Ford, a managing director at Morgan Stanley Investment Management, argues that the economic data being released has had a negative bias so it appears likely that company earnings will be weak in the short term. There is a refinancing risk embedded in the capital structure of the corporate sector, given the uncertainty about the future availability of capital from the banking sector. There is a clear shift in emphasis from equity holders to debt, with companies no longer buying back equity but focused instead on making sure their bond holders are happy and refinancing is available.

Within credit, the widespread interventions by government have introduced a new dynamic into the marketplace. With governments adopting an eclectic approach to bank bailouts and a random character to corporate bailouts, fixed income managers are having to throw out traditional credit analysis and coach themselves on behavourial economics to try and second guess them. Moreover, while the primary markets have re-emerged as a vibrant source of investment opportunities, the secondary market is still very illiquid, with the disappearance of investment banks acting as market makers. As a result, as Jean-Francois Boulier, managing director of Aviva Gestion D'Actifs argues: "There are currently incredible investment opportunities in credit if you are able to undertake the analysis and can diversify your holdings, but you face a liquidity risk that will not disappear very quickly." 

Valuations
Valuations in the debt markets have been driven by the distress and dislocations that we have seen since mid 2007. For Luke Spajic, head of European credit at PIMCO, there are three factors that stand out: first, the housing markets, in the US in particular; second, the development and evolution of structured credit and the financing for housing and other credit markets; and third, the global savings imbalances that have helped finance the first two.

Spajic notes: "Now that the housing market has collapsed, the asset backed security (ABS) market is moribund a nd it is not clear when, if ever, it can be resurrected - and the savings surpluses in countries like China and Japan are disappearing." He adds: "There is a steep decline in global growth so now credit has dried up with the banks becoming the new high-yield market. Growth is negative on a synchronised basis globally and both growth and unemployment are projected to get worse."

The debt markets also face severe technical pressures that have been a major factor in the current malaise. As Spajic points out, leveraged investors - the natural buyers of many debt products - have disappeared, while the wealth destruction across all asset classes has left investors with less cash to invest.

Fundamentals

PIMCO's preference echoes that of many fund managers seeking a safe route through unfamiliar territory: investment grade bonds issued by non-cyclical businesses with stable cash flows, possibly regulated, possibly national champions - in other words, utilities, telcos and food retailers with credit ratings above BBB.

"I would avoid everything outside this, like  cyclical, leveraged companies, high volatility industries, housing related and so on," warns Spajic.

Rising defaults and downward credit migration will be the story for 2009. Spajic is also very watchful for "defaults in disguise" - borrowers in difficulty renegotiating with investors either to extend maturity because they can't pay the capital back, in exchange for a higher coupon, or to lower coupons in exchange for pledges on assets.

"If a borrower tries to vary a coupon, it means that they are trying to break a contractual arrangement that was agreed when the bond was purchased," says Spajic. "It's technically not an event of default if investors all agree, but these exchange offerings can be a red flag to us."

The bank debt market
Bank debt represents a large percentage of corporate bond indices and developing a strategy to deal with a marketplace that is being driven by government interventions is essential. As Ford argues, there is value in the senior paper because there is a very low likelihood of default. "The large retail banks are part of the financial infrastructure of the economy and are likely to be supported by government,"  he says.

But as Neil Murray, head of corporate bonds at Scottish Widows Investment Partnership, says, the financial sector itself has become bifurcated, with investors seeing the major retail banks unlikely to experience defaults at a senior level, but nurturing worries about paper issued further down the capital structure.

Understanding the opportunities and risks within the financial sector is now a critical aspect of corporate bond investment. There are four levels of debt issued by banks. The senior debt in Europe ranks pari passu with depositors. In the US it ranks lower than depositors. Underneath senior debt lies lower tier two debt, where bonds can have a fixed bullet maturity on a structure extendable by five years with a penalty. But as Murray points out, under current market conditions the penalty is not particularly severe.

Next down the capital structure is upper tier two debt. This is a perpetual bond in nature but with a call date that is extendable with a penalty. There is the ability to pass on a coupon without incurring a penalty, although missed coupons are added cumulatively and need eventually to be paid. Below this ranks tier one capital, with most bonds callable in principle but perpetual in nature. And as missed coupons are not cumulative, it is more like equity in producing true risk capital.

As Murray points out, both tier one and upper tier two capital have sustained severe falls in the marketplace, with investors concerned about the effects of nationalisation, and so on.

Many fund managers would agree with Rodrigo Araya, head of fixed income at Lombard Odier, that investing in bank paper is a capital structure play. "You should buy the senior debt where the credit is often government risk, while the subordinated debt needs to be looked at on a case-by-case basis," Araya suggests.

Murray is willing to consider upper tier two, but like most of the marketplace, he is unwilling to purchase tier one paper. In February, RBS tier one paper was trading at teens in the pound while HSBC was in the 50s, reflecting investor concerns about default risk at this level in the capital structure. Murray's view is that it is not yet the time to get into tier one or upper tier two as there is still a great deal of forced selling in the marketplace. "While yields of 20-30% may appear attractive if the coupon is paid, if there is no coupon, the yield is zero," he says.

Impact of government support
From an investor's perspective, there is a random element to the bailout of corporates and, as Spajic argues, policymakers have also yet to outline a clear strategy for bailouts of non-bank credits. Policy might evolve on a per-case basis as governments deal with one corporate credit crisis after another. Bailouts are likely to be based on political parameters, rather than commercial reasoning. As a result, managers such as Ford are focusing on which sectors and companies are most likely to receive government support if there was a need for liquidity. "We try to identify not just companies that will survive, but those where we, as bond holders, will survive with them, as it is possible for companies to be reconstructed with the bondholders facing ruin," Ford says.

He also raises the issue of increasing protectionism arising from government bailouts. The banks that receive government funds are well aware that they are being funded by domestic taxpayers, and the pressure will be to lend domestically at the expense of non-domestic companies, raising doubt about the ability of some companies to access capital.

High yield
The high yield market was down 45-50% in 2008 says Spajic, so not surprisingly, yields are now at historically very high levels, assuming coupons do actually get paid. Tatjana Greil-Castro, managing director of Muzinich's European operations, points out that high yield is pricing-in default rates of 20% assuming a 35% recovery rate.

"At these prices, it is difficult to identify an asset class with a more attractive risk/reward profile than high-yield bonds," argues Douglas Forsyth, portfolio manager for the Nicholas Applegate Capital Management high yield strategy. Forsyth argues that although defaults are likely to rise because of the current economic crisis, they are unlikely to reach past recessionary cycle highs because of fundamental changes in the high yield market compared with market characteristics of 10 years ago. He notes that  the high-yield index is now more broadly diversified, with few industries representing more than 10% of the benchmark, in contrast to a 42% concentration among technology, media and telecommunications companies a decade ago; there are now also stronger balance sheets due to refinancings over the past several years; and US companies in general have lower debt-to-capital ratios, with enhanced interest coverage and extended maturities. There are also record low prices  relative to recovery rates. The average bond price was 57% of par at year-end 2008 versus 75% of par during the last economic downturn. Moreover, Forsyth argues, bonds that are likely to default are trading at or below their recovery levels.

Despite all this, many other fund managers are wary of investing in a marketplace that will be hardest hit as defaults rise in a recession. Spajic argues that high-yield investors need to be wary that while the yield looks interesting, they have not been stress tested in the weakened state of the world that we are now facing, and recovery values might be significantly lower than previously thought.

Another factor worth bearing in mind is that the high yield market does not come under the regulatory umbrella that is being drawn up in terms of government guarantees and support to the marketplace via "quantitative easing".

High yield specialists counter that through good credit analysis and a cautious investment strategy it is possible to take advantage of what is an unprecedented market dislocation. Muzinich is looking at companies with good visibility of cashflows that are relatively recession-resistant. As Greil-Castro finds, there are many anomalies, particularly in the boundary between investment grade and high yield: a step change in spreads occurs with BBB- showing spreads in mid-February of 700-800 bps for cyclical stocks and 450 bps more generally, while BB+ defensive stocks could be 1800 bps over.

Leveraged loans

The market dislocations have also thrown up some interesting possibilities in the leveraged loan market. Emma du Haney, product specialist at Insight Investment Management, argues that a lot of the natural buyers of loans have been hedge funds and Collaterised Loan Obligations (CLOs), which have been forced sellers. Spreads have gone from 250bp to 1300bp over LIBOR for an average credit rating of B+, with some at investment grade. As she argues, they are high in the capital structure and enjoy a high recovery rate.

"Insight deliberately did not start investing in loans until mid 2007 so we were able to position ourselves at the outset for the more defensive risk averse market environment ushered in by the onset of the credit crunch, both in terms of name selection and position sizing," she says.

Liquidity - the primary market versus the secondary
During the past year, the dispersion of returns across fixed income fund managers has increased massively. The reason for this, Araya says, is because many fund managers have been stuck with illiquid positions.

"The key factor is to be liquid," he says. But with the investment banks no longer able or prepared to act as market makers, that is not so easy. There is a two-tier market; investors are happy to buy new issuance as borrowers are willing to pay a huge premium of up to 100 bps over the levels in the illiquid secondary market. With the absence of banks acting as market-makers and the demise of leveraged investors who had much higher trading levels than so-called ‘real money', this position is unlikely to change easily. As a result, Boulier is seeing increased use of brokers to match trades in the secondary market between end users. "The stock markets have higher risk but at least you can sell a position when you want to," he says.

Relying on the primary market for new investment raises the problem of getting the allocations that a fund manager actually wants. Boulier finds that there is no real way to get large investments outside the primary market. As of end-February, there has been more than €50bn of new issuance in Europe this year and all have done well, according to Araya. But the problem here is that investment banks generate demand prior to a placement and then investors find their allocation is poor - "often been less than 50% for a number of issues", according to Boulier.

Araya finds that even new issues of cyclical stocks are oversubscribed: "Investment banks placing new issues make a distinction between investors, depending on what their behaviour has been in the marketplace over recent years," he says. "Hedge funds are failing to get the allocations they used to get, which is now being given to real money."
For some firms, this might be seen as a competitive advantage. Spajic argues that PIMCO's good relations with CFOs, treasurers and the investment banks leading bond issues means they can have discussions on what they want.

The new-issue market is very vibrant for high quality names. "Treasurers and CFOs have embraced the new level of yields and accepted the current credit conditions and realised that the bank financing they relied on in the past may not be there, encouraging the use of the bond market as a source of financing," says Spajic. "Equity investors see that the equity risk premium returns are available in bonds at one-third the volatility, so we are seeing a major influx of investment form equity holders and from holders of government debt."

The dichotomy between the revived primary marketplace and the moribund secondary market does mean that new funds have the advantage of starting with a clean sheet of paper. Payden & Rygel are tapping into this by launching a new fund focused exclusively on investment grade bonds. As managing director Robin Creswell says: "A lot of clients are finding that many funds are full of legacy bonds that the managers could not sell when they had redemptions from their fund. So investing in these means that you are just diluting other peoples problems."

A recent development in France, according to Boulier, has been the launch of a number of retail funds that buy and hold new issues to maturity, giving the funds four or five years' life before turning themselves into money market funds once the bonds mature.

Credit default swaps
The use of credit default swaps (CDS) to manage corporate bond portfolios has now become integral for many fund managers. Indeed, Araya argues that there will be a further concentration of asset management among fewer players: "If you are competing to win large mandates, the ability to use CDS will be crucial, Fund managers that have the ability to use derivatives including CDS will win the game," he says.

Despite this, many institutional investors are wary of utilising over the counter (OTC) derivatives and, as Murray says, moving the CDS market onto an exchange would make a big difference to them. Given the pressure from regulators, the marketplace is shifting towards that position as well, with a likely first step being the use of a central clearing entity while dealing could remain with investment banks. Eurex, for example, is taking this route, offering the facility to novate transactions undertaken bilaterally onto the central clearing facility of the exchange.

At least four exchanges are likely to offer CDS. Some will stick to indices, others to single names and some will attempt both. One question is whether institutional investors would regard derivatives that are cleared through an exchange but traded bilaterally as equivalent to ‘exchange traded' derivatives in terms of the latitude they give to their fund managers to utilise them.

In conclusion, the primary marketplace appears to be thriving, even if the secondary market is still dead. Beyond the obvious investment-grade primary issues lies a universe of credit investments that requires more specialist management and the use of the CDS marketplace in lieu of liquid secondary markets. Long-term investors able to take liquidity risk are in a privileged position. But do they have the correct corporate governance structures enabling them to break free from a dependence on mark-to-market valuations in markets where no reliable ones might exist?
 

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