Credit: The cleanest dirty shirt
Non-financial corporate credit is perfectly poised for the macro environment, but spreads are tight - and other areas of the credit spectrum present considerable risks. Joseph Mariathasan reports
Stephane Monier, head of fixed income at Lombard Odier Investment Managers, is not alone in suggesting that credit will be a better option than sovereign debt over the next few years: “If you are forced to have some sovereign debt, then I would allocate it to high grade emerging market debt, or else markets such as Scandinavia, Switzerland, Canada and Australia rather than the euro-zone, the UK and the US.”
For institutional investors, this requires radical change - and academic theory might not provide much support. If ever there was a place where the efficient market hypothesis seems outlandish, it is the global debt markets. Central banks act explicitly to distort government bond markets, and in corporate credit markets the financial sector is too large to ignore but hostage to government actions that are unpredictable.
When the ECB signalled a new direction by offering its three-year, long-term refinancing operation (LTRO) at 1% and accepting a wider range of collateral, markets turned a corner. But bank debt is still likely to be volatile as investors and rating agencies try to understand the real probability of defaults. In mid-February, Moody’s put the 17 major global capital markets banks on review for downgrade - along with another 114 European financial institutions - to reflect the impact of the deteriorating creditworthiness of euro-zone sovereigns and, longer term, the substantial challenges faced by firms with significant capital market activities.
“The LTRO is helping, but there are still problems over Greece and Portugal with over-indebted borrowers,” says Garland Hansmann of Intermediate Capital Group. “How will that affect default rates? All the other stuff is noise.”
There is definitely huge appetite for fixed income. “We see clients who say that there is a secular change of appetite for bonds, similar to that seen in the 1950s when Alastair Ross Goobey of the Imperial Tobacco pension fund in the UK led the charge to having significant equity exposures,” says Robin Creswell, managing principal at Payden & Rygel in London. “Now it is full circle. If a pension fund knows its liabilities there is less appetite for equity volatility”.
But yields on sovereign bonds are almost non-existent and investment grade corporates are not much better. The market averages of 300-350 basis points at 10 years is heavily distorted by banks, which account for 40% of the value of outstanding European issuance and about 22% in the US. Non-banks are at 175 basis points. That might represent an opportunity, but the challenges in assessing value are immense.
“US banks have refinanced their debt and the balance sheets are getting stronger,” says Sabur Moini, head of high-yield at Payden & Rygel. “The trends for the largest banks are good.”
David Leduc, CIO at Standish Mellon Asset Management, agrees: “The fundamentals of the US banks in terms of asset quality, liquidity and regulatory regime are better on all measures than their counterparts in Europe,” he says, while adding that the key risk for US banks is their entanglement with Europe. A good part of that entanglement is via capital-markets exposure in the banks’ capital structures.
Investors require more capital support for Goldman Sachs and Morgan Stanley than for the traditional deposit taking banks, Leduc observes. But, in general, US banks have a higher deposit base than European banks. January might have seen a huge rally in bank spreads but Leduc warns that these issuers need to fund themselves every day in the interbank and wholesale markets - and will sell off horribly if those markets freeze. “Lehman bondholders got 15 cents in the dollar,” he recalls. “Banks with highly leveraged business models will face continuous challenges.”
This is an issue that the rating agencies have taken on board. As S&P states, AAA bank ratings are still possible but such a bank would have to possess credit characteristics, including capitalisation levels, significantly stronger than those maintained by most banks pre-2007.
When yields on sovereign bonds are almost non-existent and non-financial investment grade corporates are not much better, attention inevitably switches to high-yield. “[Investment grade yields are] very good for corporations but not so good for investors,” says Steve Huber of T Rowe Price. Huber sees high-yield issuers offering low yields relative to historical norms - but spreads of 600-700 basis points over government bonds at least provide a reasonable cushion.
“If Treasury yields go up, the lower duration in high-yield means prices may not go down so much,” he says. “In fact spreads could reduce if rates are going up due to a healing economy.”
It is the uncertainty about whether or not economies are really healing that delivers the extra spread, of course. Investment grade may be low-yielding, but investors can at least be pretty confident that those coupons will be delivered. In high-yield, as Hansmann at Intermediate Capital Group puts it, the risks to manage are default rates and the immediate transfer mechanism that affects that - GDP growth rates. “If GDP growth figures fall rapidly, as well as if there is a change from positive GDP growth to negative, we see a spike in defaults,” he warns. Luckily, over 50% of new high-yield issuance is in Germany, France and the UK, with little coming out of the periphery and, not surprisingly, none out of Greece and Portugal. “But if Germany, the UK and France have another large drop in GDP growth, then it will be a problem.”
Many European high-yield issuers prefer to tap the US market issuing in dollars, observes Moini: “The European banks are still reluctant to lend, despite the LTRO-provided liquidity. There has been $6-7bn of European high yield debt issued in the US refinancing bank debt - including a single-B $500m tranche form Polish telecom operator Polkomtel. There may be challenges for European corporates, going forward, but as long as the global high-yield market stays open, they should be able to refinance bond issues.”
But Hansmann again expresses a note of caution about that big ‘if’: “I was hearing from the lead managers that there is clear ‘Europe fatigue’, as European deals are becoming harder to place among US investors who [have] started focusing on US deals again,” he says.
Much of the high-yield issuance being seen is the refinancing of bank loans, and loans themselves are an alternative investment choice for high-yield investors. Loans have the advantage that, in default situations, recovery levels are high, in contrast to high-yield.
“When we invest in high-yield, we need to be selective, as we do not expect recoveries in a default scenario,” says Hansmann. “In contrast, when we invest in a loan, we do so expecting a reasonable recovery.”
On the other hand, loans pay floating rates over LIBOR, which have become much less attractive since Ben Bernanke signalled ultra-low interest rates into 2014.
Still, John Redding of Eaton Vance notes that BB and B-rated loans, with decent security compared with bonds, are offering yields of between 5-5.5%, unleveraged. European investors have not been big loan investors, compared with their counterparts in the US and even Asia.
“In Europe, legal jurisdictions are a problem,” says Redding. “Chapter 11 in the US is a very well tried and tested regime that allows companies to get through a restructuring. In Europe, every country has a different legal regime and these are much less tested in terms of handling defaults.”
This presents a tricky profile in an asset class that does not offer much upside over the long term: Eaton Vance, for example, has as many as 300-400 borrowers within a portfolio to diversify risk, and of its $25bn in loan portfolios, it has only around $1.5bn in Europe, in around 40-50 mostly large-cap companies across the credit spectrum.
“In the US, the current default rate is close to zero and the outlook is that it is not going to increase,” says Redding. “In Europe the default rate is 4% and the rating agencies are predicting an increase, as a lot of the financial restructurings that should have taken place three years ago did not, and banks were not prepared to take a hit.”
There is a lot of talk about credit; the consensus for economies to ‘muddle through’ this deleveraging cycle with modest growth is perfect for the asset class. But that is merely to say that defaults will be low and coupons will be paid - the scope for capital appreciation through spread tightening in most areas is low.