Is it a way of laying to rest the demons of nationalism (the German dream); a global monetary
revolution (the US fear); or simply a bad idea whose time has come (the cynical UK view), asks Lee Thomas at PIMCO
Whatever your hopes and fears for European monetary union, the markets must now face its consequences. In three months time, the birth of the single European currency will create a capital market in Europe with the potential to rival the US market. For bond managers, this is both bad and good news. Though EMU will wipe out key sources of return, it will also provide many new ways to add value. Until now, most European bond managers have constructed portfolios of countries and currencies. In the post-EMU world, managers must combine these top down strategies with new bottom up techniques.
However, to exploit these new strategies, European bond managers will need to acquire a whole new set of skills. Risk control will be crucial to avoid disasters, and quantitative expertise will be key to unlocking new opportunities, far more so than in the old pre-EMU days.
In five years' time, Europe's bond market will look radically different. Together, the EMU-11 countries' bond markets are expected to grow from $6trn to more than $10trn, rivaling the US market see fig_1. As well as a much bigger corporate bond market, expect an explosion in new products, especially collateralised loan obligations and other asset backed securities.
Driving the explosive growth in Europe's bond market are a number of disparate forces, which are working together to break apart the old order. One of the most underrated forces at work is the death of relationship banking in Europe. At present, European banks intermediate between borrowers and lenders far more than do banks in the US. They offer corporate clients loans at tight spreads, but make up the price on other products. That is why the volume of EMU-11 bonds is small and credit quality is high: most issues are rated AA or higher.
But this will change in the fiercely competitive environment following EMU. Banks will no longer be able to afford sweetheart deals for their clients. In fact they will want to improve their ROE by slimming down their bloated balance sheets. As well as doing less lending they will shed assets by issuing collateralised loan obligations and other asset backed securities. Their corporate clients will turn to the bond market.
Enter Europe's institutional investors, starved for return. They are struggling to make up the so-called funding gap between pension assets and liabilities resulting from Europe's ageing population and bankrupt public pension systems. They have also seen yields shrink (at least in nominal terms) as interest rates have fallen and converged across Europe see fig_2 so are hungry for extra basis points.
So pressure on the old paradigm will be exerted from three sides: corporate issuers bypassing banks, bank intermediaries shedding loans, and investors seeking higher returns. The result: a much broader and deeper bond market in Europe.
EMU will naturally lead to a larger and more liquid market for other reasons:
l Massive portfolio reshuffling will occur as investors and banks diversify out of their home markets.
l After EMU, corporates will issue one tranche of bonds in euros, instead of many tranches in different currencies.
l European sovereign borrowers will issue all their bonds in euros, which will make their bonds more fungible with those of other EMU members.
l As a global currency, the euro will attract global issuers and investors.
l Ongoing restructuring of public sector finances will lead to a growing municipal bond market, and more privatised companies. These will issue euro debt.
l As EMU creates transparent pricing throughout Europe, oligopolies will break down and M&A activity will in-crease. M&A usually means debt issuance.
The result will be a new enlarged bond market that may look much like America's. The EMU-11 is almost as large as the US in terms of GDP. If you suppose Europe can support markets of similar size and diversity as the US, then the EMU-11 government bond market alone could grow from $3trn to more than $5trn by 2003, predicts JP Morgan Securities. The corporate bond market could swell from $1.7trn to almost $3trn and growth in asset backed securities would be even faster.
This new environment will have a dramatic effect on bond managers. They are already seeing their old methods of adding value disappear, at least in the EMU-11. They can no longer bet on one market against another by doing rewarding convergence trades in bonds and carry trades in currencies. And betting on the level and slope of a single yield curve instead of many is obviously harder, especially if rates are fairly stable and the yield curve is relatively flat.
Further, the new bond market is likely to be more efficient as sophisticated investors roam throughout the broader single market rather than being confined to their home markets. This means it may become tougher for managers to beat their benchmarks. The US bond market, after all, is highly efficient and the average manager underperforms.
So how will fixed income managers make money in this new world, and what will distinguish winners from losers?
Passive management is an obvious and easy strategy to pursue, thanks to the growing number of pan-European bond indices. But indexing probably won't be popular. Remember, clients need extra yield.
A more attractive strategy will be to use the old approaches but in new markets. The first group of new markets will be the EU-in but EMU-out countries: the UK, Sweden, Denmark and Greece. The second group of countries are potential EU (and eventually EMU) entrants such as Poland, Hungary, and the Czech Republic.
This is not such a leap as it may seem. France versus Germany was once considered an aggressive convergence play and the franc versus the deutschemark a daring carry trade. Now, the hot trade is Greek drachma versus DM or ECU. But investors should be aware of the risks. Just because the old convergence/carry trades worked doesn't mean these will too.
For market timers, European Central Bank-watching will be another rewarding strategy. They will bet on the future direction of rates based on careful analysis of ECB objectives, policies and people
However, opportunities to use traditional strategies in Europe, however widely you define Europe, are clearly reduced by EMU. So most bond managers will combine the old top down approaches with new bottom up techniques. The explosion of new issues and instruments will clearly create a huge market for credit analysis as investors move down the credit spectrum to pick up yield. Corporate bonds, local government bonds, asset-backed securities, and also derivatives will lend themselves to management techniques now widely used in the US.
Very skilled managers may adopt unleveraged versions of the shrewd trades commonly associated with hedge funds and proprietary trading desks. Most of these fall into the relative value category. The classic ex-ample is to buy a cheap bond, and sell an ex-pensive one in the same sector and close to the same maturity. There are a myriad complex variations.
What will distinguish winning firms in this new environment? Good quantitative skills with an emphasis on risk control will be key. The old world was relatively simple. In the new world, bond managers will have to integrate macroeconomic risks (exposure to the level and slopes of yield curves) with relative value risks (exposure to the spread between instruments), and also with credit risk. So managers will require sophisticated modeling capabilities not only to assess total portfolio risk, but to evaluate individual instruments, such as asset backed securities or Polish debt.
Instead of sticking to a single style, bond managers should focus on the best risk-adjusted returns, however they can be earned. Winning firms will also be those that integrate their emerging markets staff with their other sovereign analysts, and view the world as a spectrum of credits, ranging from low to high risk.
In the post-EMU market, therefore, a manager's track record may not be a good predictor of future success. The new world will mean new winners - and new losers.
Lee R Thomas, PhD is managing director and senior international portfolio manager at PIMCO