A time to be selective
Uncertainty in sovereign markets and attractive credit spreads have seen risk concentrate in Europe's investment grade corporate bond markets, finds Joseph Mariathasan
Historians looking at 2009's European debt markets from the future might well feel inspired to quote Dickens's A Tale of Two Cities: "It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity..."
In the first half of the year more than €180bn of corporate debt was issued, but there is still some way to go before the patient can be said to be healthy after its post-Lehman near-death experience. The high yield market has seen virtually no new issuance to speak of (even the surge recorded in the US appears to be more about refinancing than demand for new money), while the ABS market remains moribund. The seizing up of the credit markets in 2008 has led to an enormous premium being placed on liquidity that still persists, while mark-to-market accounting constraints on regulated, supposedly long-term investors like pension funds works against their buying that premium, even as regulators and central banks attempt to pump liquidity into the marketplace.
Meanwhile, core European governments such as the UK are issuing record amounts of government debt and formulating strategy as they go along, with multiple and sometimes contradictory objectives in mind. Alternative techniques such as syndication have had to be introduced to find investors as the supply of debt overwhelms the capabilities of the gilt-edged market-makers to warehouse stock; previously untested new techniques in the form of quantitative easing have had to be introduced to try to maintain low yields; peripheral markets in the euro-zone have seen spreads against Germany and France rise to hundreds of basis points, while countries such as Latvia, outside the euro-zone, face the prospect of destitution without outside intervention.
European debt markets still face unprecedented challenges. But with the challenges come unprecedented opportunities: are the risks quantifiable - let alone manageable?
Untenable debt level
Unemployment is still rising, although at a slower rate and households, as a result, are constrained in their spending. There is still excess capacity in the corporate sector, so capex is below normal while governments have fired their bullets and the talk now is of the exit strategy from quantitative easing. But how will governments rebuild their balance sheets? "In the UK, the budget deficit is 12-13% of GDP and 8-9% is structural, so it will not disappear, even if the economy improves," notes Ric Ford, a managing director at Morgan Stanley Investment Management. "This is untenable because interest burden will be compounded if tax revenues do not rise."
Governments have to stabilise the macro-economy, face the challenges of their major domestic banks potentially going bust, give government guarantees to bank debt in some sort of sensible manner, and then try and deal with the effects of the credit crunch on the SMEs that are finding banks very unwilling to do what banks are supposed to be doing. "No-one envisaged that so many issues would occur simultaneously and perhaps no- one had estimated the linkages," says Michael Kushma, a managing director at Morgan Stanley Investment Management. "It is like the story of the Dutch boy putting his finger in the dyke to stop the leak, now the governments are having to put lots of fingers and toes as well."
Despite attempts at co-ordinated actions by central banks during the financial crisis, it is clear that deep fault lines exist between the anti-inflationary philosophy that dominates the thinking of the euro-zone players, and the strategies of the US Fed and Bank of England.
"The Bundesbank is not keen on a wholesale increase in money supply growth when the Fed and the Bank of England don't yet see deflationary pressures," says Alasdair MacLean, corporate bond manager at Standard Life Investment Management. "The ECB is more cautious and wants to see more evidence."
But for Valentijn van Nieuwenhuijzen, head of fixed income strategy and economics at ING Investment Management, what is most significant about the government bond market is the normalisation of inflation expectations: "There are not so many worries now about government debt supply or of default by a developed country. Earlier this year, the worries about the success of government actions were causing a spread between index-linked bonds and conventional, implying that the risk of a deflationary environment was quite high. Now the markets are no longer pricing in a depression or an unsustainable rise in inflation and expectations are closer to central banks' inflation targets."
Quantitative easing is, of course, the big unknown in this analysis. Will governments be able to turn off their purchases of debt without causing rises in yield and inflation? Van Nieuwenhuijzen argues that there is not a problem. "You need to look at broad measures of money and they have not been increasing," he says. "There is a massive under-utilisation of industrial capacity and factors like this will reduce inflationary expectations."
Still, many investors feel that it is not so easy to dismiss the inflationary potential of such a huge amount of debt issuance and see little value in government bonds. It is also evident that demand in particular segments can be driven by non-profit-seeking investors, distorting prices well away from any fair values. The index-linked market is a case in point. Bob Swarup, a partner at Pension Corporation points out that in the UK, some £300bn of index-linked demand from pension funds is chasing a limited supply of only £30bn of the appropriate government securities. "This imbalance has caused an unprecedented distortion in the price of long-dated government securities, in contrast to both historical experience and elsewhere in the world," he says. "Real yields at the 30-year mark, for example, now hover around 1%, compared with an average of 3% since records began in 1900 and about 2% in other developed countries such as the US and France."
Within the euro-zone, the flight to liquidity and concerns over creditworthiness have led to spreads over Germany and France ballooning. For the first time under the single currency we are seeing a real change in output rather than the devaluation option. How much unemployment pain can economies like Spain and Ireland bear - and more to the point, how do Germany and France manage this? It could be argued that the spreads shown by the peripheral countries were a free lunch for those not concerned about liquidity. If you doubt that Italy will default, there is a nice 25bp spread over Germany at two years and 100bp at 30 years to enjoy - spreads that by mid-June were already significantly down from their peaks.
But trying to work out default probabilities based on spreads does not get you very far, argues Quentin Fitzsimmons, head of government bonds at Threadneedle Asset Management: "Italian bond spreads in the 1990s indicated that Italy would default within 20 years, but spreads went from 300bp to 20bp on joining the euro," he observes. He has bought Greece, along with Ireland, but concedes that there is "a deep untested fault line" that needs to be monitored very closely. "It is not clear how the situation will evolve," he says.
Raffaele Bertoni, head of fixed income, Europe & Asia at Pioneer Investments, speaks for many when he says: "Our recommendation is to stay with the core euro countries rather than the peripherals, where there is still the risk of spreads widening on the back of credit concerns as well as liquidity." Kushma at Morgan Stanley agrees with that outlook. He says: "While Greece is 100bp over at two years and 250bp at 10 years, we will not be overweight Greece until I know the government is undertaking measures to improve the credit ratings."
Whether a country is better off inside or outside the euro-zone depends very much on its size. The UK is large enough to have kept out of the euro-zone and has now developed a competitive advantage through sterling being devalued and interest rates being slashed.
Those are not options for the emerging economies in Central and Eastern Europe which are fragile, dependent on western investment, and hence cyclical. "They do well when Western Europe does well, and underperform when there is a recession," says Bertoni. "There are issues over the level of public debt when you are trying to implement reforms in a recession. They started programmes of improved public finances but then found that they need to support employment due to weak economic activity arising from a lack of investment from Western Europe. The new euro-zone countries found that domestic interest rates were dragged down to very low levels in an environment where deregulation combined with a huge increase in credit demand leading to real estate bubbles that have to be deflated." Moreover, he adds, consumers were caught out by financing loans in euros, dollars and Swiss francs, leaving them with the double effect of economic slowdown and currency devaluation.
"If Latvia, like Iceland, was not in the EU, the EU would not be helping as much," says Kushma. "Greece is relatively big, but Greece would not default on its debt except by leaving the EU. But the currency support they get from remaining within the euro-zone is essential. One of the solutions for Latvia and Lithuania would be to let them join the euro right now. Doing anything else will just delay the recovery process."
On the corporate credit side, there has been a wall of issuance in investment grade, despite a lack of secondary market liquidity. As David Stanley, corporate bond manager at T Rowe Price explains, the driving force behind this has been the combination of the investment pressure of investors and the funding needs of companies, as the primary markets were practically closed from September last year, while the banks have been wary about supplying loan finance. "The massive new issuance seems to have created a virtuous cycle," says Stanley, noting that "a record supply is meeting strong demand; bonds are performing well after placement, which is attracting fresh demand for cash credits, which in turn allows corporates to obtain funding".
Moreover, as Ford points out: "Even though spreads have tightened over the last six months, over a long-term perspective, investment grade credit spreads are still well above normal levels, as they have gone from 600bp to 300bp while long-term levels are around 100bp." The retail sector in particular has been desperate for yield, given the low money market rates available. Companies have responded by reducing the minimum denomination of bonds from €50,000 to €1,000: "Carrefour could close a deal in 12 minutes and retail interest in corporate bond funds has been huge," says MacLean.
For Andrew Milligan, global strategist at Standard Life Investments, there are two issues when it comes to analysing corporate bonds. The first is the level of investor confidence: "It is noticeable that in the first half of June, there was an increase in risk appetite across the board by investors as they moved into emerging markets, investment grade corporate bonds and high yield debt. If investors feel more confident about a sustainable economy, this will continue."
Secondly, there is the profitability and cashflow of the corporate sector to meet coupon
payments. But this is less obvious and as Ford points out, the question is whether the global economy will react to the green shoots of recovery and sustain growth or whether there will be a "double-dip" recession. The problem Ford worries about is that while inventory rebuilding by the corporate sector may be giving rise to improved economic statistics in the short term, it is not clear where sustainable demand will arise from in terms of government and consumer spending.
In high yield, while there have there have been three or four high yield issues for widely-known credits, the proceeds have been used to refinance bank debt, and there is no appetite for additional leverage. "This is not new capital by and large, say, to build new factories, but instead just refinances existing debt," observes Milligan. "We can see that the banking sector is being encouraged by governments to support small and mid-sized companies, so that banks are focused much less on large companies, which instead have turned to the debt markets. Going forward, large companies may be less willing to rely on the banking sector than they were in the past, wary about whether their access to credit will be secure."
Whatever the long-term dynamics of the different sub-classes within the European bond markets, it is clear that investment grade corporates are leading investor demand.
"We've seen spreads collapse even as new issuance has increased to record pace," says Stanley. "The much wider spreads than the long-term average has enticed bond investors out of lower yielding products, while the higher position in the capital structure over equity of corporate debt has persuaded equity investors to take some risk off the table, following the extreme volatility in the stock markets." It remains to be seen whether this convergence on the corporate debt risk and return will eventually lead investors into at least some of the better quality high-yield names.