After the turmoil
While many investors have been left with severe losses, the massive dislocations raise new opportunities for those brave enough to enter the marketplace, Joseph Mariathasan finds
Pimco managing director Bill Gross states in his April Investment Outlook that, in his opinion, "the private credit markets have forfeited their privileged right to operate relatively autonomously because of incompetence, excessive greed, and in minor instances, fraudulent activities. As a result, the deflating private market's balance sheet is being re-nationalised in some cases with increased regulation, in others with outright guarantees and agency lending."
US fixed income markets have seen unprecedented turmoil during the last year. "There has been an enormous flight to quality in the fixed income markets resulting in a flood of investment into US treasury bonds," says T. Rowe Price director of fixed income Mary Miller (pictured left). "The two-year treasury is now down to 2.20% while the 30-year is 4.47% versus 4.50% at the beginning of the year. So there is a very steep yield curve. In normal times this would encourage the carry trade, with people borrowing short term and investing longer. But there is now a massive deleveraging taking place as people are selling assets."
While leaving many investors with severe losses on their marked-to-market portfolio valuations, the massive dislocations raise new opportunities for those brave enough to enter the marketplace.
Steve Kellner, (pictured right) managing director at Pramerica fixed income management (Prudential of America) sees two key factors for investors to consider. "First is the big deleveraging. Structured investment vehicles (SIVs), banks and hedge funds were all holding higher-quality assets in leveraged positions. That deleveraging has now been largely played out and its effects are behind us. The Fed put a big safety net around financial institutions, effectively giving them access to tremendous liquidity at the discount window. Second is whether the affects on the US economy of the credit crunch will give rise to a recession. With all the actions of the Fed, it looks as though there will only be a recession for a couple of quarters, which will mainly affect consumers."
Miller outlines the turmoil over the last year: "There have been a number of waves of the credit crunch. What started last summer as a housing market issue became a broader credit problem in August and September. In October there was some recovery but in November and December a second wave as questions arose on the capital adequacy of a number of institutions such as the monoline insurers and investment banks. The world's central banks reacted at the end of the year by introducing more liquidity. In spring this year there was a third wave as there has been a crisis in counterparty risks and institutions have started deleveraging their balance sheets. The real problem in the first quarter of 2008 was in short-term funding. This culminated in the mid-March weekend when the Fed rescued Bear Stearns. But the effects of weak lending in the past has given rise to a backlog of issues and that is now set against a weakening US economy."
"The structuring of the securities was fundamentally at fault," says Scott Thiel, head of fixed income at BlackRock. "The structures themselves were not able to withstand the pressures they were put under. The fundamental problem was the loose housing lending standards in the US. Borrowers bought houses in a rising market and when it turned, they could not afford the financing. The reality was that the institutions were willing to fund a house that the client could not afford."
However, the problems were exacerbated by a combination of other factors. "An environment of low interest rates and low volatility tends to encourage a certain type of behaviour - high leverage levels - and when credit spreads are narrow, people start to take on more risk," says Miller. "A period of complacency develops when you have a long space of time with low volatility."
She adds: "Product innovation with CDOs and so on was initially conservative, but as products developed and people became more familiar with them, the terms became looser until more recent ones were positively dangerous. Only a year ago, high-yield bonds were being issued which were ‘covenant light' and high-yield-financed takeovers were damaging the investment-grade market."
Much of the blame for the credit crunch has been laid at the door of the credit rating agencies for flaws in their analyses of asset-backed securities (ABS) combined with oligopolistic power and potential conflicts of interest.
"One outcome of the 2002 debacle when New York state attorney general Eliot Spitzer clamped down on investment banks for issuing biased research was that many firms shrunk their research teams or moved them to support the trading teams," explains Miller. This increased the reliance on the rating agencies.
"Without blaming them, it is obvious that the rating methodologies for securitised assets and structured finance have been invalidated," says David Torchia, (pictured left) head of US fixed income at Stone Harbor. "If you look at corporate credit ratings, a continuous change is seen when a ratings agency puts a credit on credit watch and then downgrades it a notch or two. But on the securitised side, you had the situation where AAA bonds went to BBB overnight and sometimes even to CCC. You should not have such discontinuous changes."
As a result, "we will likely pull back from our rating service-blessed confidence in asset-backed securities," says Gross. "In its place will likely come the increasing reliance on government/agency guarantees as well as the explicit use of the government's balance sheet to support and then assimilate egregious loans of the past decade."
Valuations and economy
The US financial markets are certainly seeing some interesting times. As Kent Wosepka, (pictured right) fixed income manager at Standish Mellon enthuses, "March 2008 was truly a remarkable month in financial markets. During the nine-day stretch from 11-18 March the Fed announced a new lending facility, effectively opened the discount window to investment banks (previously this had only been open to commercial banks), cut the Fed funds rate by 75 bps and arranged the credit bailout of Bear Stearns."
Despite this, Torchia has the view that "economically, whether or not we are in a technical recession, it certainly feels like one and we will feel the repercussions in 2008. If we are in a recession, historically it has not been a good time to be increasing risk in a portfolio. But the way the cycle has played out, some would claim that the markets have run ahead of the economic woes."
However, while the hope is that a recession will be short and perhaps only effect consumers, Kellner sees a "25% chance" that "the housing- and consumer-led recession rolls into a deeper recession that lasts for four or six quarters and leads to a big drop-off in global growth and greater US unemployment."
"We are not completely out of the woods in credit but a long way there," says Miller. "We will continue to see some weakness in housing. We are past the peak of drama on Wall Street and now are entering the more common or garden variety recession which will play out in the local economies throughout the US."
As a result, she continues, "we are now in a different phase where we need to look at the credit quality of bread and butter companies and follow their progress. The steps taken in bringing back liquidity have been quite extraordinary. Longer term, we see more interest rate risks than credit risk as inflation figures start getting higher."
"Because of the lender-of-last-resort operation, subsequent inflationary trends may have been fertilised because the debts that caused the crisis are now primarily in another private portfolio and not liquidated - the Fed having absorbed only 10% of the collateral," says Gross. "These debts have to be validated by policy makers through attempts to increase cash flows in the finance-based economy, which is another way of saying they are trying to reflate, which in turn is another way of forecasting an increasing probability of higher inflation."
"You can debate where we are in the economic cycle and whether or not to add risk, but what is working in investors' favour are valuations," says Torchia. "Now what has been brought to bear is that if you are a buyer of credit risk you have more cushion to play with than you have had for years. For example, if you look at investment grade corporate bonds, the Lehman US credit index was showing spreads over Treasuries of around 80 bps at the beginning of 2007. Today, it sits at 245 bps. The high point was the 268 bps reached in February/March 2008. That peak spread was similar to or exceeded the peaks seen in the last negative credit cycle in 2001-02. So from a credit perspective, spreads are much wider. Even though we have gone down 20-25 bps from the widest spreads there is some potential to go further."
Investment grade corporates
"The greatest value right now is in high quality investment grade corporate credit," says Wosepka. "Why? The corporate spread widening has been disproportionately due to liquidity issues rather than default concern. That's not to say no corporate credits will default, but unlike 2001-02, the spread widening of 2007-08 has come largely as a result of the unwinding of highly leveraged high quality positions. For example, in the past nine months, five-year GE bonds have widened from approximately 50 bps over Treasuries to 200 bps. Has the default risk of GE quadrupled? No; I doubt it has even doubled. Most of the extra spread is due to illiquidity and the unwillingness of dealers to take on any bond inventory. In the past, dealers acted as a bit of a shock absorber. They might keep GE bonds on their balance sheet and wait to sell them later on. Today, dealers either don't bid on bonds at all or they just flush them right through."
Torchia prefers the financials to the non-financial investment grade credits. "The financials are cheaper on a relative basis and are a better bet going forward," he says. "They have underperformed the non-financials but we can make a good bet that they will outperform non-financials in the year ahead. There are still more disclosures and more losses to be announced, but we have seen the bulk. Going forward we will see losses in areas that are more traditional."
Thiel agrees: "The actions taken by the Fed, not only in monetary policies but also facilities introduced to avert a credit crisis, are all very positive factors for financial institutions."
High yield spreads were "probably at around 325 bps at the beginning of the credit cycle", says Torchia. "Earlier this year, it was as wide as 825-850 bps over Treasuries. Now it is 725-750 bps. It is off the widest points, but there is still a lot of potential for general tightening. Our view as a firm is that on a risk-adjusted basis, the opportunities are better in investment grade than high yield.
"If the financial crisis spills into the real economy in a big way, then as high yield is dominated by industrials, we will see big effects, although high yield spreads are high."
Kellner shares this view: "We have more concerns on the high yield sector. It has not performed as poorly and we will start seeing a pick up in defaults with a recession. Also with high yield, we had a lot of LBOs last year at very high prices with an enormous amount of debt. These LBOs could run into big problems in a couple of years."
"The residential securitised sector, apart from the government agencies, is the part of the market that is clearly broken," says Torchia. "It has been broken for the best part of nine months and has still not been resurrected. The first mortgage and home equity are broken and will take some time to recover. If there are opportunities, we would caution again bottom fishing and focus on prime quality. Sub-prime is pretty much gone."
"The biggest opportunity is in the high quality assets that were held in leveraged forms," Kellner argues. "A good example is AAA seasoned home equity loans from the years 2003-05 now trading at 80¢ to the dollar when they used to trade at LIBOR plus 40 bps." Commercial mortgage backed paper (CMBS) is also seen as potentially attractive. "The five-year trades at 300 bps over LIBOR and there is a lot or protection in the structure, with a lot of subordination below and so on," Kellner adds.
Miller agrees, adding: "Our view is that the commercial sector was never as bad as the sub-prime. The collateral is better and the deals were better structured."
"The credit quality in these we believe is superb," says Thiel. "The delinquency rates are modest and the AAA ratings of those issues that we have been involved in have been well justified. They used to trade at LIBOR plus 25 bps and are now trading at LIBOR plus 300 bps or higher so they are incredibly cheap assets."
One sector that historically has not been relevant to European investors is US municipal bonds that, because of their tax-free status to eligible US investors, normally trade at lower yields than US Treasuries. However, the market dislocations have led to municipal bonds trading at similar yields to Treasuries leading to opportunistic plays for non-US investors who would gain no tax advantage through holding them.
"The municipal bond market has seen a confluence of negative influences on prices, almost none of them having to do with the fundamental health of the municipalities," says Wosepka. "First, the auction rate securities market failed earlier this year. Second, municipals are usually described as ‘cheap' not because of their overall yield but because of their yield ratio to Treasuries. If a 70% yield ratio to Treasuries is normal, they may now be at 110%, 120% or even 130% the yield of treasuries. A good chunk of this came not from municipals selling off but from the violent rally in treasuries. If treasury yields decline and municipal yields stay the same, ratios go up.
"Third, a large number of hedge funds leveraged longer maturity municipals and hedged out the interest rate risk in the swap market. That model broke in the autumn and winter as municipals and interest rate swaps did not perform anything like each other. In some cases, the hedge funds lost money in both the hedge and in the municipal bonds. This forced many of the funds to unwind, dumping large amounts of municipal bonds onto the market, hurting prices. Finally, we are in recession. In recession, local and state tax revenue tends to decline while costs tend to increase. On the margin, this reduces the credit quality of municipal bond issuers and should cause spreads or ratios to increase. This last point is probably the least important of any of them, but it is still a fact."
Why could this be attractive to foreign investors? "The points described are transitory," Wosepka explains. "As the world returns somewhat back to normal, it makes no sense that a tax-exempt, virtually risk-free asset should trade at 100 bps wide to a taxable risk free asset - Treasuries. Normally, municipals might have yields 100 bps lower than Treasuries. This will correct itself and opportunistic investors will reap the relative capital appreciation."
For the more adventurous, market dislocations give rise to many distressed sellers. "Investment managers or mutual fund managers may be forced to sell because downgrades are causing violations in their fund or investment guidelines," notes Wosepka. "Hedge funds may be forced to sell because prime broker haircuts on sub-prime assets have gone up, forcing them to reduce leverage. CDOs may be forced to sell because markdowns in price hit loss triggers that require the CDO to be unwound. All of these forced sellers encourage a negative price spiral. That's not to say these are fundamentally great securities - they aren't. But if we can pick up a completely beaten up sub-prime tranche at 5¢ on the dollar that is almost certainly going to receive 10¢ worth of coupon payments over the next year or two, that's probably a pretty good trade. The bond itself might go to zero, but the coupon payments we are likely to receive give us the potential for a 50% or more IRR."
What are likely to be the effects of the turmoil on European demand for US fixed income assets? "Most European clients are in mainly US investment grade corporate bonds and emerging markets debt with some in bank loans and high yield," says Kellner. "They are very cautious in general on the US and nervous about the US fixed income marketplace. They are slowly increasing exposures because spread levels are looking very attractive and in investment grade corporate bonds the spread levels are just too wide to be justified on fundamental grounds."
Stone Harbor sees "steady consistent demand, possibly increased demand. We are tending not to see investment grade only," says Torchia. "Enquiries tend to be for clients wanting multi-strategy, that is emerging markets, high yield, investment grade. Some clients who have investment grade may want high yield."
Thiel finds that investor appetite "depends on their exposure to the market prior to the credit crunch. Institutions with large exposures before the crunch - whether through corporate bonds or SIVs - are trying to reduce exposure over time. But the more opportunistic players are trying to add exposure. So those investors not scathed by the events are likely to want to increase exposure."
"Recently there has been interest in US spread sectors," says Miller. "High yield is interesting because spreads have widened by so much with only modest any changes in default rates. These are currently at 1% and historically have been as much as 5-10%. Spreads have built in a lot of protection now. The breakeven spread is 150 bps, and by that I mean that spreads could widen another 150 bps from these levels before they underperform Treasuries. So we are seeing more interest in high yield? There is waning interest in Treasuries and concerns about the dollar. But how much lower can it get? If the rest of the world follows the US into recession we may see the dollar turning."
For US fixed income players, one thing is clear, says Kellner: "There will be a lot of dislocations and tremendous opportunities so now is a great time to push business in Europe."