Bonds set to sail out of the doldrums
Prospects look good for European bonds, both sovereign and corporate, says Jeremy Yeats-Edwards at Baring Asset Management
The first half of 1999 has generally been a difficult time for global bond markets. Expectations of interest rate rises, along with perceptions of improving economic growth and the possibility of surprises in inflation have meant that most major bond markets seem to have stalled over the past six months. Europe is no exception, the euro-area government markets having declined some 2.5% over the year to the beginning of August.
However, we would argue that bonds are now emerging from this quiet period and are looking towards an improved outlook, and that the fundamentals that encouraged investors to buy bonds in the first half of 1998 are still in place. We believe the outlook is very favourable, and that with markets reaching a turning point now is the time to be increasing exposure to fixed income.
This article will go further into Baring Asset Management’s current views and what we believe investors should be focusing on within European fixed income markets. First, however, it is worth looking at the current environment, and the changes in the fixed income landscape that have occurred (and are still occurring) as a result of European economic and monetary union.
Developments in Europe post-Emu
For fixed income investors, the most basic consequence of Emu was the combination of 11 individual sovereign markets into one Europe-wide equivalent. While differences between the individual markets have not been eliminated entirely, there is now no opportunity for investors to add value from the spreads between, for example, Germany and Italy (now at around 20 basis points for the 10-year maturity).
With spreads at these levels, European investors with hunger for higher yields have been turning to alternatives, and increasingly focusing on European corporate debt.
The past few months bear witness to the dramatic development of the European corporate bond market. Issuance has surged with the introduction of the euro, there having been over $112bn worth of issuance in euro currency for the first six months of 1999 compared to a level of $30bn for the first half of 1997 (legacy currency equivalents, see Figure 1).
What is more, a vastly broader range of credits are coming to the market this year than ever before. A demonstration of the degree to which investors are eager to add yield is provided by the rating decomposition of the new issuance: the proportion of bonds carrying a rating of single A or below has risen over the past two years from a level of 14% of industrial and financial issuance to 37% this year (see Figure 2). In fact, the single-A industrial issuance so far this year exceeds the level of issuance of all industrial credits for the first half of 1998 put together.
Despite this surge of issuance, there is still a very significant gap between the European euro-denominated market and the US market in terms of both size and rating diversity. Moody’s Investor Service rates around 3,400 corporations in the US, compared to around 450 in Europe, and the split between Aaa/Aa rated bonds and lower-rated bonds is vastly different, as Figure 3 shows.
Market observers expect this to change over the coming years as issuance accelerates and the euro-denominated market begins to mimic the dollar-denominated market. To understand how this evolution will take place and how best to take advantage of investment opportunities it is important to understand the drivers behind the market.
One of the most conspicuous drivers of new issuance this year has been the M&A activity in the euro area. Monetary union has challenged corporates and financial institutions to reassess their standing in the corporate landscape. Market leaders domestically now find themselves minnows in the enlarged European market with foreign and domestic competition challenging them in terms of price and service. Companies have therefore found themselves coming to the capital markets so as to finance new challenges to their respective industries, expand internationally or shore up their dominance. As a result of such activity, Tecnost, Mannesman and Repsol have all produced substantial issuance this year in a series of deals that would have been difficult, if not impossible, before Emu.
For the European corporate bond market to develop fully, we will need to see the continued disintermediation of the European banking system. Currently 80% of borrowings occur through the banking sector and 20% are financed on the public bond market. In the US the figures are reversed as the vast majority of corporate borrowings find themselves in the public domain. This disparity is a result of the differences between the role of the state in US and European society. In the US the role of government in the banking system is restricted largely to governance and supervision. European states’ involvement with, and subsidisation of, their respective banking sectors is generally substantially greater. In Germany the credit quality of the state-owned banks is protected, even in the case of potential deterioration in intrinsic fundamentals. These banks are therefore effectively subsidised because their cost of borrowing will be much lower than that of a commercial bank.
The European Commission’s decision that WestLB repay e808m of subsidies to the German state of Nordrhein-Westfalen could herald the beginning of a government withdrawal from direct involvement in the banking system, shifting the focus of state banks to more commercial goals such as achieving a higher return on equity and a better diversification of income through investment banking and debt issuance on the part of their established client base. While there are various political, cultural, and economic reasons why this will not occur overnight, it seems reasonable to expect the disintermediation of the European banking system to be the driving force behind the expansion and development of the European corporate bond market over the next few years.
Lastly, the demolition of national boundaries in the financial world of Europe is sparking an increased focus on shareholder value on the part of European investors. As a result, companies are adjusting their debt-equity mix so that their equity holders are better rewarded. From most companies’ perspective, the benefits of being an Aaa-rated name do not usually exceed the costs (as the qualifying criteria are expensive to achieve). Companies will often accept a lower credit rating to reward their equity holders better . A good example is JP Morgan, which strategically engineered a rating deterioration from Aaa to Aa3 (AAA to AA–) through a debt-financed share buyback between 1994 and 1998.
This is likely to be a path taken by European issuers, and is a major reason why issuance will increase more quickly at the A and BBB level than at higher credit ratings. The example also illustrates how essential it is, when performing corporate analysis, to understand a company’s operational objectives and its desire to maintain or improve its credit rating.
These three pillars of change – corporate activity, disintermediation and the shift toward shareholder value – will underpin the growth of the market and broaden the depth of diversification of credit quality and industry type available to the investor. Naturally, there are still some problems with the market. There is a lack of common accounting standards and an insolvency code, and some obstacles to free capital flows remain. However, as Europe integrates further and these problems are resolved, and as market volume increases, European credit will gain credibility as an asset class and is likely to become an important component of fixed income portfolios.
What’s the attraction of investing in Europe now?
As already mentioned, the euro-denominated universe of credits is growing at a very rapid pace, and is likely, in time, to approach the size of the US market. Looking to this market for a guide as to the future performance of European corporates, it is worth noting that the US corporate market has, on average, returned just under 10% a year over the past 10 years, typically with relatively low volatility. Given a stable economic and financial environment, investment-grade corporates should outperform a government portfolio with a similar maturity and currency structure over the long term.
As to high yield debt (that is, bonds rated Ba1/BB+ or lower), so far only a small euro-denominated European market has emerged, consisting of less than 40 names to date, but this market is rapidly growing. Alone, it is uninvestable for a conservative investor, with over 55% of the universe originating in the telecom sector, and many of the names being rated in the CCC category (a category which statistically carries with it a probability of default within one year of about 19%). As the market evolves and ex-pands it will become possible for investors to base entire portfolios in European high yield instruments, but for now the market is best used opportunistically in the context of a broader portfolio. Our current view is that given the strong possibility of a lack of liquidity in this market as we approach the end of 1999, there is too much uncertainty surrounding European high yield to justify any large positions, but we certainly expect this market to gain greater significance as time goes on.
Corporate bonds in Europe seem an attractive investment, thanks to the likelihood of superior returns, default rates being kept low by strong company balance sheets, and the heavy demand for the asset class from European investors. Their outlook is also helped by the wider fundamental picture in Europe, which means that European sovereigns are also poised for good performance over the next few months.
Earlier this year we were expecting a short-term sell-off in global bond markets, which now largely seems to have occurred, 10-year Euro-11 bond yields having risen from well under 4% at the beginning of the year to practically 5% now. While continental Europe remains slow to address structural problems, there are nonetheless some signs of the beginnings of a cyclical economic recovery, and it now looks as though the accommodating policy stance of low interest rates along with a weaker euro is beginning to prove effective for growth.
That said, the performance of the bond market over the last four months or so suggests that the improving backdrop for the economy has now been fully discounted, if not overdiscounted. Market expectations seem to be pointing to considerable monetary tightening and a rapid reversal of the European Central Bank’s interest-rate reductions of 1998 and 1999, which seems unlikely given the fragility of the recovery in Germany and Italy combined with the fact that inflation is at around 1%. ECB monetary policy seems likely to be on hold for the foreseeable future and accordingly we expect European bonds to recover later this year.
The main reason for the decline appears to have been a loss of confidence in European policy makers. Inflation has continued to move lower in major countries and the growth outlook suggests that monetary tightening is a distant prospect, but the weakness of the euro and the confused verbal response to it have undermined confidence to a considerable extent.
The euro is under-owned, attractively valued, suffering from disappointing economic data, and often opaque policy pronouncements. Recent moves in the currency suggest that a turn in its cyclical fortunes might not be far away, and an anticipated recovery for the euro over the next few months is likely to increase demand for the bond markets, both government and credit. As growth picks up, but inflation fails to materialise, this will provide strong support for the corporate market in Europe.
Why use Baring Asset Management for investing in Europe?
Baring Asset Management has a strong record in European fixed income, with an experienced team of investors and some 60% of client assets under management invested in the region, as befits a Europe-based global asset manager. In the field of European corporates our dedicated credit team are able to leverage not only the firm’s fixed income expertise, but also the skill of our specialist equity teams. Our cautious and prudent attitude towards the developing European credit market, manifested through a disciplined research process, helps us deliver strong performance to our European fixed income clients.
Of Baring Asset Management’s fixed income funds, two are designed particularly for investors based in, or with special interest in, Europe. Both are based in European government bonds, with opportunistic allocations to credit, but they each have a different focus.
The newly-created Baring Euro Bond Fund invests solely in euro-denominated bonds. It is benchmarked against the Lehman Brothers Euro-Aggregate Index (which itself contains credit) and consists of a core of government bonds and high-quality credit, with opportunistic allocation to lower-quality investment-grade credit and to high yield. The lack of currency risk and focus on credit make it a useful vehicle for European investors wanting relatively low risk exposure to the opportunities offered by corporates, as well as for non-Emu investors looking to take a position in these markets.
The Baring World Bond Fund is run to add value against its European government benchmark by investing not only in European credit but also in other bond markets globally. Not surprisingly, such currency and market allocations can mean more volatile positions than will be found in the Euro Bond Fund, but the World Bond Fund has historically produced excellent returns, being ranked in the top decile within its sector over three and five years (Source: Standard & Poor’s Micropal as at 30th June 1999) and having gained a AAA rating from S&P’s fund research division.
Both these funds are now positioned to capitalise on the beneficial current outlook for European bond markets.
To conclude, it is worth re-emphasising the dynamism of the credit market in Europe and the number of excellent opportunities that the growing market offers and should continue to offer in the future. Corporates look to be a good long-term investment, offering higher yields than government bonds of the same maturity, provided the necessary credit work is done prior to investment. The market is quickly approaching critical mass where strategic allocations to the asset class will be essential and the current environment is strongly encouraging opportunistic investment in European corporates.
Although some short-term uncertainty exists, the underlying long-term environment for European bond markets is still favourable, for a number of reasons. We are in a period of slow growth and very low inflation, with forecasts pointing to a stable outlook. It is extremely hard to argue that we will start seeing inflation rise – capacity use rates are low, and price transparency is spreading thanks in part to the euro and to technological advances.
Crucially, these are the same factors that made bonds an attractive asset class during 1995-1998, and the beneficial influences are still present now. We are more bullish than we have been over the last few quarters on most quality global bond markets, and Europe is no exception to this.
There is a sound fundamental backdrop and excellent opportunities becoming available in corporate debt markets, and we expect that fixed income as an asset class is once again poised to produce good performance for investors in Europe through the medium to long-term.
Jeremy Yeats-Edwards is investment manager, fixed income specialist investment team at Baring Asset Management in London
Baring Asset Management Limited (regulated by IMRO). The value of units and any income generated may go down as well as up and is not guaranteed. Changes in rates of exchange may have an adverse effect on the value, price or income of the investment. Investors must refer to the fund prospectus before investing.