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Europeans play pick and mix

As the deepest and most liquid market in the global investment universe, the US debt market cannot be ignored. But while it may provide an ocean of liquidity, has demand for US Treasuries, particularly from foreign investors, turned the ocean sterile for investors looking for sustenance?
As Alex Over, director of Standish Mellon Asset Management points out, “US bond yields are below the earnings yield, or the inverse of the S&P 500 P/E ratio, for the first time since the early 1980s, and at this point in the cycle, equities do look attractive to bonds”.
Despite this, the existence of investors driven by non-economic motives does create opportunities in specific sectors. The reaction of firms with strong US fixed interest capabilities is increasingly to separate the alpha from the beta component of their product offerings and develop absolute return products that can offer a portable alpha.
The appetite for US debt and debt products is very mixed in Europe and the narrowing of corporate spreads is having an impact. “European investors adopt either a scattergun approach focused on particular sectors, or else adopt a broader approach including US in a global aggregate portfolio,” according to Mary Miller, the director of fixed income at T Rowe Price.
Her group for example, successfully gained their entry into the European market through offering US high yield bond portfolios to the Danish market.
The high yield strategy was closed to new investors in 2004, reaching a peak size of $11bn (€8.6bn) according to Miller, but “is back to $10bn as $1bn moved away because of reallocation decisions away from high yield as credit spreads tighten”. Kevin Cronin, Putnam Investment Management’s CIO finds that while “in the US, you can approach the market in a certain way because it is homogeneous” the attitude of European investors towards different segments of the US market is very country
specific.
“In Scandinavia, they are very receptive to the US mortgage market, while in France, they are slow to accept mortgagees but keen on derivatives. German institutions by contrast, are keen on asset backed securities but not derivatives and are more cautious than institutions in Spain and Italy. German institutions are also investing in broad-based US fixed income strategies whilst German banks are interested in CDO and CLO structures.
The Nordic region is definitely where there is more acceptance of new strategies whether cash or derivative than elsewhere. In the UK, pension plans are very focused on liability-driven investments (LDI) rather than absolute return” although he adds that “there is a lot of talk about LDI but not so much action”.
As the graph below right shows, US treasuries now account for only around 25% of the total US debt market, while securitised bonds, predominantly mortgage-backed securities (MBS) and also other asset-backed securities (ABS) account for the largest share of the US market at just over 40%, with the corporate bond sector accounting for just over 19% in the benchmark Lehman US aggregate index. The other important sector in the US is inflation-protected securities which, linked to US inflation, are less likely to appeal to European investors.

With around $2.2trn US treasury bonds held by foreigners, much of it by central banks, they are still seen as the “safe harbour” investment by global investors. As Miller points out: “Foreign ownership of the US treasury market is close to 50%.” She argues that “since 1998, there have been a number of favourable factors for US treasuries”.
There was a flight to quality after 9/11 and another after the corporate meltdown in 2002. Also in 2001, the US was in surplus so the treasury stopped issuing 30-year treasuries.” However she adds that “the supply demand balance is now changing with more interest in European bonds and more supply of US treasuries. The US has a deficit again and in February 2006, the 30 year bond was reintroduced, while global investors are also getting more involved in US corporates and mortgage bonds so the position in treasuries is less favourable than five years ago. But yields are still attractive relative to many foreign options.”
In the US corporate bond market, spreads are at historical lows, which leave little upside with increasing downside risks. Gary Bartlett, who heads Aberdeen Asset Management’s US fixed income operations in Philadelphia, (which formed part of the Deutsche Bank Asset Management acquisition), says: “There is greater risk now from corporate actions that would be detrimental to bond holders such as private equity financed LBOs, share buybacks and dividend increases. For a while, back in 2001 and 2002, bond and equity holder interests became aligned as corporate CFOs focused on strengthening the balance sheets and cleaning house.
“The house at this point is quite clean and in good shape. Market spreads reflect that but that just leaves you in a position where you are not getting much yield.
“Now corporate CFOs are focused on enhancing shareholder value, so they could very well do something that would be detrimental to bondholders.”
Pimco’s Mark Kiesel also believes that “with healthy balance sheets and high cash balances, corporate America has less incentive to cater for bondholders” and the increased dividends and share buybacks are “draining valuable cash reserves that would come in handy should economic growth slow and credit fundamentals weaken”.
The influx of investment into private equity has had major ramifications in the corporate bond markets although as Aberdeen’s Bartlett points out “we have not experienced in the US market as many problems as European credit markets had in the past six months in terms of LBO activity.
In the US it is more potential risk and less realised risk at this point but still the potential risk is quite high because of all the economic forces of these private equity pools, looking for deals day in and day out.
Most of the investment grade market has very few covenants; you find more covenants as you go down the high yield market and stronger covenants as you get into bank loans and so forth.”
Bartlett adds that: “Given where market spreads are, you aren’t getting paid a lot on credits generally. Our view simplistically is that you win by not losing in an environment like this, so avoid the potential loss, companies that are most susceptible to LBOs and significant share buybacks etc.”

The sector that probably deserves greater attention in Europe is the mortgage backed securities market. This consists of securities issued by three agencies: The Government National Mortgage Association (GNMA and commonly referred to as ‘Ginnie Mae’; the Federal Home Loan Mortgage Corporation (FHLMC, referred to as ‘Freddie Mac’); and the Federal National Mortgage Association (FNMA and referred to as ‘Fannie Mae’). GNMA is a direct branch of the US government and the other two agencies are Government Sponsored Entities.
All three operate by aggregating pools of residential mortgages and issuing pass-through certificates representing shares of the interest and principals of the home loans.
The main reason that these securities should be of interest to European investors is their credit quality. Both Ginnie Maes which are explicitly guaranteed by the US treasury and Freddie Macs and Fannie Maes, which are guaranteed by Government Sponsored Entities, are considered to be higher quality than AAA rated corporate bonds. Their backing is not only that of the US Government but they are also secured on residential property.
The second reason that the MBS market should be of interest is the liquidity which is comparable to and in some cases better than the US Treasury market and indeed, during the 9/11 dislocation of the market, the MBS market was less affected.
The US mortgage market has two fundamental features that make it different to the European mortgage market; firstly, the fact that they are predominantly fixed rate rather than floating and secondly the fact that homeowners have the option of prepaying the mortgage without incurring any penalty. What this means is that if mortgage rates fall, then the bonds will be repaid while if mortgage rates rise, people will stick to their existing mortgages for longer giving rise to the effect that the duration of MBS will shorten when rates fall and rise when rates rise.
This ‘negative convexity’ is difficult to model but MBS holders have been compensated by higher yields, although as Miller points out, “as we languish in a low interest rate environment, the high coupon bonds have been repaid and as a result, today there is far less prepayment risk than before”.
Standish Mellon’s Over sees three key factors that will dominate the US debt markets that it is monitoring: “First, the rise in global savings which has been mainly driven by the wealth transfer from oil consumers to oil producers which has helped keep bond yields around the world low, particularly in the US.
This global savings glut should diminish over the next few years which will put upward pressure on bond yields: Second, the cyclical developments in the US, particularly the unemployment rate and inflation to judge the direction of Fed policy. The US economy has been very fortunate that inflation has been low and that Fed policy has been ‘normalised’ without any financial accidents. If the unemployment rate drops towards 4% then the Fed would get much more restrictive with policy, probably raising rates over 6% but that could be a couple years away. Finally we are watching the credit cycle to see if companies start to take on more leverage and risk.”

Pimco’s Bill Gross says investors are faced with “global real interest rate valuations capped at 2% in major markets and yield spreads almost everywhere that suggest maximum future bond returns of 5%-6%”. Almost all risk premia in global asset classes he sees as trading at illogically low levels arguing that “when one can buy a US agency guaranteed FNMA mortgage at a higher yield than almost all emerging market debt, then there exists an irrational pricing of credit”.
T Rowe Price’s Ian Kelson sees US risk premia as more attractive than other markets: “We like value in US sectors compared to other sectors globally. US spreads are higher than Euro-zone, and from a corporate viewpoint the best opportunities are in the US, so we are overweight US spread risk,” but he adds that “we do not like US interest rate risk – yields are going to rise so we have hedged out interest rate risk”.

Fund management approaches
As Putnam’s Cronin notes, institutional investors can be divided into three: those who are interested in traditional products who would use the Lehman US Aggregate index as their benchmark in the US, or the Lehman Global Aggregate index outside the US; large, more sophisticated clients who are interested in separating alpha from beta and seek absolute return strategies in the debt markets and would consider everything from mortgages to credit and emerging market debt; and in the middle, those investors who are increasingly showing interest in liability driven investment approaches”.
Fund managers vary in their ability and inclination to cover all three segments of the market. Specialist fixed income firms such as Pimco pride themselves on offering a full coverage of the complete universe of fixed income opportunities.
“Outperforming riskless government debt and/or producing alpha often comes from accepting the risk associated with assets with attached risk premiums,” according to Pimco’s Gross, who also points out that “with almost all premia at compressed levels, strategic alpha in 2006 will come via the voiding of most premium or carry trades from portfolio composition”.
The sophistication of the debt derivative markets in the US allow fund managers to trade option, credit, curve and liquidity premia giving them the flexibility of hedge funds without, as Gross warns “breathing fire and assuming dragon-like status as well”.
Miller does, however inject a note of caution in the use of the credit default swap (CDS) market which, although it has seen massive growth, “is dominated by banks who are the largest players and who also lend to corporates. There are also back office issues. When Delphi Corporation, the former General Motors-owned company filed for bankruptcy, there were many times the value of outstanding bonds in derivative contracts. The derivatives had been traded but the settlement had not caught up so it was difficult immediately to know all the counterparties. So there are some risk management issues.”

While European investors are unlikely to be using a Lehman US aggregate benchmark, the US debt markets can clearly play a part in both global mandates and absolute return strategies.
But US debt markets can also play a part in LDI mandates. Standish Mellon’s Over argues that “with the breadth and depth of the US fixed income market relative to its European counterpart, coupled with the increased use of currency management strategies, we believe clients initiating LDI mandates should make use of the full array of fixed income asset classes available”.
Aberdeen, like many fully resourced fixed income managers, has the approach, according to Bartlett, of trying to “meet both of the goals that pension plans have, their historic goal of adding alpha through investments and their new goal of matching liabilities and reducing risk. We think you can do both by maintaining a broad market opportunity set. In Europe, we advocate more of a global aggregate type portfolio which allows you to add more alpha in the portfolio, and then to use derivatives, interest rates swaps and so forth as an overlay to tailor and match liability durations.”
This view that taking account of liabilities should mean something more sophisticated and flexible than merely matching a snapshot accounting picture with domestic government bonds is something that institutional investors need to be acutely aware of.
As Putnam’s Cronin argues, LDI approaches need to be “done on an economic rather than an accounting basis.
What is the duration of equity? I would say it is around 30 years but you get no benefit from this and the same is true of real estate”.
In today’s environment, European institutional investors need to heed the advice of Pimco’s Gross that they must be “willing to embrace more risk outside of index space by accepting (remarkably) less risk in absolute space”.
For European investors, certain sectors of the US debt markets combined with appropriate currency and interest rate hedging if necessary, do offer an opportunity set that should be considered in any diversified portfolio.

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