It pays to be long
Euro- and sterling credit markets both significantly outperformed their respective government markets over the first quarter. For the euro markets virtually all of this outperformance was seen in January, while in the UK non-government bonds put in an even stronger relative performance.
For both markets it paid to be long, with credit spreads narrowing most at maturities of 10 years and longer. According to data from Merrill Lynch, BBB-rated corporates performed best in aggregate, although this conceals the fact that short-dated paper in this sub-sector was the worst performing and is more a function of the existing very wide yield pick-up.
Merrill Lynch suggests the trend of improving performance with increasing maturity is a reflection of sharper quality differentials and a greater tightening of swap spreads in five and 10 years.
In the sterling credit market, the outperformance was slightly different. Here, there was a much clearer relationship between credit quality and outperformance, with AAA/AA doing best. As in Europe, the preference of long investors for stronger credit coupled with the narrowing of longer-dated swap spreads explains much of the movement. However, the fact that the most significant moves were seen in March is due almost entirely to one specific factor: the news that the Chancellor agreed with the Myners report suggesting that the minimum funding requirement (MFR) ought to be abolished.
The key element of the MFR was its suggestion that pension funds hold gilts to match their liabilities. Take away that specific ‘encouragement’ and pension funds and insurance companies would be free to diversify out of much of their gilt holdings and into the corporate market. According to Michael Markham of Investec Asset Management, the industry’s preference for gilts over corporates is more a function of the natural conservative outlook of the actuarial community than of a true liability matching requirement.
He goes on, “Actuaries are in the business of calculating the present value of future liabilities, not in deciding investment opportunities and credit spreads. The MFR has in effect been stopping rational investment; pushing funds into chasing a now dwindling supply of gilts at ever dwindling level of yields.”
Although Markham agrees that legislative issues will continue to support the higher quality end of the credit spectrum in the UK market, he is clear that the trend towards credit is a global one. “Investors need income,” he states, “ and the nature of fixed income debt is that once the coupon is set then companies are obliged to service it. With dividends, it is far more discretionary what the level should be. And credit spreads across the world are still at historically high levels even after the narrowing moves we have seen this year. The Russian crisis in 1998, and then the pummelling of the high-tech sector has pushed spreads out to very wide levels and we are actually still not back to ‘pre-crisis’ levels.”
And while demand is certainly on the increase, supply too will surely grow. During the first quarter of 2001, euro-denominated bond issuance staged a massive recovery and was 17% above international dollar issuance. Graham Bishop, a consultant to Schroder Salomon Smith Barney, points out that some of the issuance was “one-off as the telecom companies struggled to fund their UMTS licence bids”. He argues that the telecom companies’ capacity to finance very large issues has encouraged other borrowers to do the same. The average issue size has shot up, while the proportion in under E100m issues continues to decline. Bishop concludes that E1bn is now seen as a minimum benchmark for liquidity.