Look at what's on the table
When the UK retailer Boots moved its entire pension fund portfolio into bonds in early 2001, it put none of this money into government paper. Instead it invested in long-dated AAA rated corporate bonds.
For the pension fund manager, the reason for investing in corporate bonds is clear. Over the long term corporates bonds outperform government bonds. This is shown by the performance of US corporate bonds, which have a longer track record than European corporates. Data from Merrill Lynch, Salomon Smith Barney and Lehman Brothers shows that over the long term non-government bonds outperformed government bonds by margin of 1.3% between 1981 to 2001. This 20 year period covers two complete economic cycles and therefore includes a number of bond defaults and rating downgrades.
Corporate bonds also generate significantly higher returns for a small increase in volatility. Over the same 20 year period, the annualised volatility of Merrill Lynch’s corporate bond index stayed below 5.9% – only slightly higher than the 5.1% volatility of government bonds.
Finally, corporate bonds’ Sharpe ratio – the excess return of an asset divided by its standard deviation of return – has topped all other US asset classes over this period, with corporate bonds at 0.78, government bonds at 0.59 and equities at 0.47.
This proves what fixed income managers have long known – that on a risk-adjusted basis, corporate bonds are a better bet than government bonds. Neil Sutherland, fixed income fund manager at AXA Investment Managers UK (AXA IM) says corporates says: “If you look at corporate bonds historically they are actually less risky than government bonds. If you divide the annual return by the standard deviation you get an information ratio of 1.5% on a 30 year triple B corporate whereas if you do that with a gilt its just over 0.5%. So on a risk adjusted basis you get almost three times the amount of return you’d get from simply investing in a government bond.”
The corporate bond market also offers more opportunities to add value than the government bond market, he says. “If you’re managing a gilt portfolio you’ve go the interest rate view and the duration view, but that’s probably the most efficient market of all. Everyone is playing the duration view and government markets are so well correlated that you’re competing against the whole market.
“There are more sources of alpha in the corporate market. With corporate bonds you can play a stock selection view, an allocation to different rating bands, or a spread view. So you can take a number of non-correlated bets.”
Holding corporate bonds also reduces the risks of holding government bonds, Sutherland adds. “Generally when government bond yields are rising and prices are falling it means that the economy is in reasonably good health. The corollary for a corporate bond is that the yield spread is tightening in the opposite direction, and that will mitigate some of the downwards move in price.”
Corporate bonds also look attractive set against equities in the current economic environment. Mark Keisel, senior portfolio manager and corporate bond strategist at PIMCO, says that factors peculiar to this economic cycle will hold down equity prices for longer than is usual after a recession.
There is a now strong emphasis on balance sheet repair, he says, and this will favour corporate bonds: “We believe we’re in the midst of a secular change in the mindset of corporate management. Company balance sheets have assumed the utmost importance, in marked contrast to the 1990s, when the emphasis was on growth and ensuring that earnings momentum remained strong.”
Not all corporate restructuring favours corporate bonds. Michael Markham, head of credit at Investec Asset Management. “A company who’s equity does very badly may get bought, and if there’s a significant amount of debt involved, restructuring can lead to a disproportionate amount of the economic wealth of the business going away from your class of debt to another part of the capital structure.”
Fallen angel Energis provides an example, he says. “When it got into financial difficulties the sale of the underlying business involved a restructuring in which the banks managed to secure their position as senior lenders but the bondholders ended up with nothing because of where they were in the capital structure.”
There are moves now to improve the bondholders’ position in the pecking order, he says “Many new high yield issues do actually benefit from subordinate guarantees from the offering companies. That still means that we are still subordinate to the bank, but if you are a lender to a company at any level, any restructuring will need your agreement. If you’ve got a seat at the table then you can ensure that you are treated fairly.”
The main risk the corporate bond investors faces is the that a company will default (see panel). However, the rewards outweigh this risk, says Markham. Historically, investors of in corporate bonds have been over compensated for the risks of default. “If you look at how much you lost holding a portfolio of investment grade corporate bonds over the past 10 years and you look at the additional spreads you were getting, you’ll see there was a big mismatch. You were clearly being compensated to run the risk.”
The risks are greater in the less developed European corporate bond markets. Investment managers complain that the lack of of proper covenant protection against event risk – which includes the risk of bankruptcy increases market volatility and hampers liquidity. An industry working group, drawn from 25 of the largest investment management companies based in Europe and the UK has now been established to consider ways of promoting better standards in the continental European credit markets. As a first step it is calling for minimum covenants for investment grade corporate issuers.
Markham, who was on the working group that aim is to create a fair risk reward balance. “Because there is more risk we should get paid more, and I don’t think we were getting paid enough at the level of risk that we were taking.
“We fully accept that the way the capital markets have developed there is value in being able to structure debt in such a way that you get the cheapest debt being the most secure, and then longer term debt being a little bit less secure. But you don’t want it to be almost equity-like. You do want to have some security over the cash-flow generating assets of a company.”
The risks of default increase the further down the credit curve the investor goes. Data from Standard & Poor’s shows that between 1981 and 2002, the annual default rate of a triple C rated corporate was 27.87 in the first year of rating, compared with 1.38 for BB, the highest sub-investment grade, and 0.37 for triple B, the lowest investment grade.
David Stanley, vice president responsible for European corporate bond selection and credit analysis at T Rowe Price (TRP), says “investors looking for yield may be tempted to go to lower rated. As you go down the credit curve that area is strewn with riskier credit. It is dominated by industrials with high idiosyncratic risks. So there is a serious need to look at risk/reward profile going down the credit curve.”
TRP steers clear of the riskier corporates, says Stanley, and focuses where possible on improving credits – moving bonds from A to double A or a mid triple B to a strong triple B. “We never lose sight of the fact that with corporate bonds the risks are very much asymmetric. The downside is more than the upside.”
Some investors will be prevented from buying high yields, and will be forced to sell when a holding falls below investment grade. “Sub-investment grade is basically the Rubicon.,” says Sutherland of AXA IM. “A lot of big investment grade funds are prohibited from holding sub-investment grade. So when you get to the stage where credits get to the crossover between triple B and high yield you tend to get a lot of forced sellers. Much of this selling isn’t predicated on the actual fundamentals or the valuation of the company. It’s out of necessity. And because the investment grade market is, by volume, so much larger than the high yield market, there’s not always the volume to absorb all of these new bonds.”
More investment managers now have dispensation to hold ‘crossovers’ he says.“If something does drop below investment grade we generally have six months or a year to hold it so we’re not a forced seller in that situation.”
However, forced selling can mean that a corporate can move very quickly through the high yield universe either as fallen angels (investment grade to non-investment grade) or as rising stars (non-investment grade to investment grade). This in turn can make it difficult to manage a high yield portfolio against a high yield index. John St Hill, of the SEI investment management team London says there are significant differences between way the high yield indices are constructed.
The main difference is the use of a ‘seasoning’ period by one of the main high yield indices, the Credit Suisse high yield index. Issues which were originally investment-grade but subsequently downgraded to non-investment-grade are included after only a three-month seasoning period. This means that a fallen angel would not appear immediately in the index.
On the other hand, it would appear in the Merrill Lynch high yield index, which does not have a seasoning period. The immediate inclusion of a heavily weighted security inevitably has a destabilising effect on the index, St Hill, points out. “It would have a big weight in the Merrill Lynch index because it has moved from being a large investment grade stock to a large non-investment grade stock. So if it continues to fall it will have a disproportionately large effect on the index. And because it is falling it will have a disproportionately negative effect on the performance of the index, dragging it down with it.”
The classic example of this was WorldCom, he says. “WorldCom’s fall was so fast it didn’t make it into the Credit Suisse High Yield index because it didn’t stay there long enough before it went into liquidation.”
However, WorldCom’s brief appearance in the Merrill Lynch index affected its performance. “This means that managers who were measuring themselves against the Merrill Lynch index could pick up quite a lot of performance relative to that benchmark, because they would not have had time to own WorldCom. So in that particular market, the Credit Suisse index was a harder index to beat because it didn’t go down enough.”
Rising stars have a less dramatic effect on high yield indices, however. However, because their weight is much smaller. “It’s a bit of a one way bet. If something bubbles up from being small cap from the bottom of the index then it doesn’t have a big weight. But if something falls from large cap investment grade to large cap non-investment grade then it will have a big weight. So you have a ‘heads I win tails you lose’ type situation in indices which don’t have seasoning.”
Generally, high yield fund managers are unlikely to follow benchmarks as closely as their equity colleagues, and weights are less important than they would be in an equity index. “In high yield universes people are a lot less benchmark focused than they are in equity universes,” says St Hill. “Just because a security has a high weight in the index a manager doesn’t automatically have to go out and buy it. Similarly they would not own a security merely because it had a particular credit rating.
The same is true of investment grade indices. Managers tend to use these to manage risk rather than measure performance, says Stanley at TRP: “We pay close attention to the benchmark because it is obviously the way we are measured and to that extent it will dictate some exposures. But we’re certainly not trying to track a benchmark or closet index a benchmark.
“We have a lot of discretion to add value by individual name selection and relative sector exposure, and we want to know when we’re overweighting a name or sector. So we tend to look at the index more as a risk control in terms of consciously knowing where we are deviating by name, by sector, by maturity, or by rating. We want to know the extent to which we are diverging from an index, not necessarily so that we can match it but so that we can be aware of the risks.”
TRP picks its credits using a micro, bottom-up style of stock selection, and uses a macro, sector-based methodology to check for consistency. “We will buy our corporate bonds based on our bottom-up views of the individual names and then check the index exposure to see if that is consistent with our views in terms of sector,” says Stanley.
Corporate default rates began to fall at the beginning of 2002 so we have now had nearly two years of corporate default rates coming down. The ratio of downgrades to upgrades from the credit rating agencies earlier this year we started to see the ratio of downgrades to upgrades starting to improve.
However, the rewards, in terms of spreads, have also shrunk. The average spread for euro-denominated triple B bonds was 300 basis points over European governments in October 2002. Today it is around 90 basis points.
As spreads narrow the risk reward is becoming more symmetrical with less compensation for risk. Bob Parker, deputy chairman of CSAM says that “What worries me at the moment is that is that people are now looking at shifting out of government bonds into corporate bonds when spreads are narrowing. European high yield spreads at the moment are 380 over German government bonds. A year ago that spread was up about 1100. So if you bought a European high yield bond you were getting a yield of about 15% outright. Now you are getting a yield of 7% to 7.5%.
“Clearly the reward has come down. People who go into corporate bonds now have to recognise that there’s just not that much money on the table.”
However, George Muzinich, president of high yield specialists Muzinich & Co thinks this narrowing of spreads should be put in context. “Spreads have certainly shrunk, but look what has happened to Treasuries. In July Treasury bonds were – believe it or not – riskier than junk bonds for the first time ever. So although spreads have contracted, they are still very attractive.”
Muzinich says that there is money to be made on the recovery play. This is because the second distressed cycle, which lasted from 1999 to 2002, is different from the first distressed cycle, from 1988 to 1991. “The amount of defaults has been significantly higher this time. So we shall be living through a period of recovery that will be different from the last one because it will be more prolonged. The default rate is coming down, and that’s something that’s going to continue and be sustainable.”