Between a rock and a hard place
Investors in European bond markets are facing a secular change in the nature of what is on offer. For two decades till 1999, they benefitted from disinflation and more recently, the convergence of European bond yields with the introduction of the euro. This generated high absolute returns through disinflation and numerous sources of added-value through trading different currencies and yield curves.
The birth of the euro has severely diminished the opportunity value set, whilst the global economy is currently hovering between inflation and deflation, leaving bond investors with difficult choices on how to get both decent absolute returns and generate extra return through skill. European bond yields are caught between the pressures from high GDP growth and rising yields in the US, and the long-term structural differences between the US economy and the inherently slower growing Euro-zone.
After years of trying to control inflationary tendencies, the spectre of deflation during the last year shocked the US Fed into reflating the US economy with 1% Fed funds, although, as Patrick Barbe of BNP PAM points out, the critical factor is whether there is evidence of a real economic upswing seen through job creation, so bond managers are avidly watching the US employment figures.
The US has no fixed inflation target and Mike Amey of Pimco sees the Fed abetted in its process of stimulating inflation by Chinese and Japanese central banks buying up short dated treasury bonds. In contrast, he argues, the European Central Bank (ECB) has an inflation target of 0-2%, and even if they are shooting for the upper end they would probably prefer not having so tight a target as this puts pressure on the larger economies of France and Germany to have 0-1% as the less developed economies have a propensity to have higher inflation rates.
As a result, even when there is an upswing for growth as we have now, Europe cannot fully partake because its inflation targets are too tight. In addition, as Jonathan Cloke of Legal & General Investment Management states, structural reform in Europe, particularly on employment, is a key bottleneck to increased GDP growth.
After a successful reflationary policy, US rate rises are seen as inevitable and the interest rate cycle may be turning upwards globally, led by the US. This is not a great positive factor for bonds generally and John de Garis of Credit Suisse Asset Management argues anything with a bond benchmark will have negative returns over the next couple of years.
However, how closely will European yields follow US changes? Amey argues that Euro-zone bonds look attractive in relative terms, and Pimco see them as approaching fair value without any likelihood of short-term interest rates in Europe going up anytime soon, particularly give the strength of the euro. He does however, concede that in absolute terms, they would be more cautious seeing small increases in yields a possibility and certainly good for future investment in bonds. Others would concur, with BNP PAM having a number of clients in cash who are waiting for yields to reach 5% in 2005 before switching into bonds.
Structure of market
The Euro denominated bond markets account for somewhere in the region of 30% of the global bond market. There are a number of competing investment grade broad market indices such as those produced by Citigroup, Merrill Lynch and Lehman Brothers. These typically show between 65-76% in government and quasi-government debt, 12-15% in corporate debt and the rest in Pfandbriefe and other covered bonds.
According to Merrill Lynch, whilst monetary financial institutions account for 73% of the corporate bond market, the non-monetary sector is the most dynamic, with market growth of 28% in 2003 after growing 27% in 2002. The high yield sector, whilst increasing rapidly in size, does suffer from its relative immaturity. This is evidenced by a lack of sufficient diversity of issuance that hampers effective risk control in portfolios focussing only on this sector. There is also a growing market in structured products, such as collaterised debt obligations (CDOs) and asset backed securities (ABS) which managers are increasingly turning to in the search for higher yields at acceptable risks. The usage of credit default swaps (CDS) has also taken off, transforming the way that exposure to credit can be captured and managed.
When looking at investment in the Euro-zone bond markets, the key issues are the following:
Most commentators would agree that bond returns over the very long-term will be less than equities reflecting the equity risk premium of anything between 1-3%. David LeDuc of Standish Mellon sees the ‘post bubble’ deflationary environment over the last several years as a relative aberration in the capital markets, with fixed interest returns exceeding those of equities. Going forward, he, like many others, see returns more in keeping with the historical relationship with stocks in the mid-single digit range of 7-8% per year and bonds 3.5-4.5%.
However, the volatility of equities is dramatically higher and the TMT crash led many pension schemes into deficits and a focus on ensuring liabilities are taken into account, even if absolute matching is seen as too expensive. This has encouraged investment in bonds and a focus on taking on more credit risks as a way of enhancing yields.
As Stephan Ertz from Deutsche Asset Management in Frankfurt says: “Spreads in investment grades have been stable. This implies that investment risk is lower than it used to be. So if the credit quality stays stable and you have low volatility, what is the alternative? What can you do if you don’t go into spread products? Equities are very volatile, whilst if you invest in government bonds you lose 50-60bp which is a lot at current low yields.”
Pension fund reforms
Reforms to the structure of European pension provisions will have major ramifications to the bond markets. Managers such as Jonathan Cloke of LGIM see the moves towards the development of funded pension schemes and closer matching to liabilities as leading to increased demand for long dated bonds and flattening the yield curve. Pimco’s Amey regards the Dutch pension regulatory changes towards closer matching as the key to the long end of the Eurozone yield curve with its increased demand for more long-term assets, both conventional and index-linked.
Merrill Lynch calculates that the Euro-zone bond market increased 9% in 2003 after growing 6% in 2002. Jean-Francois Boulier, the head of fixed interest at the merged asset management operations of Credit Lyonnais and Credit Agricole, is enthusiastic about this and also in the choices available. “The market has seen a huge number of new issues with more high yield new issues than investment grade outside financials this year.”
He also feels there will also be much more securitisation with a number of countries interested in raising cash from assets by this technique. “Inflation-linked bonds are also now becoming more attractive and the growth in issuance in some cases is huge. France has around E60-65bn in inflation-linked issues whilst Italy has raised E22bn in the last year.
Greece has also been an issuer and even Germany is expected to be next year.” Despite the potential issuance, Amey does not see a problem for index-linked given the appetite from Dutch pension schemes as well as French retail savings products.
Boulier sees the change in attitudes towards taking on credit risk in Europe as something of fundamental significance. “People on the continent were used to the usual bank approach of credit and are now looking at a performance approach to credit, the ‘performance to risk ratio’.”
A number have now accepted lower quality bonds, as the performance is better. They would rather have a good portfolio of risks and premiums rather than a single German bond. This doesn’t mean that people are no longer prudent, they still are. However, in many cases, they compare high yield bonds against equities and see bonds as more attractive.” This is also echoed by Volker Marnet-Islinger of Cominvest Asset Management: “There has been a structural move towards more credit-type products and an increasing shift by clients to taking on more risk eg, in high yield bonds. Even if government bonds reach 5%, clients are going for higher yields.”
Whether corporate bond spreads currently compensate for the default risk is an issue that all fund managers are facing. The investment banks, says Malcolm Jones of Standard Life Investments, “presented the elixir of credit, a new way for fund managers to get additional returns over government bonds. But the past five years have been a painful learning experience for many European bond investors. First there was the implosion in the embryonic telecom dominated high yield market, leaving many investors rueing being seduced by attractive yields on offer. Then came the failures in corporate governance,” with, as Richard Hodges at Gartmore puts it, “fraud, the ugly sister of poor disclosure”. Whilst at first the problem seemed US-centric, Enron and Worldcom, were followed by Parmalat and Ahold.
Despite this, corporate bond spreads in Europe have now tightened to levels where managers such as Hodges believe that 75% are overpriced and will not compensate investors for the credit risk. Spreads are however, unlikely to increase significantly in the short-term according to many managers, with demand pressures chasing limited supply although there is also some evidence that default rates have also fallen.
Whilst returns on investment grade credits are reasonable well correlated with credit ratings, in the high yield sector fund managers find there is almost no correlation. Selection of the appropriate sectors clearly is critical but also subject to the differing opinions that are what gives liquidity to the marketplace.
Christophe Auvity at BNP PAM feels that in the high yield sector as a whole “you are sure to lose”, whilst favouring the investment grade telecom, financial and real estate sectors. In contrast, John de Garis at CSAM sees the high yield sector as offering a more favourable risk/reward ratio seeing the spreads as reasonably attractive whilst he sees spreads widening amongst investment grade credits where he declares “there is no margin for error”.
There are four clear trends amongst fund managers in their attempts to seek a competitive edge.
q Globalisation of credit research and integration with equity research: As Steven Lowe of Legal & General IM points out, “there are asymmetric risks in taking on credit risk and the best way to outperform is by avoiding losses”. The multi-asset firms are in many cases attempting to draw on the expertise of their equity research teams to add value and use equity market movements as potential leading indicators of credit issues.
DeAM’s Ertz feels that company specific risk is increasing and “if M & A picks up, there will be more company specific events. Companies may become more shareholder friendly and less bond holder friendly. The pendulum has swung a lot in favour of bond holders and we may now see it moving back again.” In this environment, as Malcolm Jones says, “to understand and properly weight the risks, it is critically important for investment firms to have joined up thinking between debt and equity investors and well established corporate governance teams”.
New entrants to the marketplace see the eurocredit sector as under-resourced and their own competitive edge as the ability to draw on global resources across both equities and bonds to generate opportunities and identify failing credits sooner. According to Laurence Linklater, T Rowe Price, for example, is focussing its own efforts on using a global sector approach as “credit is something that needs to be looked at on a broader basis”, a view that older global fixed income specialists such as Pimco and Standish Mellon would also certainly concur with.
q Utilisation of information technology and quantitative techniques: How to combine and analyse information in a meaningful manner is of course, a key question and the development of quantitative tools for both identifying investment opportunities and for controlling risks has been a major development. Firms use a mixture of internal and external sources of analytical tools.
Pimco sees a competitive edge in developing all its tools in-house through its own large financial engineering team. Others seek to amalgamate sources of information in an effective manner. In addition, investment banks, ratings agencies and specialist software houses are all offering increasingly sophisticated credit research and risk management tools. Indeed, the development and analysis of many of the more highly structured products such as CDOs, and the utilisation of more complex derivatives within portfolios, is dependent on having the appropriate technology to do so;
q Increased use of derivatives: The use of derivatives is an area that institutional investors are gradually getting more familiar with. Amey hopes that pension funds are able to give more flexibility in the use of derivatives as this enables more views to be implemented effectively and produces a better diversified portfolio eg, they can invest in illiquid bonds and adjust interest rate exposure separately.
Managers can seek credit exposure where the rewards are best and adjust interest rate exposures through derivatives. Liability driven mandates in particular, can benefit from the ability to tailor-make cashflows where necessary through the swaps markets. Amey also points out that option strategies can take advantage of volatility. “There is a structural phenomenon that implied volatility is expensive – ie, higher than actual, so that you can get paid by selling volatility through selling far out-of the money options.”
q Absolute return benchmarks and liability driven investment: With a strong possibility of yields rising in the short-term, some managers are advocating the benefits of using an absolute return benchmark rather than the more conventional bond benchmarks. This can represent a conventional long only mandate with wider flexibility to shorten duration and more flexibility in investment as well as in some cases, giving the option of going short, to create a hedge fund. BNP PAM see this as a large phenomenon amongst their client base, although even a long only absolute return fund can be a useful product for managers such as John de Garis at CSAM, who are bearish on 5-year bonds, and can steer clients towards their total return fund as an alternative.
Absolute return benchmarks also tie in with the increasing focus on liability driven investment. In France, where the investment consultants have made little headway, firms such as AXA Investment Management have developed strong capabilities in this area, and as CIO Vincent Cornet, explains: “We have been thinking of the different areas for many years and even more importantly, the mechanisms to be able to combine everything to satisfy client objectives. Should I use a credit overlay? Are the trustees comfortable with credit default swaps?”
European bond markets are growing rapidly in size; they offer potentially attractive risk adjusted returns compared to equities; the slower growth in Europe compared to the US and the ECB inflation targets should provide greater downside protection than US bond markets, whilst factors such as the moves towards liability driven investment is increasing demand.
The reaction of fund managers to this scenario has been to increase attention particularly in the credit arena, and in trying to provide liability led solutions to clients requirements, utilising where allowed, interest rate, foreign exchange and credit derivatives to create tailor-made solutions for specific mandates.