No longer the poor relation of the capital markets, the fund management industry has continued to grow and develop both in stature and capability, and most especially within Europe. Perhaps some of the most fundamental changes have been seen on the fixed income side, itself often considered the ‘dull’ partner to the racier equity market.
Just five years ago, liquidity in Europe’s bond markets was the (almost) exclusive domain of government bonds. There were notable exceptions, such as Germany’s Pfandbrief market and Danish mortgage bonds, but as a rule active fund managers were pretty much restricted to duration managing their portfolios and/or taking currency views.
“Europe’s domestic bond markets were sizeable and actively traded,” says Barclays Global Investors’ Karl Bergqwist, “and domestic corporate issues tended to be high quality at the very least, well known to their investor base already, so there was little need to worry about credit quality or pricing credit risk.”
The onset of European Monetary Union, and with it the single currency, has profoundly altered the landscape for many, including Europe’s bond markets. Bond market development has been spectacular and issuance of non-government debt has exploded.
“Bank disintermediation, privatisation and M& A activity have driven more and more companies to the capital markets,” states Martina Kocksch, fixed income fund manager at Commerz Asset Managers in Frankfurt. She adds, “I think these are pretty much unstoppable developments. The US market is older and much more developed than ours here in Europe, but I think it is certain that Europe’s non-government bond markets must continue to develop as they have been over the last few years.”
Heinz Fesser, head of fixed income at DWS in Frankfurt, believes the corporate bond market will continue its rise as long as CFOs appreciate the flexibility to tap into the capital markets. “We believe that corporate funding and the way the banks manage their balance sheets will continue to change in this way.”
“It has been a logical development,” argues Payden & Rygel’s Laura Zimmerman, “if it is cheaper for a company to raise cash in the market and bypass the banks, then that is what it will do. The first few years [of the disintermediation_process] made us perhaps a little too optimistic about how quickly the developments could continue. The bursting of the bubble has put a brake on the pace.”
Zimmerman goes on to highlight the fact that, when a market first opens, those that need the money the most tend by definition to be the weakest players and so are least able to weather any storm.
The Merrill Lynch high yield sectors in the UK and Europe had disappointing years in both 2001 and 2000, bringing the two-year losses to a huge 30% in the case of the euro. It is worth highlighting the strong positive performance over the last three months of last year which, the optimists hope, gives the market some good momentum heading into 2002.
“The auto and tech issues dominated the market with a disproportionate amount of issuance,” comments Zimmerman. “They were also big issuers in the US. However, when they got into trouble, their negative impact in the US was much, much smaller, because the American market is sufficiently diversified and the effect was dissipated. But the effect on the corporate sector in Europe was very damaging, hurting even those investors who had wisely avoided the weakest players. I do not believe that this will taint the market forever. And we should, and indeed would like to, see a much broader range of issuer types, as the market continues to mature and we get smaller issue sizes.”
“There has been phenomenal growth in Europe and it is catching up with the US,” says Bergqwist. “Corporate Europe is leveraging up, with pressure from an increasingly global equity market that is demanding better ‘shareholder value’. The result is a long-term trend towards more aggressive capital structures.”
Bergqwist suggests that the overall credit rating of outstanding issuance will deteriorate as the market develops and broadens its issuer base. He points out that a few years ago the ratings in corporate industrial Europe tended to be in the AA/A area while today it is single-A. In the US the average industrial corporate has a rating of BBB/BB depending on the sector.
Matthieu Louanges at Allianz-PIMCO in Munich agrees that this trend is somewhat inevitable. “We are already witnessing a deterioration of credit quality in Europe – as the types of borrowers broadens into the industrials and utilities at the same time as their credit deteriorates. The fall of telecoms from AA in 2000 to BBB in 2002 would be a prime example.”
With this trend to lower credits and riskier borrowers, so European investors have had to increase their credit analysis capabilities. “It is no accident that the credit rating agencies are dominated by the large and very well established US rating agencies,” comments Bergqwist. “After all it was back at the turn of the last century when the railroad companies in the US started issuing large amounts of corporate bonds that the need for an independent and more systematic credit assessment emerged. If you were an investor in New York you couldn’t know every single railroad company in California and Alaska. The situation in Europe was quite different. With small domestic markets, both issuer and buyer tended to be locals that knew each other. There was less need for formality and it was far more of a gentleman’s agreement.”
Not so now, says Louanges whose Allianz-PIMCO group has a seven-strong team of dedicated credit analysts. “These analysts are doing pure credit work and are separate from the team of corporate/credit portfolio managers,” says Louanges. “Each portfolio manager focuses on one segment and is in touch with the market all day. This is a specialised market and needs specialist skills. It is still relatively illiquid – which is why at Allianz-PIMCO it is the portfolio manager who executes all his own trades and does not rely on a centralised dealing desk.”
As well as climbing up the knowledge ladder themselves, managers must ensure their clients can follow. “We have seen strong demand for corporate debt from our clients,” says Fesser at DWS. “And, in this low yield environment, it seems obvious that the demand for higher yields will continue. Our credit side has been the area of strongest growth to meet this increasing demand.”
“We are quite sure that a key element to success is in the ability to take a global perspective – the credit markets are global and if you are not up to speed then you will not keep up,” adds Zimmerman.
And if the learning curve takes investors and their clients down the credit ladders, when will the mark of acceptability be given to sub-investment-grade debt? Investors have had a tough two years in corporate debt, and those that did venture lower got punished.
“We are utterly convinced that high yield should feature much more in people’s portfolios,” says Alexander van der Speld, who runs Insinger’s euro high yield funds. “Our own analysis and plenty of academic studies have shown that adding just a small portion of high yield exposure to a hi-grade portfolio should significantly improve the risk/reward characteristics.
“But we know there is lots of money waiting to come into the corporate bond markets and some of it will definitely filter down to the high yields and in our experience, once they know the facts about high yield and its potential to decrease a portfolio’s systematic risk clients get pretty excited about it. Of course many clients have investment mandates that are tightly defined, and this is our ‘problem’ and one that we run into every day. It is just a question of time and patience.”