The financial crisis has re-arranged the contours of credit risk, writes Joseph Mariathasan. Deciding what represents low risk is the greatest challenge

Europe might be comparable in size to the US on a range of criteria but, for equity investors, there is a fundamental distinction that cannot be ignored. Europe is still not one market and, even within the euro-zone, is divided by language, regulations, culture and taxation.

In today's topsy-turvy global bond world things are often not quite what they seem. A fundamental rule of investing in credit used to be that corporate bonds should trade at higher yields than government bonds. But the transfer of debt loads from bloated private sector to public sector balance sheets, by way of government guarantees, cheque writing and quantitative easing, has blurred the lines.

European sovereign bond spreads over the benchmark yield, as a whole, are significantly wider than those of some of their corporates. Understanding - and perhaps trying to predict - the political environment has become a key element of credit strategy. Indeed, Swisscanto's head of credit, Mirko Santucci argues that within the sectors most affected by government debt and deficit problems, ratings are no longer the most important factor explaining corporate spreads. The explanatory power of ratings as a reflection of credit quality has been surpassed by that of sovereign spreads.

Benchmarks are another case where the bond markets are topsy-turvy. Using an index as a benchmark for fund managers has the implicit implication that the index must therefore represent a passive and hence the lowest risk portfolio for an investor in credit. But as Santucci points out, the benchmark indices usually have 40-50% in financials. A key issue for any credit manager, therefore, is weighing the trade-offs between closely tracking or moving well away from benchmarks that are inherently much riskier than a more ‘pragmatic' approach would be.

Ryan Blute, vice-president of European credit at PIMCO, points out that a key distinction in today's world is between developed and emerging markets: "We now have a bi-polar world with growth in emerging markets in the range 6-10% and that of developed markets stuck at 1-3%." Should investors stick to high index weightings in financials, or move away from benchmark weightings by, for example, increasing weightings to emerging market corporate debt?

End investors need to recognise the potential conflict of interest this presents: a manager can reduce underperformance - and hence business risk - by sticking close to its benchmarks, while increasing absolute risk with much higher exposures to developed market financials than would be sensible on an absolute return basis. Given the wild swings in the financial sector, it is not surprising that outperforming credit managers are invariably those with the latitude to deviate significantly from index positions.

Banks have been at the very centre of the credit crisis and their huge weighting in the bond markets means that putting into place a robust methodology for analysing their debt is critical. "Fifteen years ago we just looked at ratings," says Santucci. "Then we started to analyse bank lending and looked at fundamentals. After that we started to look at the levels of subordination."

Tier 1 capital, the most junior form of debt, has sustained losses as some banks skipped coupons, the risk of default grew and ratings downgrades moved them into high yield territory. "Tier 1 bank bonds represented around 10% of the sterling-denominated investment grade corporate bond market prior to the crisis, resulting in a significant impact for the vast majority of bond investors," explains Ben Bennett, credit strategist at Legal and General Investment Management (LGIM). "This process was met with a degree of acceptance by bond investors as tier 1 bonds had been purchased in the knowledge that coupons could be missed and that such instruments were designed to help prop up banks in trouble."

Bennett adds that while the perception has been that bondholders have generally got off ‘scot-free' at the expense of taxpayers, this could be changing; policymakers would like to change how bonds react in a crisis in order to force losses to be realised across a wider class of bank debt than simply tier 1.

"There is a valid argument regarding lower tier 2, which is designed to protect senior creditors only when a bank actually goes bust," Bennett says. "Following the Lehman experience, governments have generally decided to prop up failing banks before they actually default, thereby saving lower tier 2 holders. Arguably, it is, therefore, reasonable for governments to assign losses to lower tier 2 holders when they prop up the bank, on the assumption that if they had not acted, the bank would have collapsed and the lower tier 2 holders would have taken losses."

PIMCO's Blute argues that financial sector deleveraging will mean that the banking sector could end up looking more like utilities. "Over the next 3-5 years, regulators will force banks to have more capital. Core tier 1 capital ratios may go up from 4% to perhaps double that," he says.

Swisscanto's approach to banking is also predicated on analysing which banks are dependent on wholesale funding. "Lehman fell because it could not access the capital markets," says Santucci. "If banks are over-reliant on capital markets, they are much more risky, so we place a lot of emphasis on loan-to-deposit ratios." Currently Swisscanto is overweight US and emerging market banks but underweight European - not only because of the risks arising from the peripheral country problems and lower rates of growth, but also because loan-to-deposit ratios are greater than 100%, forcing it to tap capital markets regularly and aggressively. By contrast, the US is seeing better growth prospects - the loan to deposit ratios are around 100% so there will be less issuance of debt, and it does not have the problems of Europe's peripheral zone.

Emerging markets have none of these problems afflicting the developed markets: "French banks have loan-to-deposit ratios of 120-150%," notes Santucci. "They are coming to the market a lot with covered bonds, but that means they will not benefit from any increase in assets unless they increase their loan-to-deposit ratios. Brazilian banks are growing at 8-10% and assets are growing at 15-20%. With that rate of increase, they do not need covered bonds." When a bank issues too much in covered bonds, the senior debt effectively gets subordinated to the covered bond holders.

Putting into place a consistent strategy that can ride the financial sector whirlwinds of the credit markets is fundamental to any successful approach to credit investment. LGIM combines a macro, theme-driven analysis for sector allocations with traditional bottom-up credit selection. A monthly cycle of meetings with the firm's four-strong economic team is used to generate 5-10 themes with a time horizon of around three months. These are then discussed with credit analysts to identify suitable bonds for further research. This translates into portfolios of around 100 bonds with holding periods of typically nine to 12 months.

LGIM cites this process as a source of its success in riding the financial sector gyrations. "People who did well until March or April 2009 did not hold banks when the banking sector blew up," Bennett explains. "But in March 2009 our economists had a strong view that the market had got so bearish on economic news that projections were looking ridiculous. Production had stopped and inventories had gone down, so the numbers could not continue looking negative. Then when the US TARP [Troubled Asset Relief Program] was put into place, liquidity had to be positive. We wanted to be in cyclicals to benefit from the economic upturn expected - and we realised that the new cyclicals were the financials."

Currently, the view is that the problems of peripheral Europe will flare up again in the next few months. Spain will have a financing issue which will be resolved by Europe's governments - but through a reactive rather than a proactive process.

"The most exposed credits in this are the peripheral Europe financial groups and the banks associated with countries that we are worried about," says Bennett. Indeed, LGIM believes that even in core Europe many financial groups are closer to the problems than non-financial entities in the peripheral countries. As a result, it is underweight banks overall, with some balance coming from an overweight in US financials and some European positions based on which jurisdictions are more bondholder-friendly: "In some countries like the UK and Ireland, the governments have taken over the banks and are administering losses to different classes of bondholders," says Bennett, adding that Germany and Denmark are also seen as unfriendly to the interests of bondholders.
Swisscanto's approach is founded on three pillars. The first is a global approach agnostic towards index sector weightings, which can lead it to a 10-15% position in emerging market debt.

The second pillar is a clear focus on capital preservation: "During the crisis we were so conservative we lost only 5% in terms of total return in our corporate fund because we had only 0.5% in tier 1 bank debt," says Santucci. And the third is making sure that most of the firm's credit portfolio managers are credit analysts who also collaborate where possible with the equity analysts who attend company meetings with them. As the primary market usually gives a premium over secondary and trading costs are still high relative to pre-crisis levels, two thirds of the 120-130 names in its global portfolio have been bought in the primary market, with the average holding period around two years.
Schroders also has a highly structured process geared towards identifying the next big trends over a 6-12 month horizon, according to Adam Cordery, head of European & UK credit strategies.

The three key areas for the firm are: asset allocation (the amount of top-down credit risk it wants to take); stock selection, focused on avoiding defaults; and, interest rates. The credit process is based on staying one step ahead of the rating agencies. "The rating agencies get it right in aggregate but, perhaps because they cover so much, they do not always get it right for individual bonds," says Cordery. The three key factors for Schroders have been, first, valuations and credit spreads: "In June 2007, spreads were as low as they had ever been, whilst in March 2009, they were at their widest," says Cordery.

Second is the fundamental outlook: "By mid-2009, default rates had already risen to near previous highs, and it seemed unlikely they would go on rising indefinitely. Then, once it became clear GDP growth was going to be a big negative in 2009, we thought things had reached a low point and were probably as bad as they were ever going to be."

Third is the positioning of investors in the marketplace: "Who is going to be buying and selling? In 2007 and 2008, there were no requests for corporate bond mandates so there were no potential buyers. In early 2009, interest in corporate bonds exploded with lots of clients asking us to pitch for new mandates."

PIMCO's strategy has both top-down macro themes based on projecting a 3-5 year secular outlook as well as security selection by experienced credit analysts. The ‘new normal' it espouses is predicated upon de-leveraging, re-regulation and de-globalisation, all of which promote slower economic growth and lower inflation in developed economies while substantially bypassing emerging market countries that have more favourable initial conditions.

As a result, Blute explains, PIMCO wants to invest in companies that organically de-leverage by generating high free cashflow to pay off debt. "We prefer companies that are linked to the strong growth in emerging markets, such as energy through exploration and production and energy service companies, and mining and mining services."

The firm is more cautious on deeply cyclical consumer sectors which are more susceptible to a recession. Unlike Schroders' Cordery, who doesn't see sub-investment grade bond yields at 7% as particularly cheap, PIMCO is much more enthusiastic. "High yield is at a bit of a sweet spot right now," says Blute, pointing out that global high yield is 85% US and not a lot of bonds are due to mature within the next few years. "The LBOs in 2005-06 produced a lot of bonds due now, but the high yield market has been open, bonds have already been refinanced, so defaults are likely to be lower. Even if high yield rates are 7%, the default rate is less than 2% whilst recovery rates have been over 60%. So, on a default adjusted basis, we are still confident on high yield."

Investors in Europe are broadening their opportunity set and, as PIMCO has found, a big theme in the last couple of years has been investors looking for global credit: "More than 75% of new flows have been into global rather than regional," says Blute. Emerging markets have been a main beneficiary of this focus. But deciding what really constitutes a low-risk portfolio in a topsy-turvy world might be the biggest challenge that investors and index providers need to face.