Ever tightening spreads
Have corporate bond spreads come down too far? A two year rally has seen spreads almost halve in the sector as a whole, with high yield bond spreads down by over 500bp. In Europe spreads are even tighter than the US reflecting a persistent domestic bias that US bond managers who have established themselves in the European market place are able to exploit through offering global bond mandates, tapping the US credit markets and hedging out currency and interest rate mismatches for European clients.
Spreads do compensate for default risks: Spreads in recent years were at their peak in 2002 which, with hindsight, could be seen as abnormally high. Peter Bentley of Pimco attributes this to a combination of factors “not only the TMT collapse, but also government bond buybacks reduced the supply of government debt, and there were some high profile negative credit stories so the market became oversold” whilst his colleague, Robert Mead, goes on to add that “in 2002, there were also issues on corporate governance reforms so the focus was shifting from equity holders to bond holders”.
As Ian Kelson of T Rowe Price declares: “Corporates have found religion in the last year or two! They are issuing equity, reducing debt, selling non-core businesses. This has been a huge exercise over the last couple of years but it may be coming to an end now and the pendulum swinging back in favour of shareholders”.
The environment for the corporate bond market has certainly changed drastically since then with many bond managers having the view that the economic environment is currently benign, with reasonable growth in the global economy and companies well positioned to withstand external shocks. “Company balance sheets are as strong as they have been for some time. The liquidity positions are good” according to Pimco’s Bentley whilst Wayne Bowers of Northern Trust Global Investments (NTGI) goes so far as to declare that it is currently “nirvana for businesses”. The downside is that whilst spreads increasing may be less of a risk, government deficits are driving increased bond issuance and raising yields, the news of the economic recovery has been priced into corporate bond markets so there is very little room for further news to move spreads tighter.
The spreads of corporate bonds above government bonds reward investors for taking on the risk of defaults of interest and/or principal, the risk of downgrades leading to spreads widening, reduced liquidity which becomes more significant in the high yield sector and the potential of increased volatility arising from interest and credit changes.
Are current spreads adequate? Managers seem to agree that current spreads are certainly adequate to compensate for the default risks. BGI’s research on the UK market for example, indicates that the breakeven spread for BBB rated bonds is approximately 50bp, whilst the market spread was almost 120bp in early December according to Keith Kelsall. Even in Europe, Kelson of T Rowe Price feels that “European investment grade spreads are historically tight, but for the right reasons. We have seen strong economic growth, companies are doing the right things in deleveraging, default rates are low – there are more upgrades than downgrades. The spreads are fine for the default rates if you are prepared to hold till maturity”.
However, as Pimco’s Bentley asks “Spreads compensate for default risk but do they compensate for changes in macro environment and credit downgrades?” Kelson does not think so – “you are not being compensated a lot for liquidity risk and credit migration, which is not an issue if you are holding bonds till maturity. As a short-term bondholder however, you need compensation for liquidity although investment grade is not as bad as high yield”. As Bentley points out: “Where we are in the economic cycle could determine what happens. There is the potential for macro economic instability and companies operate in an economic environment. Will downgrades begin to crop up? There is a lot of uncertainty in the world – whilst value exists in certain areas, in aggregate we are not being paid a lot for the period going forward”.
The huge reduction in high yield spreads does not necessarily imply they are currently worse value than investment grade. NTGI’s current house view, for example, according to Bowers, is still to be overweight high yield and neutral on investment grade. However, as Kevin Akioka of Payden & Rygel points out, “after the rallies of 2003 and good returns in 2004, we need to reset expectations, we are not going to get 20% returns in the near term. The expectations are that with bonds close to par, we can expect the coupon returns say 7% for a high single B credit. It’s not great but you are staring at Treasuries at a low 4% for 10 years and investment grade spreads are very tight”.
Whilst he also agrees investors are getting compensation credit risk, although not a tremendous amount “on the liquidity side, it is more difficult to measure. Dealers have been fairly cautious in inventory, how much they are trading etc for several years since the 1999-2000 TMT period. There have been periods in the year when volatility was high and liquidity dried up. So if there is a rising default cycle and weakening credits, this will be a worry.”
The strong domestic bias seen in both US and European investors is currently working against European investors where spreads are tighter. As Pimco’s Mead points out “the interest rate environment in Europe is more favourable that that of the US going forward. – Growth rates are lower in Europe. So it is worth having exposure to European interest rates but to take advantage of credits globally. It’s possible to do this on a clean hedged basis with a local benchmark”. When comparisons are made against swap spreads however, the comparison is not so marked according to Kelson. “In the US, swap spreads are much wider and the difference between US and European is not that different. We are seeing stronger growth in the US than in Europe so it is reasonable to see wider spreads. There is potential for it to widen more”.
Structure of the market
Investment grade: The US bond markets dominate any global approach to investing in corporate bonds with a more diverse range of issuers which can be seen in the chart showing comparison of the US and Euro markets in 2004. However, Europe has been rapidly catching up in diversity and in giving access to a wider range of credits. David Stanley of T Rowe Price points out that financial sector accounted for a combined 67% at the start of the century, which has now reduced to 40%. Triple A and double A ratings, dominated the market then, accounting for nearly two thirds of the universe. “We have subsequently seen a tremendous growth in single A and BBB issuance. A lot of this has come from the European telecoms sector, where companies sought significant capital to fund both 3G licences and their intensive capital development programmes. More importantly, the birth of the euro and lower funding costs, as well as the ability of companies to tap a Europe-wide market place, enabled a whole range of lower rated entities to access the capital markets for the first time”.
High yield: The US market dominates any exposure to high yield, although liquidity is still a major issue. T Rowe Price with $11bne8.3bn under management have closed to new business because, as Flemming Madsen explains “despite the growth of the high yield market, deal sizes are not as large as the investment grade market, so we feel there is a limit to how much you can manage effectively, without potentially impacting performance”. Their global high yield mandates have been 97% US although they do buy some European high yield but, Madsen finds “good companies are expensive compared to their US counterparts whilst poor companies are distressed!” The European high yield market is finding its feet in the aftermath of the TMT bubble. Kelson recounts that “We brought over a person to European in 2000 to build up European capabilities but after the TMT crash, 60% of the European high yield market went bust and we sent him back to Baltimore. European high yield is immature and undiversified, probably less than a tenth the size of the US. It is a struggle to see European high yield as an asset class”.
Akioka of Payden & Rygel has the view that “Europe needs a few more years of growth, it’s only 10-15% of the US in size. We need more companies in different industries. We are getting some nice companies coming out of Europe. More paper more industrials, more non-telecom. In two to three years, it may be possible to have a dedicated European high yield, or else a 50% US 50% European mandate”. Pimco have been more enthusiastic however, and Mead declares that “European high market has matured to the level where we are running specific European high yield mandates. These would have 150 names, 80% in local currency and
Rating agencies: Whilst ratings of corporates are critical in defining the universe of potential investments for a specific mandate, they rarely feature much beyond that for active bond managers. As Rick LaCoff of Payden & Rygel declares: “We never rely on rating agencies. For every credit we buy, we have our own rating which we can compare with S & P and Moody. It gives us some idea of relative value. I would never invest with a company that did not do its own ratings”.
Indices: Bond indices have a number of fundamental and practical problems, the most perverse being that the more a company borrows, the greater its weight in an index, despite the fact that this usually implies a lowering of credit status whereas in an equity index, an increased weighting of a company reflects increased optimism regarding its prospects. In practice, indices still have to be used to determine the universe available, but sticking rigidly to low tracking errors can be a recipe for disaster. The Lehman indices completely dominate the US market and as a result, have carried over into global aggregate and European indices. There are a few other broker providers such as Merrill Lynch, but the most significant alternative is iBoxx, which produces corporate bond prices from a consortium of market makers, giving greater transparency.
Credit derivatives: Credit derivatives have now become an important part of the investment process for many managers when they are allowed to use them and this usage is set to increase. However, they are generally available only for liquid stocks and as Payden & Rygel’s LaCoff finds “one problem is the use of ISDA agreements – every time we have a new counterparty, our client would need to sign an agreement”. Pimco’s Mead concurs with this “We use them occasionally. It is something that even if we don’t use a lot, we keep a close watch on because it is a useful indicator of what is happening in the credit markets. Clients need to be more comfortable with this sector, - they are more used to vanilla derivatives. We do see this changing over the next few months and years.”
Fund management approaches: The key factor governing investment approaches to corporate bonds is, as LaCoff declares “the upside is always limited but the downside is your investment. With this asymmetric payoff, if you get it right, you get 6% but if you are wrong, you will only get your 40 cents in the dollar back.” What does this mean in practice? “We are willing to pass on the biggest yielding bonds that might be risky for the sake of companies that we know better and understand” says Akioka, a strategy that most bond managers would concur with.
BGI run their European corporate bond mandates on an enhanced index basis, and even here, according to Kelsall, the focus is actually on excluding bonds that are likely to be problematic, which they tackle using a combination of quantitative model based approaches that incorporate signals from both equity and bond markets, combined with a team of credit analysts.
Approaches adopted by active managers tend to revolve around the trade-off between a macro-economic and sector top-down viewpoint, and a bottom-up stock selection approach. Pimco, for example, have a global process driven by views on the global economy, government bonds, swaps and the corporate bonds in aggregate. As Mead describes it: “This gives us an idea of what bias we should adopt in the corporate bond market. We form a view with the analysts of which companies and also discuss the strengths of different sectors. What companies, what sectors and how we want to structure the portfolio in aggregate”. T. Rowe Price, by contrast, according to Kelson, “relies on fundamental credit research using a bottom up process with a large credit team split by sector so the auto analyst in Baltimore would cover both GM and Renault for example. We do all our own research and assign a credit rating internally for every issuer we buy. Fundamental credit research gives 70% of our added value. The remaining 30% is due to sector allocation, ratings exposure etc”.
Of course, in practice, all companies invariably utilise both macro-economic research and individual stock research to some extent, and this can determine relative weightings of different credits as well as sectors. Akioka for example, says of Payden & Rygel’s approach, “now we are currently optimistic that the economy won’t fall off the cliff so we can take more credit risk, we are taking more single Bs rather than BB. This leads us to look at industries differently; we can look at those that issue more primarily single B. At some point, we get into bottom up, stock picking by our analysts”.
The outstanding firms are clearly those who are not only able to produce good research but also able to translate it into specific recommendations for their portfolios. Multi-asset firms try and capitalise on their equity research capabilities whilst specialist bond houses would argue as Pimco’s Mead does that “to leverage off equity research is difficult and only doable if you undertake equity research through cashflow modelling”. More significantly for future corporate bond mandates, particularly for those European investors willing to give much less restrictive mandates, will be the ability to select the best priced names throughout the world and bring them into the portfolio. This inevitably means having a strong capability in the US corporate sector coupled with derivative expertise to hedge out currency and interest rate mismatches. Those European houses who have not as yet built up their multi-currency and derivative capabilities may find themselves losing out to the US houses that have.