Institutional investors in Europe have been used to dealing with broad macro-economic issues such as differential inflation rates and fluctuating currencies. They were quite successful generating excess return by arbitraging currency and interest rates within Europe. A few weeks before EMU the investment landscape was dominated by historically low yields and relatively flat yield curves. Rising correlation among the markets had limited diversification opportunities and falling volatility diminished return potential for fixed income investors.
We recommend a strategy that does not limit portfolios to a universe of government securities but enables investors to take advantage of rather different sources of return.
US managers have many years of experience investing along a single yield curve and making use of a wide universe of non-government fixed income securities to achieve an appropriate diversification. Let's take a look at the post-EMU environment. There are many converging factors that will result in a brave new world for capital markets in Europe. These include favourable conditions on the supply and on the demand side for credit.
In recent years global money managers were producing exceptional returns by investing in high-yielding Spanish or Italian bonds. But the days of making 'easy money' through 'convergence trade' belong to the past. Therefore investors appetite for new financial instruments that provide higher returns than government bonds will increase.
Moreover, term-structure decisions in a low volatility environment carry higher risk. For an investor with a government-only constraint, the only option will be to look for additional diversification. These factors create a demand for new supply that will not go unnoticed by underwriters and issuers.
In the US there are twice as many corporate bond issues as there are bank loans. In Italy by contrast, corporate debt represents only one-tenth of the amount lent by banks. The approaching currency union will change the way corporations borrow money.
The deregulation of the banking sector and increased competition will lead to falling margins. Therefore bank lending at unprofitable rates will become a thing of the past. It is likely that corporations will turn increasingly to the fixed income market to borrow money. Due to balance sheet optimisation strategies, asset securitisation will certainly increase.
A logical model is one which takes a cue from the world's largest bond market; the US. In the region encompassed by the euro, high yield issuance (below the investment grade level of BBB") has increased more than 25 times in less than five years. Nevertheless, more than two-thirds of the bond issuance is rated "AA" or "AAA". This is in contrast with the US where less than 10% of the rated bonds fall into the upper two categories! It is expected that high yield debt will be the fastest growing sector within the European debt market.
As mentioned earlier, we follow a strategy which restricts portfolio in-vestments by liquidity and credit, rath-er than to a 'government-only' universe. Diversification can be achieved horizontally through using a variety of sectors as well as vertically, to capture yield advantage from differing credit ratings. But we believe that a pure quantitatively oriented strategy to-wards credit will fail, since recent changes within the capital markets, for example low yield levels, low volatility and high correlation, are not reflected in traditional models. Investors in non-government markets should not focus on credit alone. Measuring credit risk in terms of a bond rating can be misleading.
Empirical studies on rating changes and price behaviour for euro-DM issues have revealed some interesting results. The market starts to discount the event sometimes up to 100 days ahead of the actual rating-downgrade announcement, in terms of a downward price-trend. This simple example should stress the fact that credit research is only one part of the process, determining value is the other.
Within a qualitative approach, our economic outlook forms the basis for an appraisal of individual sectors. The outlook is incorporated into the individual credit selection which takes into account fundamental as well as technical factors. Qualitative considerations such as corporate strategy and management style in combination with a relative value assessment will complete our search.
In practice, the credit research and relative value processes are significantly more complex. The goal, however, is the same: formulate a forward-looking credit and relative value judgement.
To maintain the risk profile defined under pre-EMU conditions and to take continuous advantage from a well diversified portfolio, traditional restrictions must be modified and other suitable well defined constraints incorporated. Successful fixed income management in the post-EMU capital markets requires a change in paradigm. Macro-economic processes will be enhanced by micro-economic parameters and quantitative tools will be significantly reviewed. Investors in Europe are building up already their infrastructure to better analyse corporate credit.
Nader Purschaker is with portfolio management and Matthias Klein is with client relations at Metzler Asset Management in Frankfurt"