Investors, disenchanted with equities and suffering low yields on government bonds, are turning to corporate bonds in droves to access the historically high yield premium on which they are currently trading. European investors, deprived of the returns they traditionally made from trading between the legacy currencies, have taken advantage of the huge growth in euro-issuance post EMU spurred by bank disintermediation. But this additional return does not come without risk, and in the case of corporate bonds, the risk is significantly larger than the potential excess return.
In theory, broadening the investable universe to include non-government investment grade securities should provide diversification. Part of the argument for taking credit exposure is that it is negatively correlated to government bonds and so including corporate bond exposure reduces the volatility of a bond portfolio. Adding in the corporate bonds results in an opportunity set of two to three times the market cap of sovereign issues alone, and five to 10 times the number of securities. But much of the return from corporates this year has come from interest rate moves rather than improving credit.
As interest rates were cut to help the ailing global economy and yields fell there was a flight to quality, affecting particularly the lower quality issuers. As a result corporate bond yields have remained stable or risen, while government yields have fallen. The average spread of a BBB (or Baa) credit, the lowest rating that is still considered investment grade, over governments has risen to the widest seen since 1983, and because yields on governments are currently so low, the spread can effectively double the yield to maturity, (see charts).
In almost every early instance of default or rapidly worsening credit, the rating agencies were wrong-footed. Later, they overcompensated by making swingeing cuts, sometimes several notches at a time. The ratings agencies’ lack of leadership has led to greater reliance in the market on models for default probability that work from the basis that the price of a company’s equity and debt is inter-related. Merton’s theory proposes that debt should be considered as a short put on the company and equity a long call at the value of the debt. The market value of a company’s debt is then the difference between the asset value and its equity. From this a probabilistic estimate of the likelihood of its asset value falling below the outstanding debt can be generated, and from this an implied credit spread. JP Morgan research by credit strategist Matt King has shown that the results from these models and spreads in the credit derivatives market have moved in tandem throughout the recent downturn.
King is forecasting that credit will break free from equities only when deleveraging becomes obvious. Deleveraging will cause credit markets to improve before equity markets, as balance sheet ratios will improve faster than earnings. Already ratings agencies are forecasting a turning of the corner, with Moody’s indicating some evidence that default rates peaked in February 2002.
Global market strategist at JP Morgan, Jan Loeys, predicts the most attractive long term returns are to be had from corporate bonds, given current entry prices. In comparison with other assets, like equities and governments, which need to fall in price to achieve their long term equilibrium returns, Loeys predicts that euro-denominated corporate issues on aggregate will not suffer significant downside from the current entry point because long term equilibrium yields are near current levels.
But despite opinion that prospects for corporate bonds may be improving, SSGA head of fixed income, Mark Talbot, feels that much of the move into corporate bonds has occurred for the wrong reasons. Most mandates that include corporate bonds specify that paper bought must be investment grade, and this makes a fund a forced seller if the rating falls below BBB. Talbot highlights the inherent anomaly of an investor bearish on equities re-allocating to corporate bonds, commenting: “If equities continue to fall, spreads will increase further. In this scenario, a better diversifer to equity risk would be governments. By switching into corporates, investors are maintaining exposure to the same underlying risk, and simply shifting to a different part of the capital structure with a different pay-off profile”.
Talbot considers credit risk may be harder to manage actively because of the asymmetry between risk and return. “As Merton explained, the return on a corporate bond is analogous to being short a put, and the excess yield of corporates over governments can be seen as the put premium, which may be less than 100bps per annum, with the downside the risk of default, and the potential for total loss. This creates problems for the active manager, whose natural inclination is to pick winners, because the potential upside is so small relative to the downside. An active manager may hold 50 positions versus a 1,000 stock benchmark. Effectively he has 50 large overweights versus 950 small underweights. If any one of his holdings defaults, he will suffer a loss of 2% of the portfolio on that holding, and to recover that loss he would need to outperform by 10bps on 20 other bonds. This level of stock-picking skill is out with the realm of most active managers.” SSGA’s contrarian approach is to passively hold the index and buy credit protection on constituent bonds that it considers are most likely to default or suffer ratings downgrades. “SSGA tries to exploit the asymmetry of returns on holding corporate bonds by actively seeking out the losers. If a default occurs, the protection will allow us to put the bond to the derivative counterparty at par, rather than suffer a loss. This approach will do best at a time of defaults and ratings migrations, and is particularly appropriate when equity markets are weak as the portfolio is protected against the worst effects of credit/equity correlation.”
Credits rarely improve dramatically (a recent exception being Household, a poor quality financial recently purchased by HSBC), and most companies have a natural ceiling to their credit rating, dependent on their industry of operation. By contrast, any company can default and companies are defaulting currently at a higher rate than the average for a cycle. This makes managing a corporate bond portfolio a more onerous process than simply owning governments, and amongst investor groups, pension funds are at an advantage in being able to access corporate bonds, whereas other investor groups subject to greater scrutiny may not. Being tax-exempt, there is a tax advantage for pension funds to hold corporate bonds and receiving income, which the corporate can offset against tax, versus holding the shares and receiving dividends out of post-tax earnings. These arguments, as far as Andrew Smith, actuarial consultant at B&W Deloitte, is concerned, make far more sense than the theory that corporate bond yields are unduly high. Smith contends: “Sufficient analysts are researching the credit market for it to be unlikely that credits are wildly underpriced. The market price reflects the risks and in the current environment is placing more weight on the extreme downside scenario”. Smith agrees that to try and pick undervalued bonds on the hope of potential upside is the wrong way to manage corporate bonds. “The key differentiator is the manager’s investment in systems and controls to manage risk,” avers Smith.
Ascertaining whether a manager has outperformed through taking too much risk cannot be extracted from the standard performance measurement tools of excess return and standard deviation. As Smith explains: “Corporate bonds are generally not volatile assets, and a manager might outperform by 20bps year after year before suffering a huge blow-up. The additional risk taken to generate this outperformance will not show up until the manager suffers a loss from a default. To fully understand the risk in a corporate bond portfolio involves drilling down to the underlying holdings and no performance measurement reporting tool does this at present. Tools used by the banks to price credits and predict the risk of default have been slow to transition to the investment management community.”
Unless a pension fund wants to take a highly active approach with regard to its corporate bond portfolio, the minimum number of issues to achieve sufficient name diversification is probably 100. If a smaller number of names are held, default on one name can wipe out the excess returns on the rest of the portfolio. With an allocation of E50m or less it may be difficult to achieve this level of diversification without a great deal of effort. An alternative for smaller funds to achieve broadly-based exposure is a traded index product, such as the JP Morgan European Credit Index (JECI). Various other banks have also created European credit indices, but the JECI is the broadest, containing the most liquid issues from the 100 most common names.
The JECI index can be purchased in a fixed or floating rate form, or unfunded, which means that the institution transacts a swap with JP Morgan to receive the spread on the floating rate instrument, in return for the liability to pay over any losses on the default of a company within the index. Bond weightings in the JECI index range between 0.5% and 1.5% and aggregate to industry sector weightings in standard benchmarks. Bonds are traded and settled in the normal way. The most recent issue of bonds, based on a recomposition of the index in October 2002, pay 4 7/8% fixed or libor +90bps floating, and the market price of the issue will move in accordance with changes in the market spread of the underlying bonds, and interest rates in the case of the fixed rate issue. The initial offering of the JECI 2 index issue was E1bn and JP Morgan is tapping the issue to satisfy demand. The most recent sizeable transaction was in E200m of bonds which was transacted at the screen price.
The next step from an indexed portfolio is enhanced indexing, an approach for which Barclays Global Investors (BGI) is well known. Partha Dasgupta, head of fixed income strategy in Europe for BGI, comments: “As European funds have moved from solely domestic allocations to a broader European and investment grade mandate, the natural first step was indexing. Now they have greater comfort in the asset class, we are seeing interest in enhanced indexing”. BGI runs $30bn (E30bn) in credit of a total of $55bn in fixed income in London, and its total credit exposure is $55bn globally. Dasgupta explains: “Enhanced indexing demands a scientific discipline similar to an index fund manager”. At BGI, the tracking error in an enhanced index strategy will be of the order of 40-50bps, and the active bets will be on individual securities rather than factor risks. As Dasgupta avers “there is more to be gained by avoiding the worst 10 bonds than seeking out the best 10 bonds in an index, and BGI skews its credit research to evaluate the probability of negative as well as positive events.” BGI segments the credit universe by sector, duration and rating and ranks bonds in each risk bucket to find ones with the right level of yield and the lowest probability of default. BGI’s models use equity inputs to help corporate bond returns, essential, says Dasgupta, “because the equity market discounts information faster than the cash bond market”. BGI also factors liquidity into its process by including inventory information from brokers.
Gartmore, which runs £8.3bn (E13bn) of fixed income money, £1.6bn in specialist credit mandates, perceives increasing demand for sterling corporate names from UK funds, as a re-allocation away from gilts and equities. “Whereas previously, fixed income managers might at their discretion have held small weightings of 5-10% within portfolios linked to a gilt benchmark, once a specific allocation to corporate bonds is set, a manager must become more disciplined in his approach,” relates Paul Grainger, senior investment manager in charge of sterling bond funds at Gartmore. Gartmore attempts to marry up the top-down view on sector allocations with bottom-up analysis of specific credits and the pricing and terms of instruments in the market. Gartmore is increasing its coverage and assets under management in euros, in anticipation of UK pension funds diverting money towards Europe on the UK’s possible entry into EMU. Although Gartmore sees opportunity in the rapidly growing credit derivatives market, both for hedging and actively taking positions, none of its existing mandates permit their use.
Henderson Investors runs £13bn in corporate bonds, mostly sterling issues, with most of its external mandates from UK pension funds. Colin Reedie, head of credit portfolio management, comments: “Whereas the corporate bond market was under-analysed in the past, in recent years it has become more discriminating in its treatment of issuers and most active managers have had to invest heavily in analytical resources, as have Henderson, to cope with greater spread dispersion.” Henderson typically runs portfolios of 100 or so investment grade names, with risk tolerances varying by client. Despite significant negative rating activity from the agencies this year, in most cases, the market had already priced-in credit quality concerns, forcing some investment grade issuers spreads’ out to 500-600bps over government bonds.
Historically, once a bond has gone beyond this point, its price will become decoupled from Treasuries and it will trade at a price that reflects to what extent assets cover outstanding debt. Although over the long term, spreads on corporate bonds overcompensate for the risk of default, this is a cyclical asset-class and as a result defaults tend to be clustered. The situation this year has not been helped by a cutback in risk capital by the banks, which has reduced market liquidity especially in difficult credit situations. As Reedie avers: “This year, almost every situation has got worse before it got better, and as a guiding principle, ‘the first cut is the cheapest’ would have served you well.”
A greater emphasis on financial ratios and balance sheet visibility is why Deutsche Asset Management (DeAM) head of fixed income in Germany, Jörg Sihler, is particularly positive on the outlook for euro-denominated corporate bonds. Sihler notes: “The credit curve is particularly steep at present with longer-dated BBB bonds trading at a 230bps yield premium to European government bonds. But the quality of European corporates is generally higher than the US as there has been less incentive for executives to massage the balance sheet.” DeAM has increased corporate bond assets under management in Frankfurt by E1.5bn this year, making the total invested in European credits of E4bn. Says Sihler: “With little prospect of improving equity performance in the short term, investors are deciding that they are better off taking the same risk for a higher yield.” Sihler prefers to run corporate bond portfolios separately to governments, setting a target for risk and performance as if it were a separate asset class. Sihler is dismissive of indexing, suggesting that the indexed investor is more likely to participate in a default because beyond a certain size of portfolio the investor is simply taking more market risk. For this reason DeAM runs fairly concentrated portfolios, containing some 35-50 holdings. Although DeAM had some critical issues, it has enforced a strict sell discipline, divesting across all accounts at the first sign of trouble. Detailed analysis and an insistence on understanding the company fully has helped it avoid the major disasters, and it sets a minimum issue size of E150m to avoid being trapped by deteriorating liquidity. DeAM theories developed by Altman to calculate its own internal credit ratings, which can provoke trading activity if found to be different from market assessments. Earnings forecasts from DeAM equity analysts can also be used as inputs. Its prompt action on the worsening situation is supported by watch screens, which flag changes in model outputs, equity market volatility and news flow.
If the fund is not making a dedicated allocation to corporate bonds then it will likely move to a benchmark that includes corporates and governments. Inclusion of corporates in global bond benchmarks has helped reduce some of the tilt towards Japanese government debt in global bond benchmarks. The most widely used global indices, which take in both government and non-government investment grade issues, are the Lehman Global Aggregate Index (LGAI) and the Salomon Smith Barney World Broad Investment Grade (WBIG). The LGAI contains many more smaller issues than the WBIG and accounts for 20% greater market value. The LGAI includes a far greater variety of issues in different denominations, and includes Japanese corporates, which are not in the WBIG. The LGAI has about a 16% weight to corporate bonds, whereas the WBIG has just under 11%, and this arises from the smaller minimum issue size of the LGAI, at $300m. A study by State Street Global Advisors found the two indices to be highly correlated, with a correlation coefficient of monthly returns over the period of 0.993, and concluded that the risk/return characteristics were not significantly different for either one to be considered a better benchmark.
Within specific denominations, other index providers may offer an advantage. A typical UK strategic benchmark is now 50% gilts and 50% corporates, with the corporate allocation measured against the Merrill Lynch Sterling Non-gilt index, which includes any non-government investment grade issuer. In Europe, the purely corporate Lehman European Aggregate competes with Merrill Lynch in the popularity stakes, although the iBox index, operated by Deutsche Börse, is highly regarded for being derived from competing broker prices, rather than a single bank’s quotes.