Investment in European fixed-income markets has undergone a radical change with the introduction of the euro. We find ourselves in a period where long-term interest rates will continue to be low and rather stable. Investments in credits, which are bonds that are not issued by governments, is an alternative way to obtain performance.
We at Robeco and Lehman Brothers have carried out a study to find out how much outperformance, corrected for risk, can be achieved, by investing in credits. When investing in credits, we distinguish the following decisions:
1. Asset allocation (government bonds versus credits)
2. Credit allocation (rating classes)
3. Sector allocation (financials, utilities.)
4.Debtor (issuer) allocation.
The study was performed on US corporate bond data and US dollar denominated eurobonds. We assumed perfect foresight of future market developments. In debtor selection, for instance, the best five% bonds, i.e. the bonds with the highest excess returns, are selected each month.
The “perfect foresight” results are of interest because they represent the best possible results. Actual investment results in credit markets depend on the quality of the investment strategy in place. The most significant conclusion that has been important for the design of our investment process is that potentially a large outperformance can be achieved by means of debtor selection.
Although the study used US data, we believe the results are relevant for investments in credits in general and for investments in euro credits in particular. As a result of the study, We pursue an active selection policy within debtor classes. With asset allocation, credit allocation and sector allocation, it is possible to achieve only a limited out performance by means of an active allocation policy.
We, therefore, apply an active asset allocation, rating allocation and sector allocation policy to diversify portfolio risks. The expression active policy means that investments are made in as many debtor classes as possible, in order to reduce risk.
The question arises whether an investment policy as described here can be applied to the euro credit market. To answer this, we first outline the structure of the euro credit market, and then deal with the issue of whether the market offers sufficient possibilities for such an approach.
To give an impression of the present structure of the eurocredit market, we draw a comparison with the US credit market. The most obvious differences between the two are: credits in Euroland are a smaller proportion of the total bond market. The US market consists of 54% credits, the euro bond market includes only 33% non-government bonds.
The euro credit market is dominated by issuers in the financial sector. The US credit market consists of 28% financials, the euro market claims 71%. Compared to the US market, issues in the euro credit market have relatively high creditworthiness. In the US, 21% of credits is AAA or AA, in the euro market 74% of the credits are in these classes.
From these features it can be seen that the euro credit market is not as fully matured as in the US. However, it is our opinion that it offers possibilities for Euroland investors. Constructing a well diversified portfolio with current issues is possible because investment portfolios in credits are small in relationship to capitalisation. Moreover, it is the case that the process of constructing a portfolio will involve mostly participation in new issues. Therefore, our view is that the growth of issue volume and the rating and sector spread of new issues is more important than the current features of the market.
The euro credit market is growing steadily. In 1998, a total of $169bn (E186bn) was issued in eurobonds. 1999 is expected to see an issue total of $260bn, a growth of 54%. Compared to 1997 this would mean a growth of 250%. There is every reason to suppose the market will continue to grow, especially as the role of banks in providing capital is diminishing.
The supply of paper that will arise because banks are providing less capital, will most probably generate a more balanced rating spread than is currently in use. This change will mean that the ratio of issues from the financial sector compared to other sectors will decline.
It will also lead to a more balanced sector spread. This is because companies that are leveraged, and therefore have a need for financing from the bond markets, generally have lower ratings than AAA or AA.
This clearly indicates that the differences between the US and European credit market are diminishing.
Peter Ferket and Edith Siermann are with Robeco’s credit team in Rotterdam