Investment Grade Credit: No bears threaten Goldilocks
“We have pretty much a Goldilocks scenario for euro-zone corporate debt.” That is the intriguing assessment of Gary Jenkins, an analyst at LNG Capital, a hedge fund specialising in European credit.
Too much economic growth, and animal spirits are roused, fuelling debt-funded spending on investment and on mergers and acquisitions; too little, and issuers might struggle to service the debt. Instead, Jenkins notes, the euro-zone is experiencing mild growth and companies are responding with conservative management.
“In the world of bonds, the euro-zone looks a fairly attractive place,” he concludes.
Jenkins and other investors acknowledge the disappearance of an earlier powerful investment play in euro-zone corporate debt markets – investing in debt within the euro-zone periphery, in the expectation that subsiding fears of euro-zone fragmentation would tighten spreads between peripheral and core country bonds. However, investors see plenty of other fixed-income opportunities, both inside and outside conventional bond markets.
“We’ve had the directional move, where spreads on pretty much everything have tightened,” says Nick Gartside, international CIO for fixed income at JPMorgan Asset Management. He thinks spreads could tighten further still but that, by far, the more important dynamic will be “quite a big dispersion within the corporate bond market” as investors focus on returns from more careful analysis of individual issuers’ balance sheets and cashflow.
“We’re now very much in a bond picker’s market, as well as a stock picker’s market”, he says.
The sector cited most often by investors as one that holds promise is bank bonds. Bond investors like the CEOs of the companies they have invested in to be cautious – so they are thankful that, in the long wake of the credit crunch, regulators are weaving caution into the very fabric of the banking system.
“The re-regulation of the banking industry following the crisis of 2008-09 has really made the banking sector very attractive to fixed-income investors,” says Evan Moskovit, portfolio manager for the Global Investment Grade Credit fund at ING Investment Management in New York. “It has really boxed the banks in.”
Moskovit cites, in particular, the trend for deleveraging, by which banks cut lending and sell off existing loans to meet stricter capital requirements imposed by regulators. Analysts note that these rules make banks correspondingly less attractive to equity investors, but more so to debt investors.
If investors see bank deleveraging as a reassuring trend, they have two choices – to stay in the safety of senior debt, or to travel further down the credit hierarchy.
Owen Murfin, fixed-income portfolio manager at BlackRock, still sees value in holding bank senior debt, although he acknowledges that returns are not spectacular. “Buying BNP Paribas senior debt might not offer the most exciting spread
in the world, but it will protect you from the releveraging trend in other parts of the bond market,” he says. BNP Paribas’ euro-denominated five-year debt currently trades at 78 basis points over Bunds.
If investors are prepared to take on riskier bank debt, they can opt for contingent convertible capital instruments (CoCos) – bonds whose value is contingent on particular events. Several bank CoCos can only be redeemed at maturity if the issuer’s common equity tier-1 ratio stays above a certain level. However, this contingency pushes them down to junk debt level and makes many investors wary of them.
Are the CEOs of non-financial corporates showing the same bond-friendly cautiousness as their bank counterparts?
Jenkins of LNG Capital detects few signs of the optimism which has led, at previous times, to bond defaults – in either the financial or non-financial sectors. “We’re seeing a lot of M&A activity,” he acknowledges, “but in sectors, such as pharmaceuticals, that tend to be fairly cautious when it comes to maintaining credit ratings and risk profiles.”
However, Murfin is more worried. He says he is “becoming more and more concerned about the risks arising from releveraging in euro-zone
companies outside the financial industry” – with companies adding debt in order to expand. When it comes to the strategy of growing companies through M&A – usually funded through increasing debt ratios – Murfin notes that several of the preconditions are already there. In particular, CEO confidence in the global economy is high and financing is cheap. “There’s pressure on each company not be the last name left behind,” he notes.
For those investors willing to take on the risk of investing in corporate fixed income, Fraser Lundie, co-head of credit at Hermes Fund Managers, says the risk-reward ratio is, in some cases, better in the euro-denominated credit default swap (CDS) market than in the bond market.
CDSs can be bought to insure against the risk of default by a particular company. Lundie cites the steelmaker ArcelorMittal, whose CDS prices are about 70 basis points cheaper than conventional ArcelorMittal bonds. For utility company Veolia Environnement, prices are about 30 basis points cheaper, with a 20 basis-point difference for energy companies EDF and RWE.
“In Europe, there is a little bit more value in accessing credit through the CDS market than via the bond market,” Lundie concludes. He credits this to the recent growth in liquidity in the CDS market, and the decline in liquidity in euro-zone bonds because of the increased capital cost for banks of holding bonds under Basel III rules.
Another “slightly outside the box” option for euro or sterling investors looking for pure credit risk, according to Gartside, is to invest in bond markets outside the region that offer better opportunities, and then to hedge the currency risk back into the investor’s base currency. The current low level of interest rates makes this extremely cheap. Gartside notes that the US corporate bond market is the world’s biggest and most liquid by far – presenting many more opportunities than the euro-zone market – and that in many cases the same companies issue there. He cites Vodafone, for example, which issues debt in dollars, pounds sterling and euros.
Nevertheless, leaving aside the individual credit quality of particular bond issuers, the same dark cloud is hanging over all euro-zone investment-grade bonds – the threat of eventual monetary tightening by the European Central Bank. One potential solution pursued by many investors over recent months has been to buy and hold short-dated bonds – a strategy whose returns would be completely unaffected by market movements that responded to signs of ECB rate rises.
However, Lundie dismisses this as “the most consensual, overcrowded, ill-thought-out trade” that currently exists. He says that because so many people have opted for this tactic, short-dated bonds have become heavily overvalued.
Another option is stop worrying about monetary policy tightening on the grounds that it will not happen, at least to a great extent, for many years. Jenkins notes the low inflation in the euro-zone, which puts pressure on the central bank to keep monetary policy extremely loose.
“The euro-zone has so many problems to sort out that quantitative easing will be on the back burner for years,” he reasons. This suggests
that the porridge will remain not too hot and not too cold for corporate credit investors for some time to come.