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Is credit due?

Corporate bond managers insist that active management is no luxury in their asset class. Martin Steward asks if they are just talking their book

The case for ignoring credit benchmarks is obvious: why on earth would investors want more concentration in the companies loading up on the most debt - especially during the worst credit crisis in history?

"Why expose yourself to anything less than best-in-class?" asks Stephen Thariyan, head of credit at Henderson Global Investors.

But that's what active bond managers said back in February, and the bounce since then has not been confined to ‘best-in-class'. By September, the broad investment-grade indices were up about 15%, BBB was up 22-25% and high-yield had screamed to 40% or more. As Hymans Robertson's head of manager research, Stephen Birch, puts it: "Much of the performance has been generated by simply holding on to the credit exposure that caused the losses in the first place", and trustees should now demand "a credible strategy for managing credit exposure more actively".

But that might require a leap of faith. The latest Standard & Poor's Index Versus Active Fund Scorecard (SPIVA) shows underperformance of benchmarks by most fixed-income managers to be "unequivocal". One might at least ask just how stretched the beta rally is before giving up on an index exposure. Current spreads of about 200bps are comparable with pre-Lehman, if not pre-2007 days, but higher than the average since 2003, about 115bps. In past cycles the journey from widest to tightest spreads has taken two to four years. Non-financials investment grade is pricing in a default rate of 11%, and financials 20%: that now seems pessimistic. No one expects a return to 2006, when asset-swap spreads fell to 26bps, not least because the shadow-banking carry trade no longer fuels the fire, but the 75bps level does not seem unrealistic.

"That still represents another 100-150bps of tightening, a return of more than 11% from capital appreciation alone," observes Jamie Stuttard, head of UK & European fixed income at Schroders. Investment-grade spreads are still cheaper than they were in the Savings & Loan crisis, or the Asian crisis, or LTCM, or 2002 after Enron and Worldcom."

What about technical pressures? Liability-driven allocators have gorged on long-dated fixed coupons, redirecting money from equities, which have offered the same kind of returns with three times the volatility, and from profits on government bonds; retail investors have been searching for any yield above deposits. The general distaste for government exposure seems robust - but could the equity rally start to suck capital out along the risk spectrum?

"There is currently equilibrium between the implied return on investment-grade credit, the equity risk premium and the risk-free rate, at around 5%," points out Alan Dorsey, head of investment strategy & risk at Neuberger Berman. "The substantial wave of refinancing, driven by the fear around interest rates, is helping to maintain that equilibrium."

Eurocredit new issuance records have already been smashed this year: as early as February Roche placed $16bn. Finance directors knew that depressed sovereign yields meant they faced a similar nominal cost of debt as three years ago while offering investors healthy new-issue spread premiums. "Credit has played a very important role in turning the world around," says Simon Thorp, head of fixed income at Liontrust. "Companies on both sides of the Atlantic have been able to raise hundreds of billions of dollars."

That is significant for the active-versus-indexed decision. Companies securing long-term liquidity improves the outlook for defaults, says Lombard Odier's head of credit, Rodrigo Araya: "It's not loss of revenue, profit margin or free cash flow that causes default, but financing issues." Secondly, that volume of issuance changes the complexion of the indices, swamping a lot of the outperformance effect from the BBBs, the subordinated financials and other high-beta credits. Like Roche, many of the biggest issuers have been high-quality names, often defensive utilities - E.On, Gaz de France Suez, Iberdrola, National Grid, Vattenfall - leveraging for bondholder-friendly capex growth rather than stock buybacks or M&A sallies.

"At the beginning of the year financials constituted almost 60% of the index, with banks making up almost 50%, and a large part of that was subordinated debt," says Hans Stoter, head of credit investment at ING Investment Management Europe. "With the decline of tier one, downgrades into high-yield and the issuance of senior debt and new industrial and utility corporate debt, the percentage of banks in the index has declined to about 42%, respectively. I would argue that the investment-grade index has become healthier."

Paul Abberley, CEO of Aviva Investors, speaks of taking "a scenario-balanced view through the rally", making sure portfolios did not become too exposed to the risk of the recovery flopping. Similarly, Stuttard describes a year of "transition, using periods of volatility and the primary market to populate portfolios with the risks that we didn't want last year". Both rightly claim this as "active management" - but primary market activity has led to similar effects in the benchmarks.

It's the old saw about good loans being made in bad times. But, as Stuttard reminds us, the benchmarks contain bonds issued one year ago, five years ago, 20 years ago: "They include good vintages and bad vintages - an active manager should distinguish between the different risks and opportunities these represent."

And this is just one example that shows that active management is not just about simple sector rotation (indeed, although new telco issues look defensive, the 2001-2002 vintage often comes with step-ups because back then investors had been worried about their balance sheets). Within financials that were issued this year, Rabobank's 11% tier one stacks up well against RBS's 5% upper tier two (especially after regulators stopped RBS from calling it). Authorities get involved in other ways, too: one should not expect GM's fate to befall the big French or German auto brands.

Managers can play against ratings, including allocating a proportion outside of investment-grade indices - a comparison of AA-rated GE with BB-rated Fresenius gives an idea of how easy it is to find excess value that way. Similarly, although Gibson Smith, co-CIO of Janus, urges investors to overweight companies that have the ability to deleverage through free cash flow, this doesn't preclude bondholder-friendly names that want to releverage: "You can generate significant returns from businesses that use debt for acquisition with a view to returning quickly to their optimal capital structure," he says. Having integrated equity and credit analysis helps to assess intentions: "Management will tell bondholders, ‘Our priority is paying-down debt' and tell equity holders, ‘Our priority is to buy back stock'."

Finally, while liquidity has been abundant in primary markets, secondary markets are recovering far more sluggishly as banks remain reluctant to hold inventory, and managers can optimise trading in this newly constrained environment. "The concept of liquidity has changed and we are looking at understanding our ability to transact, and transition our views through the market," says Mark Wauton, Aviva's head of credit. "To that end we've just hired a prop desk high-yield trader with experience maintaining relationships across the Street."

Looking further out, although the primary markets have provided sector rotation from high to low beta in the indices this year, will they give passive investors a rotation back into high beta ahead of recovery, rather than forcing them to lag behind market momentum? In sectors such as autos, where GM, Fiat, Renault and others have been moved out of investment grade altogether, the opportunity cost of being constrained to the index could be huge. "When they get re-rated back up, the indices will take time to catch up," says Luke Spajic, pan-European head of credit and ABS portfolio management at PIMCO. "If you have little discretion or are indexed, you can only move in line with the ratings agencies."

The credit markets have been kind to passive investors this year, and arguably they now present less downside risk than for years. But we now move into an environment of greater uncertainty - and opportunity. As Aviva's Abberley suggests: "The best that can be said is that corporate bond indices are less unfit for purpose than they were before."
 

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