Martin Steward finds corporate bond managers tip-toeing carefully around banks’ capital structures to limit their underweights - and ramping up other sources of risk to compensate

You know something is badly wrong on this side of the Atlantic when the top four holdings of a strategy labelled ‘European Investment Grade’ are Wells Fargo, Goldman Sachs, Citigroup and JPMorgan.

“Is that a home-country bias?” ponders Boston-based Standish Investment Management portfolio manager Jake Gaul. “I don’t think so. There are a lot of fundamental advantages in the US banking system versus Europe.”

Europe’s banks have not been completely absent from Gaul’s portfolio. HSBC, Credit Suisse and select Nordic names still account for some corporate bond exposure: and a year ago he held some covered bonds, which are rated separately from their issuers as they benefit from the security of those issuers’ loan books, but which traded at similar levels to standard senior unsecured bonds; But he finds it increasingly difficult to find value anywhere among Europe’s banks.

“Lower tier two JPMorgan, euro-denominated trades significantly wide versus other tier two bank paper in Europe - and JPMorgan is one of the strongest banks in the world,” he says.

And yet the strategy remains 10 percentage points underweight financials, despite those US holdings. Recent announcements from rating agencies clearly signal the direction of travel, says Gaul: “The whole sector has been overrated and is probably still overrated.”
And our featured US corporate bond funds aren’t exactly groaning under the weight of bank paper, either: Delaware Investments is 6.5 percentage points underweight financials; MacKay Shields is eight percentage points underweight financials; and SEIX Investment Advisors runs a significant underweight to banks.

“It’s a high-confidence position for us,” says SEIX portfolio manager Adrien Webb. “There are still a lot of assets that will continue to cause problems, especially residential real estate. The banks will be the number one vector for contagion out of Europe in the event of any drama. And even without any drama, Europe will experience a recession. My guess is that if banks were a tiny part of the index, nobody would own them.”

That is the more extreme position. Thomas Chow, senior portfolio manager at Delaware, sees signs of “stabilisation” in residential real estate exposures and points out that credit cards, autos and other loan books look much healthier. Lou Cohen, managing director at MacKay Shields, reveals that his portfolio is actually moving back towards the benchmark after running a really big financials underweight through 2008 and 2009. While he doesn’t see where growth will come from, that is positive for bondholders who see risk being taken out of the business. “The true underlying credit quality of the major US banks is quite good.… even for some of the poster children of distaste over the past couple of years - banks like Citi and Bank of America,” he says.

Both prefer more solid names - JPMorgan, Wells Fargo, Goldman Sachs, Morgan Stanley - and venture down in the capital structure to lower tier two. Crucially, this is not just about confidence in the credits but also in the way that US banks’ capital has been restructured.

Basel III requires much bigger cushions of loss-absorbing capital, but Europe’s banks have resisted biting that particular bullet: witness attempts to replace non-loss absorbing tier two debt with contingent convertibles. By contrast, ‘CoCo’ has not been to the taste of US issuers at all; the vast majority of liability management has been simply to retire expensive tier two and issue equity instead. “The US banks took a lot more of their medicine in 2010,” as Webb puts it.

The result is cleaner capital structures - tier one equity and senior debt, with not much in-between - and clearer seniority for all bondholders. Against those cushions of deposit and equity funding, Europe’s reliance on money markets and hybrids on the liabilities side looks distinctly shaky - even before investors consider how assets are being weighted to calculate capital ratios.

“Dexia had almost the highest tier one capital ratio in Europe,” Webb observes. “Two weeks later it folded. The whole tier one capital thing can be misleading if you don’t know how assets are being risk-weighted.”

Among the top European portfolio managers, Patrick Vogel, head of European credit portfolio management at Legal & General Investment Management (LGIM) comes closest to this scepticism. His 16 percentage point financials underweight compares with more neutral positioning at Kempen Capital and Insight Investments.

“We just don’t feel comfortable with banks at all,” he says. “[Basel III represents] the right steps, but they still don’t give enough comfort to the investor community. We’ve found a lot of discrepancy in banks’ risk-weighting - which means that the tier one ratio, usually taken as an indicator of the strength of a bank, is relatively meaningless.”

At Kempen, the neutral weight is really about the benchmark. The strategy observes a five percentage point active weight limit on sectors (beta-adjusted) - it simply cannot take huge bets. To achieve balance, it has gone for high-beta geographical exposures and covered bonds for the extra security - BBVA is in its top 10 holdings, and it also holds Unicredit and Intesa Sanpaolo. In corporate bonds it has favoured the highest-quality names (Rabobank, Nordea, HSBC) at lower tier two, for fear that senior bondholders are increasingly subordinated to the covered bonds.

“The difference between being a senior unsecured and being a lower tier two subordinated holder is becoming less clear, and if banks get the opportunity they will come to market for senior unsecured funding, which will put a limit on spread-tightening for those issues,” says senior portfolio manager Richard Klijnstra.

While Insight Investments still exploits senior versus covered bond relative value, senior fixed income product specialist Emma du Haney feels that this opportunity has largely played itself out; portfolios lean more on lower tier two as part of a general rotation back into financials.

“We did well going underweight financials against industrials [in 2011], and moving back the other way more recently,” says du Haney. “The growth situation clearly affects cyclicals. And longer-term it’s not sustainable for financials to trade wider than other corporates - a bank’s business is to borrow money and lend it on, so that model is broken if banks’ cost of capital remains higher than their return on capital.”

Du Haney points to the large volume of recent corporate issuance out of France: European companies are being rebuffed for loans as banks de-leverage; the banks’ spreads narrow as they cut back on risk and the corporate spreads widen as they are forced to offer premiums to the primary bond market. “At the same time the banks don’t have to come to capital markets so much, because they have all the liquidity they need from the ECB,” she adds.

Doubters say that’s a valid argument only if banks do, indeed, resume the utility-like business model. Vogel notes that loans are neither scarce nor expensive for Europe’s large-caps, because banks use them as loss-leaders for higher-margin services. They don’t need to be compensated as much for default risk as corporate bond fund managers do, while governments and the ECB sit behind them. “The banks need to get honest again,” he says.

Webb at SEIX says: “At the moment when the Street is trying to sell you a financial they’ll throw up a chart showing how cheap it is relative to industrials or utilities. But I’ve always felt that financials should trade wide to these other sectors because it’s much more difficult to figure out the balance sheets[…] The last thing I’m going to do is go to a client and say: ‘We didn’t really like Bank of America, but we were pretty sure the government would bail them out if anything happened’. But, frankly, I think that’s where a lot of analysts are right now. They don’t put it in their research papers, but they’ll talk that way over drinks.”

And so today’s environment presents a formidable technical challenge: rude health in non-financials and unlimited central bank liquidity are driving risk, while financials remain a mess - and represent half your benchmark.

Barbells abound: cutting back risk in one area to take it in another. We see it within financials: covered bonds in peripheral euro-zone names; lower tier two in robust franchises. We see credit spread duration barbells across all of these strategies: overweights at 0-3 and seven-plus years on the curve and underweights at 3-7 years. In terms of ratings, those who hold AAAs tend to be overweight, balancing universally high weightings in BBBs and high yield, and resulting in universally low weightings to AAs and single-As.

The most extreme iteration of this comes from the LGIM portfolio. Its strong performance through Q3 reflects the fact that through the second half of 2011 it carried 14% of its portfolio in short-dated German Bunds (avoiding cash, to make sure that it would get Deutschmarks back in the event of a euro-zone break-up). But LGIM clearly aims to outperform a credit benchmark and, in any case, its general macroeconomic view was brightening. Attempts to model a scenario in which Italy and Spain went through a similar recession to 2008-09 simply proved impossible under reasonable assumptions. The Bund liquidity was rotated into credits - especially BBBs - and the portfolio outpaced its benchmark by 40 basis points in January, even with its big underweight to financials.
“It’s not so unusual for us to have a high weight to BBBs,” says Vogel. “LGIM has a lot of resources and we benefit most from concentrating them on riskier names that we understand better than the average analyst.”

Strategies with tighter constraints on credit-quality or beta have suffered, by comparison, through 2012. Alain van der Heijden, senior portfolio manager at Kempen, concedes that his preference for more security in stronger peripherals cost the portfolio in January. Where others balance underweights to financial-sector risk with high-yield non-financials, his strategy can only hold bonds downgraded to high-yield - it cannot buy bonds already rated high yield. Currently, its only position is a Société Générale tier one.

Instead, it focused on picking up value in insurance companies like Munich Re and Allianz that were dragged down with the banks. These are A and AA-rated institutions, generally, but their ratings are heading in the wrong direction. The portfolio’s yield, at 4.6%, is actually slightly lower than the benchmark’s, but the beta of its higher-risk positions still needs to be offset by high-rated ABS. Other managers, without such tight constraints, seem better able to reach down to BBB and BB non-financials that are heading in the other direction as improving credits.

Standish is a good example. It is required to maintain average credit quality in line with its benchmark but, by barbelling with AAAs, it has been able to allocate almost 7% to high-yield, in addition to a meaningful BBB overweight.

“In terms of fundamental credit risk, owning high BBB industrials with strong balance sheets is probably a less risky proposition than even some AA-rated financial institutions,” Gaul argues. “[In high-yield] we look for credits likely to be heading to investment grade.”

He picks out Ford and Heidelberg Cement, but also the poster child for re-rating, Pernod Ricard. After taking on bank debt to finance acquisitions, management made it clear they felt it was time to graduate to investment grade, says Gaul. “When they came to the US market we bought aggressively. We felt that there was an incentive for them to keep that balance sheet clean. In dollars, we think pricing is fair today, but in euros we still think they present good value.”

Ford, Heidelberg and Pernod are pro-cyclical names, favoured because they are still de-leveraging at a point in the business cycle when equity holders are pressing companies to deploy their idle cash. Other examples are not easy to find, and for that reason managers of European portfolios tend, instead, to hold higher-rated non-financials generating recurring revenues. Insight likes rolling-stock lessors and real estate landlords, for example. Vogel at LGIM favours utilities like EnBW, EDF and DONG Energy, but sees them as part of a broader allocation to reliable cash flows that includes infrastructure (BAA and Autoroutes Paris are in his top 10) and media.

“We find satellite operators that we consider to be similar to utilities - as long as we keep watching television they will continue to generate revenue,” he says.

Standish also “sees value” in the sector, but Gaul picks out News Corp - a non-cyclical name with a conservatively-managed balance sheet, for sure, but one which was increased in the portfolio only after a sell-off following scandals at its newspapers. Similarly, Tesco was increased after a disastrous Q4 profits warning.

Otherwise, quality non-financials look expensive. In sectors like consumer staples some names trade through the swap curve, says Klijnstra at Kempen, even as equity holders press for capex: “That represents very little upside for a long-only investor.” As a result, Kempen has been much more attuned to relative rather than absolute value - for example, buying Casino Guichard-Perrachon at 100 basis points over its fellow French retailer Carrefour (carrying less debt but pursuing a sub-optimal business strategy).

Many of these dynamics are evident in the US, too, but here managers seem better able to take risk. Again, this goes for spread duration and credit ratings: Delaware Investments’ strategy is 11 percentage points overweight BBB and 14 points overweight high-yield, including CCCs; MacKay Shields is 24 points overweight BBB and 19 points overweight high-yield. But it is also evident in sector positioning.

Some issues are recognisable from the European environment; in utilities, consumer, telecoms, pharma and large-cap industrials at mid to high BBB, Chow says that “pristine balance sheets” are making equity holders’ trigger fingers itchy. “Balance sheets can support that for now, but things can become problematic very quickly - perhaps within the next 12-18 months.”

But whereas European managers tend to respond by focusing on individual value opportunities or relative-value pair trades, the US managers are more prepared to embrace pro-cyclicality and growth to balance their aggressive underweights to financials. Major holdings for Delaware include resort chain Wyndham Worldwide, capital goods names like Meccanica and industrials like Alcoa and Georgia-Pacific.

“The BRICs continue to grow and it’s still early days for demand on resources,” says Chow. “Alcoa, ArcelorMital, Georgia Pacific - they benefit from that. But they also remain cautious, with the flexibility to pull back on capex plans.”

Where US managers differ it is about the sources of growth. Chow’s portfolio is global, in terms of underlying revenues and willingness to look at names like Woolworths in Australia and baking giant Grupo Bimbo in Mexico.

By contrast, Cohen at MacKay Shields plays BBB and BB across a much more domestic-oriented portfolio. His biggest overweights are to utilities (11 percentage points) such as Duqeusne Light, Puget Sound and Georgia Power and consumer cyclicals (13 points) exemplified by high-end department store Nordtsrom. “Our macro outlook, as it pertains to these bonds, is less about booming emerging economies and more about domestic consumption,” he says. “With the US consumer feeling a little more optimistic - but not too optimistic - many companies can grow their business without big increases in capex or excessive reliance on acquisitions. Even further down the credit spectrum, our theme of gradual recovery in domestic growth is a blessing in disguise for bond guys, for precisely the reasons that it doesn’t get equity guys very excited: the caution expressed by management is good - Nordstrom have been very cautious with stocking levels, pricing, and costs - but the likelihood of a big back-up in Treasury rates is also reduced.”

The exception among our US managers is SEIX. Its credit ratings spread looks much more like the Europeans’ - overweight AAs, underweight single-As, a slight underweight in BBBs and a mere 5% allocation to high yield (all BBs). Its conservative positioning gave it very consistent performance to the end of Q3 2011, but left it out of Mercer’s top quartile after the Q4 rally.

“In June, with QE2 coming off in the US and our expectation that the Greek situation would grab headlines again, we took a fair amount of risk out by selling financials and rotating into diversified manufacturing names,” says Webb.

This comes across in SEIX’s top 10: there is Intel with its net-cash balance sheet; IBM with its recurring revenues; General Eletric with its product-line diversification. There is a strong natural resources tilt, it is in issues like Statoil, the eighth-largest holding, which is two-thirds owned by Norway. Among its BBBs we find relatively stable names - pipeline companies like Enterprise Products and Enbridge are good examples. “They use a lot of capital so it’s unlikely they’ll find themselves rated above BBB,” Webb concedes. “But it’s just as unlikely that they’ll ever slip below BBB: their revenues are typically cost-plus like an electric utility, but whereas electric utilities trade very tight to the BBB index, pipelines trade with a significant spread.” Aircraft lessor Aviation Capital, the second-largest holding, delivers lower-beta exposure to a high-beta industry: “Amazingly, they increased their earnings through 2007, 2008 and 2009,” says Webb.

But, importantly, SEIX comes closer to Delaware than MacKay Shields in its willingness to embrace growth. Statoil has Brigham Exploration in its sights as an acquisition target. Another of its BBB top-10 holdings, Australia’s Woodside, was bought in 2008 as it issued bonds to finance a new liquid natural gas project. “Shipping demand for LNG from Asia is a growth area, and therefore not so cyclical,” says Webb.

Growth very rarely comes up with European bond managers, but good credits coming to market to finance sensible growth are an important source of extra yield in US markets.
“Nothing makes me more nervous than a small company with a pristine balance sheet, growth issues and a stagnant stock price,” says Webb, pointing out that Woodside’s bonds outperformed substantially once its new project came online. From among many other examples he picks out InBev’s acquisition of Anheuser-Busch in 2008.

“They came to market at just the wrong time and that forced extremely wide spreads on them - and we bought a lot,” he recalls. “Management bonuses had triggers linked to deleveraging targets, and as they approached those targets we sold. You know it’s just a matter of time before they lever-up again - and we’re waiting so we can buy their new bonds at a good level.”

It is the breadth and depth of US corporate markets - especially at BBB and below - that generate these opportunities in volume and enables meaningful allocations to capital-appreciation beta in non-financials. In today’s environment - early signs of economic recovery, but an understandable reluctance to gear into that via bank paper - those opportunities are invaluable. They must partly explain how US portfolios have outpaced European portfolios over the past three years - and it is difficult to imagine the situation changing radically over the next three years. No wonder seven out of Standish’s top 10 ‘European’ holdings are US names, or that Insight’s ‘European Credit’ strategy has almost 13% in US issuers.