Martin Steward finds risk-averse managers picking up spread from asset-backed bonds, subordinated financials and ‘rising-star’ high-yield issuers

Credit portfolio managers generally like to emphasise their bottom-up stock selection and many strip out interest rate, currency, sector, country and sometimes even ratings risk from their portfolios entirely.

But in the past five years top-down risk has come to the fore. Moreover, whereas the major top-down consideration used to be sector exposures, now it is all about political and country risk.

“In the last credit bear market, to be defensive you’d go to utilities and financials,” as Henderson Global Investors portfolio manager Chris Bullock puts it. “Now it’s clear that country has been much more significant than sector.”

At Scottish Widows Investment Partnership (SWIP), investment manager Daniel McKernan agrees. “Our performance comes from stock selection, but it’s difficult to select stocks without some cognizance of what’s going on top-down,” he says. “At the moment the issue is what’s going on in Europe, of course.”

Sovereign credit analysis was done in emerging markets but never for European countries, adds McKernan’s colleague and investment director at SWIP, Mark Munro.
“Now, of course that’s become a crucial part of our analysis. We took a decision 18 months ago to come out of peripheral banks in totality because we weren’t prepared to live with the volatility.”

While the decision on where to take risk regionally is now a key one for European credit portfolio managers, exiting the peripheral euro-zone banks does not necessarily mean exiting periphery altogether. Sometimes investors get paid for the risks associated with troubled countries. Indeed, Munro says that a zero weight in peripheral banks frees up some risk budget for peripheral corporates.

He picks out Luxottica, Italy’s sunglasses and lenses manufacturer, retailer and franchiser whose organic growth in emerging markets requires minimal capital outlay and generates a lot of very bondholder-friendly free cash flow.

“We bought into this name when it wasn’t rated. Two months later it was rated BBB+ at S&P and in March it was put on positive watch,” says Munro. “Eighty percent of the rally is probably already there, but this is one we’d just like to hold.”

Overall, however, peripheral exposures are neutrally-weighted within SWIP. McKernan says that these are difficult calls to make because while Italy looks the better sovereign risk, Spanish companies like Telefónica, Iberdrola and Gas Natural Fenosa have progressed much further at the company-management level.

At Swisscanto, head of credit Jérôme Benathan is a little more bullish. He likes utilities and utility-like names that are not too dependent on their sovereigns or domestic markets, picking out Portugal’s EDP and its committed credit lines from China Three Gorges, which owns 21% of the business; and noting that more than half of Telefónica’s revenues come from Latin America.

“Picking up the right credit in a challenged country is always better than picking a challenged credit in a good country,” Benathan observes. “There are really some jewels in the peripherals, like Telefónica: these management groups have done a great job to withstand sovereign ratings pressure.”

It is a point echoed by Bullock at Henderson, who bought Telefónica as spreads widened during the sovereign scare of summer 2012. Just a couple of years ago management seemed complacent, he suggests, confident in their strong business model – but in the past year they have been producing a multi-point plan to tidy up the balance sheet. He contrasts that with Telecom Italia, whose bonds have enjoyed a good run after it cut its dividend and divested some German and Latin American business.

“There’s not a lot more they can do, but governance is also weaker and it’s harder to understand what’s driving things in that company,” he says.

Other managers simply find Europe ex-UK unattractive. “We don’t really like continental Europe,” says Stephen Rodger, portfolio manager at Baillie Gifford, which is underweight Europe and zero-weighted in the periphery.

This regional position expresses a broader risk-aversion. Baillie Gifford’s allocation to supranational bonds is high – 11.6% of the fund, with the IBRD as its top position – and it has a further 6% in government-backed agency paper.

“To offset our underweights in Europe and credit risk we have been buying ‘interesting stuff’ outside Europe,” he explains. He points to a University of Cambridge issue he recently bought to the tune of 3.5% of assets, AAA-rated but yielding 50 basis points more than the UK government. Rodgers suspects it could yield 10-15 basis points less than its sovereign within a couple of years.

But as well as the security of 800 years of history, Rodger likes other kinds of security: asset and mortgage-backed paper makes up more than 19% of his portfolio, versus 13% for the index. He finds significant mispricing in the market, probably because these are relatively small issues, enabling him to smuggle in more spread without adding risk.

“Sitting here with just £3bn I can happily put 3% into Telereal if I like it enough, which would be a 30 times overweight,” he says.

Telereal owns the property portfolio of the BT Group and secures its credit against telephone exchanges. Similarly, Tesco’s 2041 and 2044 bonds, secured against its supermarkets, currently offer as much as 50 basis points extra yield over the retailer’s equivalent unsecured paper.

At Royal London Asset Management (RLAM), portfolio manager Sajiv Vaid is less bearish – he thinks that spreads are “cheap” and doesn’t have the supranationals that loom large in the Baillie Gifford portfolio – but he, too, likes asset-backed paper as a way to get low-risk spread into his fund.

“The fund aims to be top-decile in terms of yield without taking a commensurate increase in risk,” he explains. “We have chosen to hold less than 5% in high yield and instead attempt to exploit market inefficiencies with unrated and off-benchmark positions.”

This leads to double the benchmark weight in asset-backed and covered bonds, and significant overweights in social housing, investment trusts, property debentures and other sectors often backed by collateral and rated AA or single-A.

“A good example is Grosvenor Finance, a £200m issue that represents a floating-rate charge on the Duke of Westminster’s properties in the West End of London,” says Vaid. “It has to have a minimum of £387m of assets pledged to protect the £200m of principal raised. That sort of bond yields around 2% over government bonds, whereas Next – a good retailer, but quite operationally-geared with lots of leasehold assets – yields only 1.6% over government bonds.”

Is it really a free lunch? Vaid points out that structured paper tends to be very long-dated, delivering a big dose of credit duration into the portfolio. If yields rise and are not offset by spread compression, he concedes that he might be forced to sell good assets to keep control of duration, so he maintains a very diversified portfolio partly to avoid being shut out of liquidity should conditions change.

This is what puts off those managers who shun asset-backed. “There are pockets of increased spread but you do sacrifice some liquidity and can get some serious gap risk when the market becomes volatile,” says McKernan at SWIP.

Rising stars
That leaves good old-fashioned credit risk and, at the moment, the result is usually a meaningful overweight in BBBs and at least some exposure to high yield. The managers at Baillie Gifford, Henderson and Swisscanto all emphasise that their teams are split by sector rather than between investment-grade and high-yield – enabling them to pursue ideas anywhere along the credit spectrum.

Bullock points out that a lot of the bonds rated above BBB are senior financials out of Germany, France and Austria, “hanging on by a thread” as assumptions about taxpayer support begin to fade. “Rather than buying single-A and risk downgrades, we would rather buy BBBs that are improving or stable,” he says. “And in high-yield, a lot of what we own is BB secured corporate paper.”

The ‘rising stars’ among the BB and BBB-rated corporate names that Bullock identifies for more spread with less risk are also well-liked by SWIP and Swisscanto and even, in smaller weights, by the more conservative Baillie Gifford strategy.

“Because we are not taking any of those other long risks we have some budget to spend on stock-specific re-rating risk,” Rodger explains. He picks out Daily Mail & General Trust, rated investment-grade by one agency and high-yield but with a positive outlook by one of the others; he anticipates 10 percentage points of outperformance from this bond alone if and when the second re-rating occurs.

Similarly, Munro at SWIP cites crossover names like Pernaud Ricard and Barry Callebaut from the past and GKN, Lafarge and Heidelberg Cement from today’s holdings.
“Their good chances of making it back to investment-grade over the next 12-18 months should keep a lid on their volatility,” he says.  

A higher-risk version of the same theme can be found in corporate hybrids, favoured by SWIP and Swisscanto in particular, and RLAM to a lesser extent.  

“Hybrids are a big theme for us and arguably the biggest story in credit markets this year,” says Munro.

He cites Pennon, the UK’s water and waste utility, which came to market with an unrated sterling hybrid in 2013 that offers an unusually big coupon step-up at its first-call date in five years’ time: Munro reckons that the coupon would jump to 12.5% – a huge incentive for Pennon to call the bond. “If this company is still around in five years’ time they are absolutely paying this debt back,” he says.

In keeping with the crossover theme, Munro points to ratings agencies’ changing methodology with regard to hybrids – stripping out the equity credit previously granted to certain instruments and effectively re-classifying them as straight debt. Munro picks out a hybrid issued by Austrailan oil and gas supplier Santos that is likely to be re-rated as a result of this change in methodology.

“The move actually really hurt the company – but it will mean that the bond will soon be very, very cheap investment-grade paper,” he says.

“A lot of discussion has been triggered by the change in methodology from the rating agencies with regard to hybrids,” notes Benathan at Swisscanto. He picks out a Dong Energy bond as being in a similar position to Santos’s hybrid. While he warns of the ratings volatility that comes from the uncertainty around these changes in methodology, citing Origin Energy as an example, he has been active in the sector.   

“We will often buy hybrids of robust credits if we think the senior debt is too expensive,” he says. “With EDF, which is a single-A, we bought a hybrid, for example. That has increased our mid-to-low BBB exposure, as have the peripheral corporates.”

Both Benathan and Vaid at RLAM draw parallels between their corporate hybrid allocations and their holdings in subordinated bank paper. Once again, it is about going where the spread is keener but the risk lower. In this instance, it is all about the asset-liability management being forced on banks by regulatory developments.

Banks are buying back their subordinated debt at the first call date, often at above-market levels, and replacing it with contingent capital notes or other forms of ‘alternative tier 1’ capital. At the same time, they have sold a heap of senior secured covered bonds. Unsecured senior paper has become increasingly subordinated, while subordinated paper has become increasingly senior. In response, a common strategy has been to balance subordinated exposures with senior secured.

“The sterling covered bond market was opened up by Leeds Building Society [in 2010] and within the space of six months we took our exposure from zero to about 6%,” says Vaid. “A great example was Clydesdale Bank, which issued in August 2011 at 245 basis points over government bonds, and six months later had rallied by 120 basis points – a 14% return from a AAA-rated asset. That just shows you don’t have to go down the risk spectrum to get those sorts of returns.”

Returns have been so good, in fact, that RLAM has been taking profits since the beginning of the year, as has SWIP.

“Where we can, we hold covered bonds next to subordinated, but we think the senior secured side of that has largely played out,” says Munro. “It’s been a huge rally.”

As well as balancing subordinated risk with senior secured, it has to be said that most of our strategists have preferred to take their bank risk in the UK or US. SWIP, in particular, has seven banks among its top-10 holdings, but only one, ING, from the continent and one other, HBOS, from the UK.

“The US and UK banks have performed just as strongly as the peripheral European banks,” says Munro. “Lloyds and RBS, Bank of America and Citigroup – they were all phenomenal last year: the Lloyds 6.5% 2040 senior bond delivered a total return of 20%-plus.”

The big exception to this is Swisscanto, where Benathan is closing an underweight in seniors and doing so at the short end of the curve in the euro-zone periphery. Two-year paper yields 3-4%, he observes, with LTRO still available but being repaid: he picks out Banco Espírito Santo, which was also boosted by the extension of Portugal’s bail-out loan.

“I wouldn’t buy subordinated paper, but short-term senior is a good way to ease back into these names,” he says. “We are re-visiting our financials exposures line by line. If you get the financials right, you get a lot of things right.”

Swisscanto, SWIP and RLAM all agree on an overweight to banks, at least. Baillie Gifford’s emphasis is much more on insurance and especially re-insurance companies – Amlin is its third-largest holding and it has held catastrophe bonds in the past – while Henderson has an underweight to financials in general.

During the second half of 2012, its portfolio was neutral to the sector – which was in fact “a big position for us”, says Bullock. Like Vaid and Munro, he acknowledges subordinated lower tier-2 paper as the “sweet spot”, citing the Nationwide bonds with a 750 basis-point spread that he bought before summer 2012. But Bullock notes that these are now at 300 basis points over Gilts. He felt the subordinated-banks rally had gone far enough by year’s end.  

“That’s been wrong, but after a big rally, the Italian elections and Cyprus we thought that BBB and high-yield corporates looked more attractive,” he says. “The one risk to that, which has been realised, was a drying up of supply. The ratings are also optically higher and the maturities shorter than most of the corporates, so if you’re an insurer driven by ratings and maturity, then you’ll go for the financials. It’s a very technical market.”

Significantly, even one of our least risk-averse managers says much the same thing.

“The technicals are overshadowing everything else at the moment,” says Benathan. “We see a lot of forced buyers in the market getting dragged into overpriced primary deals. That is a sign of over heating, so we prefer to give away some carry by building up cash levels for better times.”

Whether it is RLAM balancing ratings risk with collateral or Baillie Gifford with supranationals, Henderson balancing high-yielding corporates with an underweight in financials, Swisscanto balancing peripheral bank debt with cash, or SWIP capping its high-yield risk by selecting rising stars and hybrids, all five strategists are struggling to make up for a general lack of spread while not feeling entirely comfortable about taking risk. SWIP and Baillie Gifford seem to have given up the most relative performance in exchange for their caution, but all are now positioning for a much rougher ride in credit markets.