The temptation to look beyond sovereigns for yield is understandable. But Martin Steward finds that the obvious move into top-quality corporates may not be the way to do it

Corporate credit portfolio managers are getting used to talking about ‘yield’ as well as ‘spreads’. This lexical challenge comes as more and more institutional investors turn to credit to do the jobs that used to be reserved for the sovereign market: low-risk income generation; duration or liability-matching. 

“Each week we seem to hit new lows in core sovereign yields,” says Jake Gaul, a portfolio manager at Standish Investment Management. “And we’ve seen increasing interest in high-quality corporate mandates, from pension funds, sovereign wealth funds and central banks, as a replacement for AAA sovereigns.”

As several sovereign issuers have ceased to be perceived as ‘risk-free’ they have been removed from investors’ government bond benchmarks and capital has flowed into the ones that remain. This has both diminished the available sovereign market and pushed core yields to very low or even negative levels. Corporate bonds are increasingly seen as the only place left to go.

“A number of clients are pushing into more investment-grade corporate credit but want to know how they can do that without increasing default risk,” says Christian Roth, head of global fixed income at Morgan Stanley Investment Management (MSIM). “Indeed, they really are looking to decrease default risk.”

 MSIM offers what seems to be the obvious solution: credits that are so strong - because they have very diversified or monopoly-type businesses, unassailable brands, or ties to government, like a defence company or utility - that they are highly unlikely ever to be priced for default. It calls them ‘franchise credits’.

“A portfolio of lower-spread, low-volatility securities allows bonds to be bonds,” says Roth. “When your equities are doing very poorly that bond portfolio should hold up well.”

However, this is easier said than done. MSIM’s universe includes about 200 issuers: you’d have difficulty getting that many names if you focused on AAA or AA-rated corporations. Less than 1% of the Barclays Euro Aggregate Corporate Bond index is rated AAA, and only another 16% is rated AA - including financials. And while they are often very large, they issue a small amount of debt almost by definition.

“When we speak to clients who are making their first step into credit as a move away from sovereigns, their focus is on AAA and AA, but that’s a complete non-starter if you want a diversified portfolio or an investable universe,” says Gaul at Standish.

“Sometimes a client will ask for x amount of yield from a fairly high-quality portfolio  - but the only way to get that yield is by taking a high degree of financial-system risk or indirect European sovereign exposure. At which point they say: ‘No, thank you’.”

As well as being impractical, it is expensive. Index yields for AAAs are about 90-120 basis points; and that only rises to 1.5-1.7% for AAs. It’s only as you get to single-A that yields edge up towards 3%.

“Forcing yourself down the route of investing according to a particular ratings or sector constraint leads you into the common mistake of buying those securities even though they are very expensive,” says Richard Ryan, manager of M&G Investments’ Alpha Opportunities fund. “I’ve nothing against high-quality German industrials - they’re great companies. But they’re not great investments because we’re not the only ones that recognise that they are great companies.”

Investors need to snap out of the idea that they are going to corporate issuers as sovereign proxies, or looking for ‘risk-free’ assets with a yield pick-up, and see themselves as simply addressing the fixed income problem with “a bigger toolbox”, suggests Amundi’s head of fixed income Eric Brard.

Pete Drewienkiewicz, head of manager research at Redington, agrees. “We certainly do use high-grade corporates in liability-hedging mandates, but not really as an alternative to sovereign debt,” he says. “It’s more about achieving a nice mix and a better blended yield: you’d probably want to have a slightly more diverse portfolio that is not quite so highly-rated.” Indeed, you’d need to do so, he argues, because you would need more than the 20-30 basis point AAA/AA spread to compensate for the inconvenience of not being able to post them as collateral against derivatives.

There are some opportunities that deliver better spreads than over-loved corporates before you have to head down the ratings. Supra or quasi-nationals like the EFSF, the EIB, Germany’s KfW, or BNG, the Netherlands’ public-sector bank, offer spreads of 100 basis points or more even at longer maturities. High-rated asset-backed securities (ABS) and the bank-issued covered bonds trade relatively cheaply, too. Eric Holt, head of credit at Royal London Asset Management (RLAM) particularly likes UK social housing association bonds, which are generally rated from single-A up to mid-AA, with very long maturities, trading at 150-200 basis points over Gilts at 30 years and sponsored by government (subject to the vicissitudes of housing policy).

Once you do venture into corporates, you find that the better-looking investment grade spreads are in BBB non-financials. These include names like AngloAmerican, Deutsche Telecom, Imperial Tobacco and Thames Water. “There’s no shortage of names with stable-to-improving credits at these ratings with decent spreads,” says Gaul.

“Quality corporates come from both investment grade and high yield, and what we tend to look for is seniority, security and, above all, strong relative value,” says Ryan. “Security and seniority seem still to be undervalued by investors and we find that very puzzling.”

Olivier de Berranger, a portfolio manager at Financière de l’Echiquier, notes that truly global multinationals, rather than being priced off of their respective sovereign curves, are finding their yields being dragged down by German sovereign rates, while those with a domestic focus in the euro-zone periphery see their credit priced in line with their own beleaguered governments. But there are exceptions.

At Pioneer Investments, Gareth Walsh, head of European credit research, and Tanguy Le Saout, head of European fixed income, note that issuers in the euro-zone periphery have curves that are fairly flat between two years and 10, and completely flat between five years and 10. Ratings agencies cannot allow companies to be rated more than two notches above their sovereigns so, inevitably, there is some technical correlation - but often this does not make much fundamental sense. Walsh picks out Pirelli: internally rated as BBB+, with more than 90% of its revenues coming from outside Italy, strong profitability and modest gearing, he reckons it would be 350 basis points cheaper if it were German. “Over the last 6-9 months it’s been country of domicile that has determined the spreads on many corporates,” he notes.

But this is as much about maturity as it is about credit quality and domicile. Because the government yield curve is so steep, the difference in spread between AAA/AA and BBB bonds is most pronounced at the front end. While the highest-quality issuers remain priced as if they were interest-rate risks - exhibiting quite steep curves - lower-grade issuers have a greater proportion of their credit risk priced-in, and exhibit flatter curves.

“That means that the part of the curve where you have most visibility also happens to be the part of the curve where you are best-paid for taking credit risk,” notes Christine Johnson, corporate bond fund manager at Old Mutual Asset Management (OMAM).

Brard at Amundi agrees and, to illustrate the point, he observes that during recent bouts of credit market volatility the downside has been more limited in high-yield bonds than in high-quality corporates. If lower-rated issuers are being priced properly for their credit risk, they go into any period of market volatility with a flatter yield curve, and because credit spread volatility is higher at the short-end of the curve then the long-end, the flatter the curve the more protection you get.

Lionel Martellini, professor of finance at the EDHEC Business School, recalls that his project of research into managing sovereign bond risk by diversifying into corporate credit was inspired by looking at what happens on nominal and inflation-linked curves.

“There is a clear analogy between comparing credit and sovereigns and comparing nominal and real bonds,” he says. “If you look at the time series of the breakeven inflation rate you clearly see that there is much more volatility at the short-end than the long-end. And the magnitude of the effect is substantial: something like a beta of 0.30 at 10 years versus two years.”

But there is substantial disagreement about exactly how steep investment-grade curves are and exactly how vulnerable those curves are to aggressive flattening in a credit bear market. Gaul at Standish says that a BBB industrial certainly has a flatter curve than the likes of a Walmart, offering more of a “spread cushion”. In the US in Q3 2011 he notes that the long end of the credit curve outperformed the short end, but says that was probably because much of the short end is dominated by financials, which saw the biggest sell-off.

“If we experience another period of stress, what would happen?” he muses. “It’s hard to say, but my guess would be a fairly sharp sell-off at the front end.”

Similarly, Union Investment’s head of credit Stephan Ertz warns that high-grade corporates are at the low edges of their spreads today and that some even trade through the swap curve. “Curves flattened substantially in Q3 2008, and in that kind of deep crisis the flattening effect is much greater than the steepening that you find in high-grade credit curves in benign markets,” he says.

The reason for the original steepening, of course, is that these high-grade corporates are considered sovereign proxies and get priced as if they were almost purely interest-rate risk. But Robin Creswell, managing principal at Payden & Rygel, uses precisely that point to argue that these issuers’ curves should not flatten substantially during a credit sell-off.

“The higher quality stuff didn’t sell off that much in Q3 2011, compared with the lower-quality corporates,” he insists. “As long as you think that the governments of the world are going to support the financial system, the very highest-quality bonds look more and more like sovereigns and trade with much more liquidity than the lower-quality bonds. Only if those policies were abandoned would you see that link fracture.”

The other alternative, of course, is the sudden appearance of an idiosyncratic default risk - an oil major’s drilling platform blowing up, say. 

“An initial condition for a high quality credit portfolio is that you don’t have exposure to that systematic credit volatility,” says Richard Ford, head of European fixed income at MSIM. “With a well known, strong performing consumer staple it’s hard to see what credit event would be correlated with a change in the credit curve of that asset. I can see the possibility of an idiosyncratic event doing that, but the likelihood is very low, especially as many of these companies are very diversified.”

Ryan at M&G agrees. “Without that idiosyncratic risk, high-quality credit is behaving much more like interest-rate risk rather than credit,” he says - meaning that the curves are relatively steep, but that they will remain steep or even steepen further in the event of generic credit weakness.

The contention owes at least something to the fact that corporate curves are more numerous, idiosyncratic and patchy than sovereign curves. Nonetheless, we can look at some examples of curve movements from Q3 2011 to get a sense of how different credits reacted through a period of volatility.

Figure 1 shows what happened between 10 years and 20 years for selected issuers. As might be expected, the German sovereign curve steepened initially before settling back to its initial shape. Germany’s state-owned development bank KfW exhibited a very similar pattern. The EIB curve flattened, but don’t be misled: this was a bull-flattening - the front end of its curve was so low that downward movement in yields could only be expressed in the longer-dated bonds. The GE flattening, by contrast, was a bear-flattening: the 10-year yield moved up more than the 20-year yield.

The picture becomes even clearer when we focus on the two-year and 10-year points in figure 2. Again, don’t be fooled by the flattening in the curves of Germany, KfW and the EIB - these were all of the bull variety. This would have been a curve-steepening had short-end yields not already been anchored at near zero. Our highest-rated corporate, GE, saw its curve bear-steepen slightly - but the initial move was a bear-flattening as the two-year sold off much more rapidly than the 10-year. Our next highest-rated credit, Shell, reacted more like the sovereign and quasi-sovereigns, with a straightforward bull-flattening. But it was our lowest-rated corporate, BAT, that showed the most pronounced (bear) steepening: its two-year bond yield actually fell by 10 basis points, while its 10-year rose by 28 basis points.

In figure 3 we look at the curves of the credit spreads over the German sovereign. As might be expected, the KfW spread curve barely moved; and the EIB’s stayed close to the benchmark sovereign’s curve, too. The two AA-rated credits’ spread curves moved in opposite directions, as the long end of GE sold off and the long end of Shell rallied. But intriguingly, it is the BBB+ BAT whose credit spread curve most resembles those of the supranationals.

There are at least two conclusions one can take away from this. One is that a higher-rated credit can be either quite well anchored at low yields at the front end of its curve, or highly liable to a sell-off there. It seems pretty idiosyncratic - and perhaps related to sector. The other is that a lower-rated credit can be just as well anchored at the front end, and can experience most of its credit spread volatility further out on the curve. 

A strategy for using credit-spread assets in place of sovereigns begins to suggest itself - and it isn’t necessarily about a straightforward move into the highest-quality issuers across the entire curve. At the front end, investors are apparently well paid for taking extra credit risk: lower investment-grade or even high-yield looks good for spread here. In the seven to 15-year part of the curve, the spreads on higher-quality corporates look most generous and, as we have seen through Q3 2011, there is room for bull-flattening from the interest-rate sensitivity of those bonds. At the very long end, governments may have to continue doing the job; high-quality corporate spreads, if you can find them, are illiquid and not particularly generous. But a little extra yield could be obtained from supranationals and idiosyncratic credits like housing association bonds.