Measuring credit quality post-Euro
Over the past year, fund companies have been preparing for the launch of the euro. Since the begining of the year, many fund sponsors have merged funds and redenominated the 'new' funds into euros. In other cases, existing funds were simply redenominated in euros. The flurry of activity was clearly evident on January 4, when Moody's confirmed the ratings on over 30 fixed income and money market funds that were involved in mergers or accounting currency changes.
Other fund sponsors are revising product lines, looking for pan-European opportunities for their shareholders. Under Europe's economic and monetary union (EMU), investors should have the advantages of a strong currency, eliminating differential inflation risks and currency risks among the EMU countries. But what effects will a single currency have on the credit quality of euro-denominated funds? Will credit quality improve or suffer? There are no easy answers to these questions, although the changing economic structure of Europe is sure to affect the credit assessment of some funds. The first major event affecting the credit quality of euro funds took place months ago when the 11 participating countries were confirmed. The certainty of a pan-European currency had a significant effect on the credit quality of funds domiciled in non-Aaa EMU countries. To understand why, it is useful to look at Moody's approach for rating individual securities within a given country.
Moody's currently assigns a foreign currency debt ceiling (FCDC) to all countries in which there are ratings. This ceiling, which caps ratings on foreign currency obligations subject to acts of state, is based on the concept of monetary sovereignty. It reflects the risk of government implemented exchange controls that could limit access to foreign currency. From a ratings' standpoint, this means that foreign currency denominated securities in a given country can be rated no higher than the country's FCDC, even if the obligor's creditworthiness, measured in local currency, is stronger on a stand-alone basis.
Domestic debt ratings, on the other hand, are not necessarily limited by a country's FCDC because domestic debt issues are serviced using the country's local currency. Because transfer risk does not exist, the rating reflects the fundamental credit risk of the issuer.
When the single currency was introduced, a single FCDC was established for the euro, replacing individual country ceilings. The euro's rating is Aaa, meaning that fund ratings which were limited by a foreign currency ceiling could be changed to reflect their underlying holdings. Last May, for example, a number of Italian bond funds were upgraded, which invested in Swiss, German and US government debt, from Aa (Italy's FCDC) to Aaa (reflecting the credit quality of the holdings in the funds). If one looks at the typical European bond fund in a pre-euro environment, it invested in high grade debt. These holdings were predominately government securities with a sprinkling of 'blue chip' corporate debt. The average fund also had a moderate duration of three to six years, depending on the currency. In fact, fund duration shortened after 1994, when many funds suffered a short-term performance drought following spikes in interest rates. For many retail funds, performance was achieved not through investment in lower credit quality holdings, but by taking advantage of interest rate spreads between the EMU countries and arbitraging currency risk. As Chart 1 shows, however, by May 1998, rates within the EMU had converged to a point where spreads between countries were negligible. The fixing of foreign exchange rates to the euro on the first of the year eliminated any potential for foreign exchange arbitrage. So the question is what's left to enhance return? The logical answer is the holding of the fund. As pan-European competition between fund managers heats up, there will be a heightened emphasis on performance. But performance will have to be achieved using new risks. This means not only will fund companies need to invest in new risk management tools and techniques, but previously 'experienced' fund managers may now be 'inexperienced.' Many asset management groups, which historically relied upon their parent bank or insurance companies credit departments have found it necessary to develop their own in-house credit teams. This process involves finding qualified analysts and also requires the development of policies and controls to assure that risk is controlled. The development of a single currency in Europe will undoubtedly have a profound effect on the investment industry throughout the world. Over the next few months, investors will see an increasing number of new funds with an emphasis on credit risk or benchmarked against various euro indices. Currently, most euro indices are highly concentrated in sovereign debt. However, as the euro securities market develops, these indices will change to reflect the market as a whole. When the euro securities market grows, undoubtedly the amount of corporate issuance will increase, opening up markets for both investment grade and high yield (junk bond) issuers. In addition, the European structured securities market is growing quite quickly. These securities are often quite complex, and can present both market and liquidity risk factors to the funds purchasing them. Investors must be alert to the fact the risk elements in bond funds is slowly shifting towards credit risk and ask their fund manager how they are addressing these new challenges to the European fund industry.
David Vriesenga is representative director, global fund ratings at Moody's Investor Services in London