As the yields on long-term lending shrink, it becomes harder for active managers to justify their fees managing these kinds of investments. Indeed, there is a case for saying that the credit markets in total are not attractive right now for institutions, with even BBB bonds offering just 50-70 basis points over Libor.
Amid this tightness, more unusual products are being considered to earn excess return. Asset-backed securities (ABS) bundle together all kinds of loans, the classic being mortgages, and then repackage them to borrowers and shareholders. Over time the structures have become more sophisticated to offer a greater variety of risk and reward to lenders.
Christian Behring, senior portfolio manager at ZAIS Group in New Jersey, describes ABS products as “mini banks”. He points out that there is an inherent illiquidity in ABSs, and the sub-category, collateralised debt obligations (CDOs), which means that even in today’s expensive environment for bonds, investors can earn a premium. For BBB products, he estimates the pick-up is 50-200 bps over Libor, potentially higher than conventional bonds.
The liquidity premium is boosted by investors’ general lack of understanding of ABSs, although Behring notes that German insurers have been in the forefront of ABS investing, followed by the big banks. This is partly for historical reasons, when insurers could take stakes as equity holders in these ‘mini banks’ but book the investment under their bond allocation.
Although this ‘regulatory arbitrage’ has been outlawed by BAFin, the experience makes insurers more comfortable than pension funds with ABSs.
While there were generous times in the 1990s, when insurers were earning 15-20% on a nominal bond, Behring does not pretend that ABSs constitute some magic solution for Germany today.
For one, they have been affected by the thirst for debt-like investments. AAA UK mortgage-backed securities, for example, are trading at just 5-10 basis points over Libor currently, an all-time low. Secondly, there are risks. ABSs tend to perform and be rated like the bonds which form the package.
After 2002, American high-yield bonds experienced extraordinary default rates, nearer to 10% than the historic average of 2.5-3%, as a consequence of the demise of certain technology, media and telecom stocks, according to Behring. “The credit agencies usually put in a stress test on ABSs, which do not reflect historic default rates and are advantageous to investors,” he explains. “But 2002-3 was a different story.”
Ironically, there followed a great time in which to tap these products. “Two years ago I would have said without a doubt that ABSs are the place to be in credit. Today, I would say they should comprise 10-30% of a fixed income portfolio but in the search for alpha, I am not sure credit is the place to look right now,” concludes Behring.
Another type of investment which has been of historical interest to German investors for reasons of asset allocation is the convertible bond. These are issued as corporate credit with an option to convert into equity. That option provides some share-like exposure to the holder who may otherwise have reached the limit of their permitted equity allocation. Ori Gotfrid, director at mandate search specialists, bfinance in Munich, says he has seen more searches for convertibles in the last 24 months than any other type of asset.
The optionality of convertibles, however, is best exploited during ‘choppy markets’. When prices are volatile, there is far more interest in these hybrid products between bonds and equities. But volatility has tailed off in recent years. Implied volatility for European convertibles has dropped by more than 40% over the last four years.
For consultants like Marcus Burkert at Heissmann in Wiesbaden, this trend does not make convertibles so appealing. He points out that the growth of asset managers’ selling volatility as a regular practice may in part explain the fall in volatility.
On the other hand, for convertibles specialists, like EMCore, based in Zug, Switzerland, volatility has fallen but will now bottom out. “The worst time to invest in convertibles was March 2004,” says Markus Brossard, portfolio manager at EMCore.
He shares Behring’s scepticism about other forms of fixed income investing, and points up one advantage of convertibles often overlooked: “Convertibles are a good diversifier away from interest rate risk; the correlation is almost as low as for equities.” EMCore data also show that over the past 10 years, convertibles have returned more than equities for far less risk. EMCore’s own product for the German market has achieved an annualised return of 6.14% for annualised standard deviation of 5.34%.
Convertibles may have some attractive diversification characteristics. They also tend towards an asymmetry of returns relative to equities, whereby the percentage of upside is greater than the percentage of downside.
But if investors are searching for an even lower correlation to traditional investments, then metals, grains and natural resources may be the answer. Boris Shrayer, head of investment products in commodities at Morgan Stanley, reckons that investors can earn returns of 10% above Treasury bills if they select the right combination of commodity futures.
In the search for excess return this seems most attractive, for a volatility lower than global equities. Morgan Stanley’s estimates do not even account for active management of the futures. Rather, they focus on those futures in the GSCI index which exhibit the characteristic of backwardation persistently.
Backwardation means that the futures price is higher than the expected spot price. It rewards long-term investors who are prepared to run the risk of holding claims on a commodity prior to delivery. Certain commodities such as gold rarely exhibit backwardation because supply is not uncertain; central banks in recent decades have been more than happy to sell the stuff.
A more startling example is natural gas, whose buyers tend to be utilities. The latest research paper in Morgan Stanley’s Global Pensions Quarterly, notes that natural gas spot prices have more than tripled since 1991 yet the total return of investing averaged -10%. This is because the utilities play safe and overstock in expectation of severe weather conditions.
But copper, live cattle and petroleum are among those which do tend to backwardate and Shrayer claims not only is there a direct relationship between backwardation and return but that the fundamental reasons for backwardation will not change. In other words, the recent interest in commodities is a matter for caution and probably active management of futures - oil futures are not permanently in backwardation - but not a signal to avoid commodity as oversold.
Commodity sales teams must be selective in their target addresses, however. BAFin forbids investments by those under its regulations, including insurance companies and Pensionskassen.
“This is very restrictive when you compare it to other countries,” comments Nigel Cresswell, executive vice-president at Morgan Stanley in Frankfurt, “especially when you consider the liability-related characteristics [commodities are a better inflation hedge than bonds or_equities]. Effectively an asset class that is extremely efficient in a broader portfolio context, used by pension funds in the Netherlands and Switzerland, is being removed from the toolbox of German Pensionskassen.”
Like the regulator, Burkert is not entirely convinced. He recognises an interest in commodities, as in convertibles but not so much action. Data on investors’ allocation being collected by Heissmann at this moment show that on average bond and money markets have grown in favour. Plus ça change…