The indiscriminate sell-off in European bond markets sparked by the sub-prime crisis has opened up opportunities for canny investors and reminds Joseph Mariathasan of the words of former US president Franklin Roosevelt
At his inaugural address in March 1933, US President Franklin D Roosevelt declared: “The only thing we have to fear is fear itself - nameless, unreasoning, unjustified terror which paralyses needed efforts to convert retreat into advance.”
Roosevelt went on to ascribe the causes of the Great Depression that was then enveloping the US economy, saying: “Primarily, this is because the rulers of the exchange of mankind’s goods have failed through their own stubbornness and their own incompetence, have admitted their failures and abdicated. Practices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.”
Looking at the aftermath of the sub-prime crisis among US and European banks and rating agencies brings these words to mind. The credit crunch had its epicentre in the US housing marketplace, but its ripples created violent shock waves in the Europe bond markets.
“For the first time in years, spread levels in investment grade credits look attractive - they are far in excess of what would be required in a worst case scenario,” says David Jacob, head of fixed income at Henderson Global Investors.
What used to be the most expensive sector in the credit markets in Europe, financials, has now become the cheapest. Moreover, as Stephane Fertat, fixed income portfolio specialist at T Rowe Price, argues, there is much more dispersion in credit spreads between issuers so there is now more latitude for an active manager to outperform their benchmarks.
But the biggest dividing line in Europe is between old Europe and new Europe, says Jerome Booth, research director of Ashmore. “The central and eastern European emerging countries never bought leveraged products, unlike the developed countries of old Europe, which are now struggling with the consequences.”
While newspaper headlines focus on negative economic news, giving rise to escalating fear among consumers and policy reactions by politicians, the underlying economic picture, as yet, is not necessarily so grim. However, according to Andrew Bosomworth, portfolio manager for Pimco Fixed Income Portfolio Management in Munich: “At the economic level, there is an underlying slowdown in the continent and the UK seen in the real economic data. Inflation indicators are showing a divergence, with core inflation at 1.7% and headline inflation at 4% in Europe.”
Scott Thiel, (pictured left) co-head of fixed income at BlackRock, adds: “The inflation picture is dire and at multi-year highs. Oil prices are high and energy price rises will pass through into wage increases. There is balance between higher inflation and slower growth. Our view is that the slower growth side will win so we are unlikely to have rate hikes after July.”
“Financial conditions have tightened in Europe as the result of the credit and liquidity crunch,” says David Leduc, director and senior portfolio manager, global fixed income at Standish, part of BNY Mellon Asset Management. “At the same time, the strong euro has decreased the competitiveness of European firms. We have begun to see some weakness in earnings and balance sheet fundamentals, particularly in the retail sector, and expect that trend to continue into early 2009. We also expect credit markets to remain volatile, particularly in the financial sector.”
The other major theme is the impact of the credit crunch leading to deleveraging across the debt markets. “Financial markets are seeing a deleveraging of the financial systems in intermediaries, the banking sector and some of the other operators in the shadow of banking such as conduits and SIVs [structured investment vehicles],” says Bosomworth. “This started 12 months ago but is still continuing. Packages of ABS [asset-backed securities] and leveraged loans are coming into the financial markets as their owners try to find another home. As a result of all of this, the cost of capital relative to government bond yields is high.
“The impact of the credit crunch on financial stocks has been dramatic,” says Thiel. “Subordinated bond spreads are 425 bps over government bonds and over 100 bps wider than in the 2002 high yield bond Enron debacle. Financial bond spreads have widened to very distressed levels.
“Clearly, there will be write-downs and so on. But what part of the bond market has been most affected and therefore where there is most value? It is the European subordinated financial sector. The financial sector has government support, as seen with Northern Rock. The companies also have a strong commitment to their ratings and are also highly regulated.”
A key theme emerging from the current turmoil is that the financial sector is a sector apart. As the Northern Rock debacle shows, regulators and policymakers are forced to rescue key distressed intermediaries, which, while leaving equity holders with severe indigestion, gives bondholders substantial downside protection.
“We try to look for sectors under the umbrella of the regulators. Their policy responses will be aimed at ensuring the entities survive, that is, the financials and intermediaries - the deposit taking banks within the investment grade corporate sector,” Bosomworth says.
He adds: “We have a bias for senior debt and covenanted structures, which are to the benefit of bondholders and not the issuers. Also tier two capital and tier one capital for top tier banks are attractive, but not for tier two away from the umbrella.”
Fertat of T Rowe Price says: “There are long-term opportunities for investors especially when banks are recapitalising their balance sheets at the expense of equity holders and increasing the equity/debt ratios.”
Thiel adds: “The issue with European high yield is that the universe tends to consist of industrial companies. High yield spreads are 1,000 bps or so but there are some concerns that if there is a global slowdown because of inflation and so on, it will be the real economy that is at risk and high yield tends to be industrials that are part of the real economy.”
John Lovito, head of fixed income at Lehman Asset Management, says: “The credit crunch is moving from a liquidity crisis that affected mainly banks to a more typical credit crisis affecting industrials. So, longer term, there will be more value in financials rather than going into industrials just ahead of a downturn.” As a result, “the high yield sector is virtually closed out”, says Bosomworth. “Given the economic outlook for a slowdown, highly geared companies are not in a good position. There are a few companies worth looking at - those without any financing needs in the next 12-24 months.”
Leduc says: “The market for high-yield issuers will remain challenging and our outlook is for higher speculative grade defaults well into