Pricing in credit risks
As Bund yields touch down to another all-time low, do investment grade credit spreads also have further to shrink? “We are not back at the (credit spread) lows we reached back at the end of February/early March this year,” says Klaas Smits of Robeco Asset Management.
“And we are not expecting them to get back down to those levels at this stage. Credits are still good and we have had a great run through 2003 and 2004, but we are now at the stage where we have to question whether the risks are being adequately priced.
“The best is clearly over for investment grade. We are entering the next corporate cycle where, despite the economic environment being quite positive, there is now some inflation in the system but companies have no pricing power because of China and its neighbours in the Far East,” says Smits. “One option for companies is to buy revenues through merger and acquisition (M&A) activity. This tends to lead to higher leverage and is inherently less friendly towards bond holders.”
Petercam’s Bernard Laliere adds: “Our macro-economic models do indicate higher rates, but not a blow-out, certainly not 10-year yields rising to 4%. What’s driving spreads and keeping them low is the strong demand from pension funds and insurance companies searching for higher rates. Some insurance companies in Belgium and Germany, for example, now have a negative spread for certain products, between the rates on their liabilities and fixed income assets. The credit market’s technicals are very supportive and new issues are hugely oversubscribed.”
Smits states: “Although credits can still offer value, we are getting to the stage where, in this quest for yield, investors perhaps forget the troublesome times that may lie ahead. We have taken the view that we can afford to miss out on the remaining spread tightening if there is any because absolute yield and spread levels are so low and we can take a few months of this pain. But even though we are bearish on credit spreads, we do not believe that there will be anything like the four-fold increase we witnessed in the credit crunch of 2002. That year, when BBB spreads widened from +50 to +300, was unusual and credit spreads are not historically that volatile. We need to take a step back from the daily volatility and separate out the facts from the flood of rumours.”
Etienne Gorgeon, head of credit at Fortis Investments, says: “It is definitely not that bad an environment for credit overall. It may sound very counter-intuitive but recent studies have shown that credit outperforms govvies as central banks raise rates. However, we are clearly at a stage where we have to be very careful about stock selection. And at the moment there is something of a drought in terms of new issuance, which is not particularly healthy for our market as we need to maintain a good minimum flow in the primary market, otherwise liquidity could dry up.”
Although investors are generally not that bearish about interest rates in general and may not have very strong views for or against credit as an asset class, many participants appear to have quite strong views within their credit portfolios at present and are heavily skewed away from their respective (credit) benchmarks.
“We are overweight credit with respect to governments but underweight virtually everything within credit,” says Gorgeon. “We have a very significant overweight in financials and in certain telecoms. We realise that we have entered an environment where leveraged buy outs (LBOs) will become a more common occurrence for most corporate sectors. Financials, however, tend to be excluded from this LBO threat. Unlike in other corporate entities, both equity shareholders and bond holders of a bank actually have a common interest: if a bank’s credit rating were to fall then both investor groups would suffer. In a ‘normal’ LBO, the takeover of a company is funded using a significant amount of borrowed money rather than via equity funding. Although LBOs are often pretty good news for equity holders, they tend to be detrimental to a company’s credit rating(s). As such they are generally to be feared by investors in corporate bonds.”
Laliere says: “Between June and September we have been putting lots of our new cash into Tier 1 paper because we see lots of value there compared to BBB paper and corporates in general. We are careful, and our process has been always on a name-by-name basis. Tier 1 is high beta, which has tended to deter investors who would rather avoid high beta paper because it would underperform if a generalised spread-widening were to occur. There are, inevitably, rumours of M&A activity but industrials have so far been the main targets. We have looked for banks which have low profiles and would enjoy a credit improvement in the case of M&A, or those banks which demonstrate a careful approach to M&A.”
Another reason tier 1 paper is relatively attractive now is that it was left behind when the rest of the market rallied after the dramatic falls in March, says Gorgeon. He adds: “Tier 1 Subordinated bank paper was one of the few sectors left out of the rebound in May and September. By the end of February and early March when the market was at its highs, it was apparent that virtually everyone was long bank paper. In a crisis it is very hard to sell ‘ordinary’ credit, and it is bank paper that is easiest to sell, which investors duly tried to do. Thus the market was awash with this paper. For many investors this was a rude shock as it was the first time they had lost money on financials. This large overhang of supply has been a significant factor in the recent relative underperformance of bank paper.”
Laliere says: “With credit spread pick-ups so low, an industrial at a spread of, for example, +30./+40 basis points over swaps carrying with it the additional risk of an LBO is significantly less attractive than a bank with good fundamentals and no - well, almost no - risk of LBO hanging over it. The main risk to our present scenarios is economic: if US inflationary pressures were to increase, the Federal Reserve could feel the need to turn more hawkish, triggering a broad increase in corporate funding. That would be bad for credit, but it is not what we are forecasting.”