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Joseph Mariathasan finds corporate bond managers coping with the new realities around benchmarking, ‘risk-free' rates and agency credit ratings

The world of bond investing has experienced many developments over the past two decades, but the global credit crunch and subsequent government interventions have turned many previously held assumptions upside down. The debt of emerging markets has evolved towards an investment grade asset class, while the debt of some ‘submerging' markets in developed Europe has become junk. US credit markets have shrunk - 73% of the US debt market is now government credit with a complex and uncertain impact on private sector issuance; the idea of risk-free rates in finance can be questioned when even the US has such large debt outstanding relative to GDP and it is seen as quite acceptable that euro-zone corporate credits can have higher ratings than the sovereign risk of their own jurisdiction.

Investors and consultants who have not yet grasped the depth of the changes will find themselves struggling to determine what should be their strategy towards investing in bonds generally, and in investment grade credit in particular. "Historically, investment grade credit was seen as a low alpha, safe asset class and many institutions managed it in-house with limited resources," explains Raphael Robelin, senior portfolio manager at Bluebay Asset Management. "Small teams managed very large amounts of money with a consensual approach to decision making." But in this new world order the traditional approach to risk control based on benchmark indices and ratings from external agencies may actually have the opposite effect to its objectives. "What has happened in the past two to three years has raised awareness of how volatile the asset class actually is, and the importance of ensuring investments are managed by strongly resourced teams with experienced credit analysts."

Whether managed in-house or externally, institutional investors need to reconsider the very foundations on which their fixed income investment policy is based.

"The Swiss have traditionally managed weightings against a government bond benchmark and put in a lot of credit exposure, but after the crash we changed benchmarks to use aggregate benchmarks for such aggregate portfolios," says Benno Weber, head of fixed income at Swisscanto in Zurich.

Such an approach has increasingly become the trend, but the use of any index benchmark has its drawbacks. The European investment grade marketplace is 50% financials but, as Simon Pilcher, managing director of M&G's fixed income division, points out, looking at risk objectively would suggest having no more than 15% in any single sector. Adopting a passive approach of following a bond index is not a low-risk strategy for a fund, but an extremely high risk - and yet high-performing managers are seen as those who have beaten an index that no sensible person should invest in.

Moreover, a fundamental difference between equity and debt indices is that the amount of an issuer's debt represented in a bond index is not very sensitive to the market's pricing of its debt. The credit spread forms only a small part of a bond's yield (outside of high yield or distressed debt portfolios). As a result, we have the perverse result that the weaker an entity becomes financially through the issuance of more debt, the more a capitalisation-weighted index will weight that entity.

"People invest in fixed income in order to meet future liabilities with a high degree of certainty," Pilcher observes. "Proper thought has to be given to the portfolio construction from the perspective of what the portfolio is trying to achieve."

Not only does removing the shackles of an index benchmark reduce the concentration of risk within the financial sector in particular, it can also open up a wealth of new opportunities for fund managers to achieve the objectives of the strategy through considering other investment-grade cashflows that might not be as obvious as traded bonds.

One development is a renewed interest in absolute return bond funds. "We are seeing strong demand for absolute return funds and we launched a UCITS fund in June last year," says Emma du Haney, a product manager at Insight Investment. Some firms such as Bluebay have embraced this concept and see strong merits in managing long-only funds and hedge funds together: "We see them as complementary skillsets and our fund managers running long-only portfolios sit next to our managers running hedge funds," explains Robelin.

Agency problem
When Luke Spajic, portfolio manager at PIMCO, describes ratings agencies as "like the in-laws" (you may not like them, but you have to live with them), he articulates the feelings of much of the marketplace. The problem - and indeed the opportunity for many fund managers - is that their ratings have huge influence in markets but are often behind the curve when credits deteriorate or improve (See page 57 for our interview with S&P on structured credit ratings).

"The rating agencies now have a bad reputation," says Swisscanto's Weber. "In the case of bank subordinated debt they took too long to adjust ratings and then overreacted. Moody's was the worst and undertook multiple downgrades without considering the effect on the markets. When we look at Greece and the other at-risk countries in the euro-zone, very few of the rating agencies are credible in terms of what they are doing."

Bill Gross, CIO of PIMCO, has been even more scathing in a recent commentary, attacking rating agencies' "sordid, nonsensical role" in "perpetrating and perpetuating the sub-prime craze", and ridiculing the fact that Moody's and Fitch still rate Spain as a AAA credit, while he sees the country as one "with 20% unemployment, a recent current account deficit of 10%, that has defaulted 13 times in the past two centuries, whose bonds are already trading at Baa levels, and whose fate is increasingly dependent on the kindness of the EU and IMF to bail them out". But even he accepts that rating agencies will continue to exist because a certain portion of the investment world will always need them to justify investment in their portfolios.

Of course, that means well-resourced fund management firms can undertake research independent of the agencies, enabling them to "bypass, anticipate and front run all three, benefiting from their timidity and lack of common sense", as Gross says.

T Rowe Price, for example, has 12 investment grade analysts (nine in the US and three in London) who independently assign ratings. Portfolio manager David Stanley is also able to draw upon the resources of a team of high yield analysts as well as developed and emerging market fund managers and analysts. "Investment grade analysts will collaborate with macro colleagues with regard to credits that have explicit and implicit state support, especially as the sovereign risk can be a large driver of spread movement," he says. "On average I expect them to be within one notch of the rating agencies but they could be multiple notches apart, which they should be able to justify."

Clearly, institutional investors need to ensure that any stipulations on ratings given to fund managers do not end up acting against their own interests by either restricting their choice, forcing them to sell inappropriately or even encouraging purchases of poor credits in the search for extra yield.

Countries versus companies

The idea that corporate risks would always have to be below the sovereign risk of the country the corporate is domiciled in is a tenet of credit analysis that now looks outmoded. As Stanley points out, many of the corporate names within peripheral euro-zone countries have substantial operations outside of the sovereign. If they have sufficient earning power outside of the country, they could still service their debt, irrespective of the sovereign's confiscatory abilities. Similarly, in emerging markets most domestically focused companies are subject to a sovereign ceiling, but if enough of their revenues come from outside the country of incorporation, they can be rated through the sovereign. Gazprom is a good example, with half of its revenues coming from outside of the former Soviet bloc, where ratings, currently the same, had previously been above the sovereign.

"In theory, if Italy dropped to BBB-, I would expect a name like Finmecannica to remain at its baseline rating of BBB to BBB+, as it only receives approximately 23% of revenues from Italy, with defence budgets in the US, UK and increasingly Asia and the Middle East being of greater importance," Stanley suggests.

An additional factor that Stanley also draws attention to is that some companies have substantial foreign ownership, which serves to alleviate the quality of the company's ability to service debt over that of the sovereign. OTE, the incumbent telecommunications operator of Greece, is currently rated mid-to-weak BBB by the agencies and is a good example of this phenomena. Deutsche Telekom (DT) already holds a 30% stake in OTE; should the Greek government exercise a put option for another 10%, DT's share would rise to 40%. This substantial stake has kept OTE's ratings from declining in lockstep with Greece's, which are lower (Standard & Poor's puts it at BB+ and Fitch at BBB-) and on negative outlook.

An important element in the agencies' reasoning is their expectation that the stronger DT will assist OTE in gaining access to the bond markets, reducing the impact of the sovereign's lower rating and the more volatile behaviour of its spreads. But, as Stanley admits, while these factors should have an impact on the ratings, the market has shown recently that it is not prepared to be so rational with regard to valuations, and especially in cases of extreme stress. So, regardless of the geographic earnings profile, spreads are likely to be hurt by a declining sovereign rating, even if the corporate rating stays stable.

Another far-reaching aspect of the new world order is the impact on fixed income markets of reduced capital from the banking sector. Prior to the credit crash, Europe's banks were aggressively pursuing the ‘relationship banking' model, providing credit to companies at very attractive rates. In that environment, blue chips had no need of the bond markets. Post-Lehman, banks are demanding higher margins and tighter covenants, while the Basel III regulatory environment requires more capital to be set against corporate loans and even undrawn lines of bank credit. All of a sudden the capital markets don't seem to be driving such a hard bargain.

There are other ramifications, most notably in the reduced position-taking of fixed income market makers, which has also created opportunity for fund managers. "In the past, banks tended to keep a substantial share of newly issued bonds on their balance sheets, gradually selling it to satisfy retail demand," notes Swisscanto's Weber. "But the banks no longer have the capital to do that, so we are effectively stepping into that role by buying newly issued bonds and then selling it on to satisfy retail demand. It is difficult to sell older bonds because they are so illiquid."

M&G has stepped in to replace bank finance for sectors such as infrastructure. "Banks have been pricing long-term debt far too cheaply for these sectors," says Pilcher. "Now they are realising the cost of funds is going up and you can get runs on banks if they hold illiquid long-term assets financed by short-term liabilities. In contrast, pension funds and insurance companies have long-term liabilities so are well positioned to take less liquid long-term assets onto their books." But, as he adds, taking on long-term illiquid assets requires the fund manager to be confident of two things: "Firstly, we need our own analysis and we cannot rely on ratings agencies; and secondly, we need to ensure that appropriate covenants are put in to protect us so that if things go wrong, we have a seat at the table for a dialogue with management." Such a move is also illustrative of another strategy that M&G is espousing aggressively, which is to seek much wider diversification of investment grade risk through identifying other sources of investment grade cashflows - including private placements, social housing and other property-related debt.

Evolution is usually preferable to revolution. But when times change, the winners are often those that are able to move fastest. Adopting a new philosophy for fixed income management might be difficult to do, but when retaining the status quo may prove to be unsustainable, there might be no alternative. The credit crunch and its aftermath has provided a catalyst for institutional investors and their advisers to re-examine their fundamental beliefs. It may even be time for believers in free markets to follow the advice of Karl Marx, whose gravestone in Highgate Cemetery in North London has the epitaph: "The philosophers have only interpreted the world in various ways; the point is to change it."

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