The bottom-up revolution
After its enthusiastic launch last New Year, the euro spent the rest of 1999 in ignominious decline against the rest of the world’s currencies. Today the forex markets are still grabbing the headlines in the popular press, but behind the scenes, and without much razzamatazz the euro-denominated securities market has burst into life. In fact, by the end of 1999, there was more euro issuance than dollars in the international bond markets, with more than $603bn (e600bn) raised in euro-denominated issues.
Graham Bishop of Salomon Smith Barney goes so far as to describe the events as “an economic revolution from the bottom up”. He goes on, “The euro is a ‘big’ currency already, in terms of commerce certainly. We believe that use of the euro will increase between third-party countries. Take the Middle East countries for example, at the moment they sell their oil to Europe and now get only euros. In the past the old European currencies would have been converted into dollars and put into the money markets, but today there is the option of hanging on to their euros, and putting them into the capital market. The demand for a big and liquid market is here already and will get bigger. This is a permanent change.”
That there were such enormous volumes of issuance in 1999 did not come as a very big surprise to market participants. Events in 1998, such as the Russian crisis and then the LTCM affair, caused many potential issues to be pulled or postponed, while there was a flurry of issuance ahead of Y2K. John Ong at Deutsche Bank High-Yield Capital Markets says, “In the high-yield arena we expected the market to double, in terms of both number of transactions and size. And this happened against a backdrop of a difficult market in the US, where defaults were higher, interest rates were rising and flows into high-yield mutual funds – which account for a third of all high-yield funds – were flat on the year. In the bigger picture it was better to put your money into equities than bonds.”
The huge increase in acquisition activity within Europe, arguably triggered by EMU and its removal of currency cost and risks, was a source of much of the issuance, but the real driver was activity in the telecoms and cables sector. According to Ong, telecoms accounted for over 60% of all issuance, and he explains: “These companies need the cash, because they are going in for massive scale building projects with negative cash flows, for a while at least. The capital market is the obvious choice of cash for them, bank loans would not be an option.” Ong highlights the changes going on in the banking sector, saying, “Bank pricing of_loans is in a world of its own, and many banks have long-standing relationships with their clients. Going forward, however there is a real drive to see the banks become a lot more return-oriented than before.”
The managers at JP Morgan Investment Management believe that growth will continue, although not at the speed seen in 1999. George Bory, credit strategist, explains, “The telecoms sector dominated 1999, and stripping this sector out you see a picture of much more modest growth. But we agree that issuance will continue. If you look at the utilities, or banks, or retailing , we are seeing much M&A and re-organising of resources as competition intensifies. This will ultimately lead to a need for debt financing.”
The restructuring of the banks is highlighted by many managers as a vital part of the euro-denominated capital market’s evolution. Portfolio manager Sander Nieuwland goes on, “The role of the banks is key. It was their reorganising in the US which drove the development of the US corporate bond market. What is happening now in Europe is not identical to the US, but is similar in many respects and will contribute to the growth of the credit markets in Europe.”
On the other side of the supply/ demand equation, there are a growing number of buyers for non-government fixed income assets, driven primarily by the quest for income. Jim Leavis, from M & G agrees, adding, “With yields on government bonds, postal accounts and savings banks so low, there is a huge need for income, on a regular basis. Demand for high yielding bonds is definitely outstripping supply: it’s a seller’s market.”
As investors clamour for higher yields than available in the government bond markets, so the investment management industry has found itself having to adapt its ways, and fast. Rogier Crijns, senior portfolio manager at ABN Amro Asset Management, agrees that the industry is having to move quickly. He adds, “Credit analysis is a growing element of our investment process but it is an additional dimension to increasing returns, along with curve changes, currency plays and duration analysis. Country spreads do still matter, though we are also focusing our attentions on European industry sectors too , and getting to know them very well.”
JPMorgan, with a long history of investing in credit in the US, re-organised their investment process to incorporate the credit aspect along side the interest rate decision. Bory explains, “We have a dedicated credit team looking at Europe on a sector basis, drilling right down to individual companies. Name recognition value is not enough, especially with the amount of M&A activity going on!”
Julius Baer Investment Funds launched its corporate bond fund in October 1998, and today it is the firm’s fastest-growing bond fund. According to Philipp Langeheinecke, head of products and services, the fund was introduced to take advantage of the changes happening in the European bond markets. “We argued that European credit markets would develop in a similar way to those in the US, and that issuance by non-AAA/AA rated borrowers would increase dramatically. We think the European high yield market is still too small and fragile , and susceptible to severe liquidity problems, and so our fund is mainly investment grade, with only one fifth allocated to high yield.” Julius Baer opted to manage this fund in-house and has built credit analysis teams in both London and Zurich, to support its existing fund management team.
Many managers still have their government-bond benchmarks. For some, investing outside benchmarks is allowed, and provides opportunities for excess returns. Crijns states, “We are talking to clients about changing their benchmarks to include more non-government debt. And we are listening to the index suppliers and assessing the new non-government indices. In Euroland, big issues tend to dominate this still small market, which makes it difficult for investors to match their benchmarks. But this is a problem we are sure will be solved as many more issues come to market.”
Langeheinecke adds, “For our corporate fund, we wanted an index that best reflected the profile of the product, which has bond-like volatility with a yield pick-up. As there was nothing out there, we have built our own using a combination of the various Merrill Lynch non-government indices for Europe and the UK.”
JP Morgan agrees that the European indices are not yet providing a good indicator for risk matching. Nieuweland says: “The indices are heavily concentrated in bank debt . However, as the market broadens, then from the larger pool an index that investors actually want to own can be created. It is a gradual transition from government to corporate aggregate indices.”