In the past, global fixed income has been attractive to European investors because of diversification benefits and opportunities to add value through exposure to foreign markets and currencies. More recently, however, the appeal of conventional global fixed income, which concentrates on government bond investments, has waned somewhat owing to the decline in yield levels and the reduction in the opportunity set (resulting from the introduction of the euro).
In this environment, European pension funds should consider adopting the global aggregate approach to global fixed income, which includes investing in other sectors such as corporate bonds, mortgages and asset-backed bonds as well as government bonds. This style of investing offers higher yields, and a much wider opportunity set than the traditional government-only approaches, while still maintaining high average quality. Equally, global aggregate investing also entails new risks and it is vital that investors have suitable resources in place to manage and control these risks.
The euro: catalyst for change
The euro has had two major effects on the composition of the global fixed income universe. First, the process of European Economic and Monetary Union (EMU) has led to a major reduction in the number of government bond markets throughout Europe. Fourteen regional markets have now been consolidated into one super bloc. In the post-EMU European market, Euroland is a near 80% component, with the peripheral markets of the UK (14%), Sweden (3%), Denmark (3%) and Switzerland (1%) comprising the residual.
Second, and arguably more importantly, the euro has been the catalyst for the development of a euro-denominated credit market. Exchange rate complexities and local banks’ stranglehold on corporate financing activities had previously deterred the development of a large European corporate bond market. However, with the introduction of the single currency, there have been meaningful supply and demand changes that have nurtured the growth of this market (and continue to do so).
Now, with banks less willing to lend purely on the basis of relationship grounds alone, European corporations have had to seek funding elsewhere. This demand for funds has been exacerbated by the takeover spree undertaken by European corporations in the last few years. The trend has been particularly evident in the telecom sector, as corporations have sought scale in their operations. (Examples include the highly publicised Vodafone/Mannesman and Deutsche Telekom/Voicestream acquisitions.) For some companies, the growth of the European corporate market has led to capital optimisation opportunities. Relatively low business risk companies such as utilities are able to leverage up their balance sheets (ie, take on more debt) to generate more attractive earnings-per-share performance.
The global aggregate opportunity
The emergence of the Euro corporate market alongside the well-established US credit markets has created the environment for a multi-sector approach to global fixed income investing. The new style, known as global aggregate, offers investors the chance to benefit from a much broader opportunity set of fixed income investments than traditional government–only mandates, and has been met by a new generation of benchmarks.
Since Lehman indices are considered the industry standard in the US, it is useful to examine the Lehman Global Aggregate Bond Index (LGABI – see table 1), although other benchmarks are also offered (for example, by JP Morgan and Citigroup).
As opposed to traditional global benchmarks, which have been solely government, the LGABI is over 50% non-government, allowing fixed income investors opportunities for greater diversification. Corporate and mortgage sectors each comprise just over 20%, with the remaining 10% accounted for by agency investments. Inevitably, the non-government sectors are dominated by the US market, although it is notable that euro credit has been the fastest growing market: in the period 1997 to 2002, new issuance in Europe increased by a factor of 3.5 versus 2.8 in the US. Yen-denominated corporates are also important, but the challenges of poor liquidity and narrow spreads lead to an unattractive assessment of that market.
However, the key feature of a global aggregate benchmark,
relative to a government one, is the potential for yield enhancement. A simple comparison of the projected yield-to-worst for LGABI versus the Salomon World Government Bond Index (SWGBI) shows a considerable difference of 70 basis points in favour of the former. At the same time the LGABI is still a high quality product with credit quality similar to the Salomon Index. As well as a significant yield advantage, the LGABI with its 8230 issues offers much more scope for value to be added through security selection than the SWGBI (618 issues) (see table 2).
In addition to securities in the index, the global aggregate style of investing also embraces seeking opportunities in other parts of the global fixed income universe. High yield, emerging debt and new wave convergence markets (such as Hungary, Poland and Mexico) offer tactical opportunities to add value to a global aggregate portfolio, and should be considered part of the investible universe.
Risks in global aggregate
While the expansion of the global fixed income universe leads to greater opportunities, it also creates new risks. In the area of corporate bonds, in particular, the much-published defaults of Enron, WorldCom and others have placed doubt in investors’ minds as to whether credit risk is worth taking. Despite the experience of the last year or two, history supports the notion that investors are, on average, paid for taking credit risk. Thus, in the US over the last five years (to 31 December 2002), AA-rated corporate bonds have outperformed Treasuries by 60 basis points pa. Over the longer timeframe of ten- and twenty-year periods, the outperformance has been 180 basis points pa and 90 basis points pa, respectively.
Meanwhile the BBB sector has underperformed in the last five years but has outperformed over longer time periods, posting an excess return of 30 and 120 basis points over the last ten and twenty years respectively. Indeed, the level of corporate malfeasance exposures in the last 18 months is likely to lead to improvements in corporate governance and transparency to markets that will ultimately benefit credit investors.
Being paid to take the risk over the long-term is also supported by the strong intrinsic value of credit spreads. Moody’s default history shows that the expected annual default rate of a euro AA ten-year corporate bond is only 9 basis points, relative to an average yield pick up of 53 basis points over governments. While part of this yield premium is also compensation for the fact that credit markets are less liquid and more volatile, the yield premium is very attractive for the longer-term investor. Even greater value is offered in the BBB sector, where the
average yield spread of 183 basis points compares to a historic default rate of 51 basis points per annum.
Other risks in global aggregate investing including mortgage repayment risk and currency risk. US mortgage bonds, although AAA-rated, offer risk to the investor in that the timing of principal payments is uncertain, and as a result the underlying duration of the bonds can be unstable. Currency, meanwhile, remains a risk as well as an opportunity, although it is possible for European investors to eliminate currency risk entirely through adopting a fully-hedged approach. This is potentially attractive as the yield enhancement benefits of the global aggregate style are retained, while in the present environment hedging out of US dollars and Yen boosts overall portfolio yield owing to the structure of currency forward rates.
The new global fixed income environment presents investment managers with a number of opportunities and challenges. From the perspective of generating alpha, a manager’s options have now increased: traditional global fixed income investing has been mainly concerned with managing duration across different bond markets, and controlling currency risk. In global aggregate mandates, a manager can potentially add value in four different areas: not only country/duration positioning and currency management, but also credit allocation and individual security selection. The resultant diversification of the sources of return should be beneficial in securing less volatile, more consistent investment performance.
At the same time, however, this wider investment universe places significant resource demands on managers. In particular, credit analysis of individual corporate issues is very labour intensive, while investments in mortgages and asset-backed securities also require specialised skills. Does this mean that the competitive advantage must lie with the biggest bond managers who have the deepest resources? Not necessarily, because although being resource-rich is an advantage, being asset-rich (ie, managing too much money) may be a significant disadvantage as many of the best opportunities in global fixed income (such as corporate bonds, high yield, emerging debt, and new convergence markets) are characterized by less than perfect liquidity. For example the average issue size of a US corporate bond is less than $500m compared to over $15bn. for a US Treasury issue. Thus the largest global managers may face constraints when it comes to flexibility, speed of response and ability to trade in less liquid markets.
For European investors, global aggregate fixed income is likely to become increasingly attractive: it potentially offers long-term investors higher yields and exposure to a diversity of sectors and issuers. But the complexity of the global aggregate universe will result in greater demands on investment managers. High quality research, combined with the ability to trade, will be the key attributes that will set the successful managers apart from the crowd.
Ian Kelson is head of international fixed income at T Rowe Price International in London