The turning of the screw
Would you be willing to lock up investments for your grandchildren to use in 50 years time if the return was going to be fixed at 4.21% annually for the total period? The answer for most people would be obviously no. Yet the French treasury issued e6bn of 50 year bonds at that yield that were heavily oversubscribed earlier this year. What appears to be an obvious choice for an individual can appear to be the opposite for a pension scheme even though the timescales may be similar.
In the scramble to try and get yields better than this, European corporate bond spreads have tightened to levels which have led some managers such as Ronny Beck at Julius Baer to avoid investing in the sector for the past year. Meanwhile, investors that do have large exposures to European bonds need to be aware of the impact of the huge amount of fund raising by private equity firms in Europe. This will lead to an increase in leverage buy-outs of many more investment grade companies and as a result, the spectre of “event risk” where an investment grade bond could turn into high yield overnight has returned to the corporate bond markets.
For Jean-Francois Boulier, the head of European fixed interest at Credit Agricole Asset Management (CAAM), “there certainly is a gap between fundamentals and market views. This applies to yields, corporate spreads and real rates in the euro markets. Everything seems expensive.” Dexia Asset Management’s global head of fixed income, Vincent Hamelink agrees: “Bonds remain too expensive compared to equities and the real yield they offer is well below historic averages.” Ian Kelson at T Rowe Price feels that “there is not a lot of value in 10-year bonds currently yielding 3.5%”.
So, who wants to be long of bonds? Not many, agrees Matthieu Louanges of PIMCO, but he points out, “who needs to be more invested in bonds? And here lies the crux: everybody.”
He goes on to argue “does it make
sense to invest at current levels? Yes, European bonds are attractive even at current levels”.
How do you reconcile the two views? Perhaps the answer depends on whether you are an unconstrained investor seeking to maximise returns, or an institution that sees itself as having no choice but to buy European bonds, and return maximisation is not the primary objective. However, even for these institutions, there is a reluctance to completely match liabilities at current yields. The major change in the Netherlands for example, through the FTK, the Financial Assessment Framework, attempts to take liabilities into account more accurately through valuing them through swap curves. This will give rise to higher reported volatilities in their liabilities reflecting their mark-to-market valuations, which can be hedged using interest and inflation swaps.
As Lodewijk van Pol of Towers Perrin in the Netherlands points out, “there are a variety of products produced by investment banks and fund managers. They are beautiful products with high fees. What is getting too little attention is that people are focussed on getting duration matched to liabilities, but are forgetting what is happening in the rest if the portfolio. If you have 50% or more invested in equities, why bother? People also tend to look only at at static liabilities, but these may change every year depending on the structure and maturity of the pension fund. There is far too little attention to that. Finally there are other policy objectives that are at least equally important.”
At current yields, as CAAM’s Boulier finds, “even if there was a willingness to match liabilities, no one wants to do it at such low rates. If you are sure to make a loss, is that better than taking a risk? If you have long-term liabilities, you can afford to take some interest rate risk”. Bluebay’s Raphael Robelin has found that “speaking to other investors it seems to me that in Europe you would expect pension funds to be doing asset liability matching exercises but in practice they don’t seem to be natural investors in bonds longer than 10 years. Telecom Italia recently issued their first 50-year bond but it was primarily speculative money that was attracted to it. The Telecom Italia bond has performed very poorly since issue.”
The huge growth in funds raised by the private equity market will have some important ramifications for the European bond markets in two ways. First of all, it increases the supply of high yield bonds, which increases the attractiveness of the European high yield market, and secondly, it will have negative implications for the investment grade sector. As Bluebay’s Robelin explains “For example, ISS was a nice stable company, BBB+, it had low leverage and a very stable business plan, then overnight there is announcement that EQT and Goldman Sachs are going to do an LBO at a 30% premium. That’s great for equity investors but overnight the bonds fell dramatically from 105 to 75 because the amount of leverage will increase from two times to seven times.”
The only protection bondholders have is a negative pledge implying that the company cannot issue bonds more senior to the ones in question. However, “that doesn’t include bank loans. So in the LBO case the bank loans are gong to be securitised on the companies’ assets and the bonds become junior to it”.
A couple of years ago the number of investment grade companies with corporate bonds which by historical standards would have been of interest to private equity numbered about 20 according to Robelin. But then, the average deal size of private equity companies was $1bn (e792m) equivalent at the maximum. Today some deals can go up to $15bn. So he sees that “the number of potential targets might be five or 10 times higher because there is so much cash in private equity and they are not willing to be patient and wait for unique opportunities. Today, there could be 100 potential candidates”.
The idea of mean reversion in asset markets is a very appealing one for many investors and provides an intellectual framework for pricing. However, when it comes to bond yields, it can be very difficult to apply in practice, since depending on what time period you take, you will get very different results. 10-year bond yields in France averaged less than 5% for the 100 years leading up to 1950, but in the next half century, they averaged nearly double that and reached a high of above 15%. What is clear from the historical experience though, is that there is no a priori reason why yields should not remain below 5% for the next half century, although few would argue that investors would not be better off in equities were that to be the case.
In Europe, as Kelson at T Rowe Price argues:“The underlying pace of growth is very anemic, and there are still lots of structural problems, for example labour markets are still too rigid. Once oil prices stabilise there won’t be further upward pressure on European inflation, so we do not think the ECB will have to follow the Fed and raise rates.”
However, demand for European bonds is not just from pension fund seeking long-term assets to match liabilities. According to Jean-Francois Boulier “savings have increased, especially in Germany and Italy and so we are flush with flows. This is not new. But now because of US tightening, we are seeing more and more Asian investors turning to the euro. Not only the leaders, but also the rest of the market. There is no longer reluctance by say insurance companies in Asia to buy euro assets. Will we see a return to fundamental valuations? You have to ask will the flows stop or remain? I think that when it comes to savings, we will continue to see savings in Europe. When it comes to Asian investors, maybe in the future they will stop buying euros, but they have already bought a lot of US bonds, there are no Asian bonds and they cannot invest in Swiss and sterling bonds in large amounts. They have a lot of savings to invest. There is a danger in investing only in US assets.”
In the short term, though, the issue is whether cash provides a better alternative to bonds where most commentators expect some increase in yields. Hamelink sees that “a further pick-up in correlation between US and EMU bond market should have a negative impact on European rates in the coming months. Overall European 10-year yield at 3.50 % is too expensive, we expect a rise to a fair value of 3.8 % within a few months.” Beck sees that 10-year bond yields “could back up over 50-60 bps. We think you will see higher yields at the end of the year so you will get capital depreciation, thought it will be partially compensated by the coupon So returns will be 4-5% if that. That’s better than cash”. So as Kelson argues “although Euro-zone yields are low they are not dramatically low, especially against the background of structural demand”.
When it comes to relative valuations within the European bond markets, opinions differ. Boulier has the view that Government bonds look most overpriced. “Depending on the days, BBB credits also look very expensive. Now they are more reasonable. I favour deep high yields and inflation-linked. They are expensive but not as much as classic bonds.”
Beck saw corporate bond spreads as “at crazy low levels, but have now risen 100bps over March/April” but has not invested in them for a year. “What you have seen is an increasingly shareholder friendly attitude by corporates, so the temptation is to leverage up the balance sheet again especially with interest rates at current levels. You can paint a 12-month picture where economic growth slows down a little and so prospects for big revenue gains are relatively limited. Looking back it has been a fabulous time, but as you know markets look nine-18 months ahead and there are concerns that the bond holders are not going to be treated as well in the future as they have been over the past 18 months.”
The attractiveness of the corporate bond market is intimately tied to the business cycle, which as Bluebay’s Robelin describes has four steps: “The environment we are just entering where companies start investing quite aggressively because the outlook is good, profits are rising and equities are doing well, the credit market does ok at this stage; a stage where companies start to have unrealistic growth expectations and start to leverage their balance sheets aggressively, we saw this in the late 1990s when European telecommunication companies paid crazy prices for 3G licences.
“Equities do really well but credit markets typically underperform. Eventually the bubble bursts and investors realised their growth expectations were unrealistic, default rates then tend to rise quite dramatically. We saw that after 2000, both equity and debt markets typically do badly, and then companies really start focusing on deleveraging, fighting for their survival and adjusting to a somewhat grimmer economic outlook. That’s what we saw in 2002-2003. It was bad for equity markets but good for credit markets.”
The European investment grade corporate bond market has doubled over the last three or four years and for Kelson of T Rowe Price “it now has a pretty reasonable set of names. The issue for us in Europe is that yield spreads of all corporates got so tight it was hard to find issues that we were comfortable with. That is changing now; but we are finding individual challenges to the credit markets, for example, GM and Ford downgrades”.
For Robelin, the sectors he sees that are going to struggle are airlines and retail, and those companies they think are subject to LBO risk. “We try and spot companies, which might be at risk, anything with an enterprise value north of e10bn it’s going to be very difficult for a private equity sponsor to go for. But companies with a value up to e5bn and with strong and attractive ratios which could be leveraged quite aggressively to generate enough cash flow to amortise the debt, they could be attractive to private equity buyers.”
As Kelson points out: “The private equity deals means that there has to be a greater risk premium in the market as a whole to acknowledge that event risk has returned and it places a lot of emphasis on credit research and following a diversified investment policy, you can’t be too concentrated on any one name.”
Whilst the European high-yield market used to be far less diversified than the US, that is less true today. Bluebay’s Anthony Robertson points out that “in 2001, 55% of the high yield market was concentrated in TMT. Today only 20%, is, somewhat less than in the US market. The correlation with the US market is now very strong, 90-92%. The size of the European high yield market is e140bn compared with the US market at e700bn. The European market is considerably smaller but is much faster growing. The diversity of new issues in Europe is also much greater than in the US. We are also seeing a much greater number of first time issuers in Europe, in the US 65% of refinancing is to existing issuers. Real like for like European growth is therefore much faster than US.” The issue for investors though, is whether current spread levels provide sufficient compensation for not only the risk of default, but also give a premium for illiquidity and the risk of credit downgrades?
Bond market yields are at historical lows and whilst they may increase by 50bp or so within the next couple of years, there is a reasonable expectation that this could represent a longer-term scenario that will persist. Corporate bond spreads in both investment grade and high yield have tightened to levels which lead many managers to exclude them altogether, favouring peripheral and emerging European markets such as Iceland, Poland and even Israel. Investors who are not forced to match liabilities may find that bonds are more attractive as short-term assets than as a long-term store of value at current yields.