The ups and downs of volatility
Joseph Mariathasan examines the impact of the recent market turmoil on the credit markets and asks where opportunities for institutions in 2008
“Fixed income fund managers have spent years arguing with their clients that the reason they cannot make much money is because there was not much volatility in the marketplace,” says Stephen Thariyan, head of credit at Henderson Global Investors. “And now there is lots of volatility but we have a dysfunctional marketplace.”
“The situation is dire in both investment grade and in high yield,” warns Axel Potthof, (pictured right) head of European high yield and bank loans at Pimco. “Good companies with no refinancing requirements are trading with basis point spreads in the 70s. Good quality names are being dumped. Banks have no liquidity while hedge funds are doing nothing and had an ugly month in January. Investment managers with ‘real money’ are doing nothing, so there is no real buying.”
Credit markets have experienced the greatest fallout from the after effects of the US sub-prime crisis and the impact on liquidity and interbank trading in the financial sector. “There is no liquidity generally and the severity varies by asset class,” says Thariyan. “The structured product markets in particular, are broken, with no bids or offers even for highly rated AAA issues by well-known names in the ABS marketplace.”
Yet many would share the view of Jean-François Boulier, head of credit at Credit Agricole Asset Management (CAAM), that “spreads are at a bargain level”. Thariyan is one: “I feel like a kid in a candy shop, it is too good to be true. There is value in high grade and areas of structured products and leveraged loans and there are opportunities across all asset classes.”
David Stanley, (pictured right) fixed income portfolio manager at T Rowe Price, adds: “It was hard to add value when investment grade credit was trading in the low 40s last year, as there was also little distribution in spreads between issuers. Now, with indices around 150, there is a larger dispersion of spreads, and greater opportunities for active managers to add value.”
Nevertheless, as Thariyan points out: “The problem is there is no liquidity and the worry is over what happens if there is a big recession. So the market is confused.”
“From an economic perspective, the outlook is bad,” says Stanley. However, Boulier’s view is that “a US recession will have an impact but it will not put global growth on its knees, so we are cautious but not desperate”. Potthof says that Pimco had been expecting a US housing slowdown and had been positioned defensively for some time. “We have been underweight credit for a long time and prepared for a sell-off,” he says.
“We are coming off a period of strong global economic growth coupled with low government bond yields; an ideal combination for corporate bonds,” says Stanley. “The cycle has changed and as the US economy has slowed, the worry is whether this will turn into a recession, and how deep and prolonged it could be. It is talked about every day.” However, he adds: “We have the view that a US recession will be relatively shallow in nature as we are seeing a fairly aggressive policy response in terms of interest rate cuts and a fiscal package, while the weak dollar is also providing stimulus. But at present there are more downside than upside risks.”
The strong US growth seen in the last few years “helped default rates to decline to 26-year lows,” Stanley notes. “The current economic slowdown has not yet resulted in a pickup in default rates, although they are generally expected to rise to around 5% in a year’s time. We know they have probably troughed and will rise over the next year, but the question is by how much? A deep US recession could see a return to double-digit defaults.”
“If spreads don’t get tighter, we will start seeing defaults,” says Potthof. “With 15-18% rates, companies can’t refinance. A company that needs money tomorrow can’t come to the market. Lower down the rating spectrum, companies can’t come to the market at all.”
Potthof adds: “It is question of confidence. If the monoline insurers can be recapitalised and if large banks have written off all their bad debts, we have a chance to recover, but if bad news keeps coming out, lending will get tighter and banks will get more cautious and will drive some companies to default.”
But despite the gloomy outlook, there is still hope of avoiding a US recession. “The other scenario is that we don’t have a recession,” Potthof says. “Fourth quarter last year was okay. If companies report decent numbers, we get confidence back and people start buying bonds, this could well be the case. However, if companies don’t show good operational numbers, people will feel there is a recession and spreads will widen.”
“The market is expecting financial accounts for the year-end,” Boulier says. “As soon as they are received, the market will have the information to look at what is happening, estimate losses in the future and move one way or another.”
The issues for the financial sector are both associated with the extent of mortgage related write offs and the drying up of liquidity. “In Europe, it was predominantly a liquidity problem with the banks,” says Boulier. “It is an appetite problem with investors, and some are not willing to commit to spend. The scenario that we are seeing developing is due to the fact that banks have mismanaged their liquidity. There were too many structured finance conduits and investments in poor quality securities. This created a liquidity crunch last year. It is improving with the two-year swap spread at around 10-15 bps and it was as high as 60 bps. The difference between three-month Libor and overnight spreads is shrinking gradually. It was up to 90 bps in December and is now down to 35 bps. In normal times it would be 15-20 bps.”
But liquidity is still poor in the cash markets with very little supply. “When there has been issuance in recent months, it has been at substantial discounts to secondary market levels,” notes Stanley. “Companies have been issuing up to 40 bps cheaper in yield terms than the secondary market. Prior to the credit sell off last summer, the majority of new issues only required discounts of 15-20 bps to ensure that their bonds were well placed in the market. But given the present level of uncertainty, financial issuers, and particularly cyclical companies, require ever-larger discounts to guarantee a successful launch. If you are a holder of secondary paper in a company that issues a new bond, you are not pleased as it invariably reprices to the level of the new bond, which is a very large concern at the moment.”
With the lack of liquidity, the normal relationship between the cash market and the derivative markets has gone askew. “The problem with credit default swaps [CDSs] is that if you want to short risk, there is no one of the other side. Banks do not want to be long,” says Thariyan. “The CDS market is more liquid than cash but has a dynamic of its own.”
As a result, credit derivatives are trading at lower spreads than cash, which, says Boulier, is very unusual. “In former times you bought the bonds and a guarantee in the CDS market and locked in the difference for a fee,” he says. “However, at the moment cash is higher, with spreads of 25 bps, but there are not enough arbitrageurs in the market. Why is this? Because there is not enough appetite in banks and not enough liquidity to buy cash bonds, so those able to bring liquidity are enjoying a 25 bps pickup. But there are not enough investors in the market. The reason is that a number of investors buy corporate bonds blindly by looking at ratings, but at the moment people do not trust the ratings agencies and lots of investors don’t have enough analysts to do the homework.”
As well as the uncertainties in the economic outlook, there are also uncertainties about the financial health of the banking sector. “Where are the details of the bank write offs, whether sub-prime, CLOs or monoline insurance?” asks Stanley. “The concern is that the deterioration of quality is spreading to auto loans and even beyond. The disclosures by European and US banks differ a lot, with European banks providing less information. We did not hold SocGen because we didn’t have much confidence that it was revealing all its information. UBS wrote down $10bn [€6.8bn] then wrote down another $4bn followed by a massive $27bn in February so it was drip feeding bad news, and the concerns were whether there would be further write downs.”
The most striking aspects of the aftermath of the sub-prime crisis have been the indiscriminate sell offs in general and the fault line that appeared between financials and non-financials.
“This has been the key,” says Stanley. “Industrial companies have historically traded at higher yields/spreads than the highly regulated financial sector. Industrial companies were the major concern in the first half of last year, being susceptible to high idiosyncratic M&A and LBO risks. But now yields have crossed over, with financials at higher spreads than industrials, and this difference is at all-time levels. There has been an underperformance from higher-rated companies, where financial names predominate. The banking sector has clearly sold off the most, and this is where we are buying, but from a position of being underweight. We remain cautious about future bank write-downs, and thus we have very diversified exposures and are only gradually building positions, at attractive long-term levels.
“Monoline insurers have now taken over from sub-prime as the major concern for banks. We have seen one or two monolines lose their AAA status and the question is whether the larger players such as MBNA and Ambac can retain their AAA rating, and the potential impact on the banks.”
Pimco has also invested in bank capital, according to Potthof. “The bonds issued by top rated banks,” he specifies. “Because of their write-offs, they have issued senior bonds and also tier II and tier I paper. If these banks go under, then the whole system goes under.”
CAAM likes some banks, says Boulier. “We have to be very choosy. We like subordinated debt, but not all.”
However, Thariyan points out that the financial sector looks cheap. “But it is the financial sector that has been taking the hits, with exposure to structured products and so on,” he notes. “How easy will it be for them to operate with the absence of a securitised marketplace for a year? They also have a lack of credit lines so short term there are issues.”
Moreover, with so many fund managers appearing to have similar views, “managers face a crowded trade in the financials, Thariyan says. “It was the same last year but for different reasons. Then the financials were highly rated and seen as immune from LBO risk.”
He adds: “In our conversations with the syndicate desks of investment banks, it appears that there is a standoff between issuers and investors and there is currently a 50 bps gap. The banks will have to issue at some stage, but the question is when in the year will they do so. If you are not in financials then at what level are they attractive? And if you do have financials, you are worried over the new issuance, which will be done at a discount to the secondary market, driving down prices.
Spreads in non-financials investment grade have widened. Stellar auto companies like BMW and Volkswagen have seen spreads widening as worries grow about a tightening of credit. So a natural trade would be long financials and short industrials or, if you can do good stock picking, selecting sectors that you feel would do well such as utilities, telecoms, energy, pharmaceuticals and food retailers. But everyone has similar ideas.”
CAAM is keener on non-financials. “We like industrials in general,” says Boulier. “There is a lot to do in terms of stock picking. The spread widening has been indiscriminate. It creates a lot of opportunities but the market is not liquid enough to be active in trading.”
“Non-cyclical areas such as cable and telecoms will outperform over the next couple of months and outperformed in December,” says Potthof. “Cyclicals like chemicals and industrials will underperform and some may go bankrupt.”
The high yield market has seen the most volatility. “We are seeing huge point changes in high yield issues,” says Thariyan. “Sometimes 5-10 point moves in a week that don’t reflect a deteriorating credit condition but a lack of any appetite for any high yield. There is no appetite whatsoever. If you look at the high yield credit curve, it is very flat, so spreads on a one-year are similar to spreads further out, so it can be attractive buying one-year paper.”
“The average single-B is trading at 600-800 bps spreads and I estimate 15% of the market is trading at over 1,000 bps whereas they were trading at 400 bps a year ago,” says Potthof.
But Thariyan says the problem is that people are worried that default rates will pick up, and as a result there will be no trading so no liquidity.
For CAAM, high yield is very attractive. “The CDS iTraxx index is currently trading around 550 bps,” says Boulier. “In August, the peak was 500 bps but it was below 200 bps in May last year so it is really interesting. My credit analysts are quite optimistic. We have the view that although it is better to leverage investment grade than buy a leveraged position through high yield, the attractive yields are worth considering. We like to take short-term bonds than take on credit risk if there is a credit crunch and given the situation we do not hold US high yield.”
The greatest confusion lies in the structured finance markets, which is why liquidity has dried up completely. “While spreads have gone out, it is difficult to know what the true value is when there are no bids or offers,” says Thariyan. “In ABS, spreads have gone out five or six times the levels pre-credit crunch, so there is definitely value there. But you are taking a mark-to-market risk if you buy something,” he adds. “There are rich pickings to be had but you don’t know the timeframes. In a six-month or one-year time frame, it could be dangerous with mark-to-market volatility, but over two-to-three years it is definitely good. The opportunities are here now but there is a lack of liquidity so we average out investments very carefully, following the advice from our ABS group on what looks cheap.”
Fortune favours the brave, and clearly the credit markets are in state of high uncertainty that will enable some investors to reap extraordinary gains.
“Most clients would say to us make sure you have enough leeway, capacity and guidelines to take advantage of the opportunities,” says Thariyan. “Tell us what you want and invest accordingly but don’t come back in a year’s time and say that you didn’t get the returns because you were constrained in some way.”
His view is that recovery funds are a good idea. “There are lots of opportunities - you can just invest in financials, high yield and ABS and close the fund for the next three years if you did not have to worry about market-to-market valuations. If it were managing my own cash, I would be doing that all day and not looking at the mark-to-market values. If you try and trade the market in 2008, you will get topped and tailed, but if you are willing to hold over two or three years it looks good. Shorter term it is more difficult.”
The problem that most fixed income managers will face in the next year though is differentials in timeframes. “We have institutional pension funds with long time frames but we have yearly timeframes and we are aware that we should be making a half decent return throughout the year”, says Thariyan. Long-term institutional investors who are able to adopt a truly long-term approach to the current market conditions will be the ones making the most gains.