Tough going for investors
Narrowing credit spreads are good for the borrower and great for the lender or investor if they own the debt while it improves. However, as spreads diminish, so too do prospects for excess returns. Credit spreads have been shrinking for some years now and have reached record lows for some classes of credit. Whilst managers are, on the whole, reasonably sanguine about the outlook for credit spreads and few expect significant widening in the next few months, the question of risk/reward balances is coming more to the fore.
Robeco Asset Management’s Kommer van Trigt agrees that the outperformance of credit versus government may be coming to an end. “Throughout a large part of 2004, we tilted our portfolios towards a continued outperformance of corporates versus credit. Towards the end of the year, however, we became more cautious, especially on high yield where we reduced our exposure towards the CCC- and B-rated area. On balance the outlook for companies is still good with full balance sheets and positive cash flow. And we are still in an environment where there is a need to search for yield.”
Van Trigt comments that the supranational bonds are not on balance an important asset class overall for Robeco. “We do manage accounts with restricted mandates, such as the central banks and others, who do invest in only the top AAA names. In general, however, we would try to add value by choosing corporate bonds with lower credits and where volatility between names is high. For an active investor it is very difficult to add value when spreads are very tight and volatility between names is very low as is the case in the supras.”
Richard LaCoff, senior vice-president at Payden & Rygel, says: “In this environment, with tight swap spreads, there really isn’t much value to be had in the AAA-rated supranational paper. These issues do not add alpha. In the euro market they’re trading at spreads of around 8-10 basis points just now. A couple of basis points’ move in the wrong direction and the carry gets eroded. We would trade them against government bonds, not as a separate asset. If we want AAA-rated paper we would elect to have higher beta corporates or AAA asset backeds.”
CapitalInvest’s Andreas Schuster agrees: “Spreads are very tight right now. They might widen in 2005 but we do not believe that it would be a substantial move. The search for yield is still on, so there is plenty of demand and corporate supply is shrinking. We would not choose to invest in AAA-rated supranationals right now. They only make sense as a buy and hold investment. If you look at the 15-year European Investment Bank (EIB) issue, it does offer a little spread, but the bid-offer is nearly 20bps compared to a bid-offer of 10bps or less for the gilt.”
But although these active managers have mandates which allow a much greater variety of type of issuer and credit quality, there are plenty of investors who have far stricter investment guidelines and for whom the supranationals provide a very valuable source of yield pick-up and investment diversification. Robeco’s van Trigt explains: “As well as being huge buyers of government bonds, the central banks and other institutions, especially in Asia, have big demand for supras right now. The highly rated AAA paper provides an important diversification option for these institutions.”
In the capital markets, 2004 was a good year for the EIB, which picked up a variety of prestigious awards based on polls taken on participants within the capital markets, including bankers and notoriously hard-to-please investors, so it is an impressive achievement.
According to those at the EIB, there is no intention of letting standards drop. “We work very hard to maintain our reputation as a ‘good borrower’,” says Peter Munro, head of investor relations at EIB. “Within our formal strategy documentation our responsiveness to investor needs is embedded at the heart of our strategy.” EIB funding teams are continually out on the road with investors via conferences, road shows and meetings.
In 2004, for example, a clear theme from investors was the growing appetite for longer-dated bonds, a theme or challenge to which the EIB was prepared to respond. “The launching of the EIB’s 15-year euro issue was quite a challenging project,” says Munro. “As part of the preparation, we took soundings from investors and from dealers. The outstandings in the maturity reflected that this tenor was the preserve of the sovereign issuers and EIB created the first benchmark to complement sovereign supply in this part of the curve.” In fact, what the EIB did launch, a 15-year E4bn issue in May 2004, was well received.
Munro goes on to explain another very important feature of, and probably contributor to, the EIB’s prestigious reputation as a ‘quality’ borrower in addition to its top quality AAA-credit rating. “We pay close attention to quality of execution and secondary market performance, which helps EIB bonds remain a stable store of value. The fact that many of our deals are very often over-subscribed indicates to us that we are well received and perceived.” In addition to its benchmark issuance, the EIB remained responsive to opportunities for targeted and structured issuance. “This strategy enables us to increase our issuing activity substantially, while paying a pathfinder role, notably by developing new areas of long-dated issues, inaugurating issuance in new currencies and reviving issuance in dormant segments.”
The EIB raised E50bn via 282 transactions in 15 currencies across all major markets in 2004, and aims to raise about the same this year. With current low swap spreads, this year will be as challenging for a borrower as was 2004. But the EIB is undaunted by the task. “We have worked hard in the capital markets. The success of our benchmark programmes in the core currencies shows our consistent strategy and careful execution. And we know we must maintain the innovation and development and keep on responding to investor needs and requirements.”
The term ‘supranational’ describes any organisation that is global or multilaterally controlled. There are a large number of such organisations and agencies, many of which do not borrow from the capital markets. In its Supranationals Special Edition 2004*, Standard and Poor’s summarised the ratings analyses on each of the 21 supranational institutions with public ratings issued by S&P.
The world’s oldest international financial organisation is the Bank for International Settlement which was established in 1930. It does borrow, but only directly from central banks. The United Nations was formed and its charter ratified in 1945, although its forerunner, the League of Nations, was created just over 25 years previously. Another global institution, the International Monetary Fund (IMF) was set up in 1945 ‘to help promote the health of the world economy’. Although the IMF requires considerable capital, its resources come mainly from the capital subscriptions of its 184 member countries.
Established at the same time as the IMF was the International Bank for Reconstruction and Development (IBRD), probably better recognised in the fixed income domain as the World Bank. The IBRD is part of the World Bank Group, which includes its private sector arm, the International Finance Corporation (IFC). Both the IBRD and the IFC are big borrowers in the capital markets.
The World Bank Group is described as a multilateral development bank (MDB) an institution providing financial support and professional advice for economic and social development activities in developing countries. There are also regional development banks – the African Development Bank, the Asian Development Bank, the European Bank for Reconstruction and Development, the Inter-American Development Bank Group, and the Islamic Development Bank. All of these institutions regularly come to the capital markets to raise funds for their activities.
One of the largest borrowers in the capital markets and the largest supranational issuer is the European Investment Bank (EIB), which raised e50bn in 2004. Other well known supranational agencies issuing bonds include the Nordic Investment Bank, the European Community, and the European Coal and Steel Community.
*Standard and Poor’s, Supranationals Special Edition, October 2004