What is driving the marketplace?
“A skilful financial economist can make a sound case for investing pension assets in either equities, bonds or any asset class in between based on corporate finance theory” according to Moshe Milevsky and Mike Orszag, co-editors of the Journal of Pension Economics and Finance. This may explain why, when pension funds with long term liabilities often seem intent on buying long term bonds to match them, irrespective of the price, the Wellcome Trust, with not dissimilar long-term liabilities, sees fit to issue 30 year bonds to take advantage of the low bond yields caused by the pension fund demand, and invest the proceeds in equities and alternative assets.
The reason for Wellcome’s move is pretty straightforward: As Jean-Francois Boulier, head of European bonds at Credit Agricole Asset Management (CAAM) declares, “bonds cannot compete with the premium on the stock markets. The prices on stocks are very enticing”. But who is behaving rationally and who irrationally? The arguments around this question underlie much of the activity driving the European bond markets.
Liability driven investment (LDI) has clearly been a driving force for much of the activity in the European, particularly the UK’s bond markets, but LDI has been a regulatory driven investment strategy rather than one based on a uniformly accepted economic framework. As such, the move towards use of LDI approaches has varied greatly in the EU.
Margaret Frost of Watson Wyatt points out that “outside the Netherlands and the UK, there is not so apparent a bandwagon in LDI. It is not obvious in France, Germany and Italy”. The UK has clearly been the first mover, with all the disadvantages that happen when unproven ideas are taken to extreme.
As CAAM’s Boulier exclaims, “paying more attention to liabilities is clearly a good thing, but when you react by mechanically buying bonds at any price, it is ridiculous”, whilst Joe Biernat, head of research at European Credit Management (ECM) has the view that “LDI is a noble concept but the behaviour of UK pension schemes is like sheep jumping off the cliff after the bridge has blown down!”
Keith Patton, head of fixed income, Europe for Aberdeen Asset Management and one of the team brought over with the purchase of businesses from Deutsche Asset Management, views LDI as a risk framework - “Our clients are keen to understand the risks inherent in the liabilities and are looking to adopt a framework to gradually close the interest rate gap. One interesting aspect is the transferring of liability risk to a more diversified portfolio on the asset side of the pension fund.”
The issue that pension schemes have to grapple with is that relative to equities, bonds do look overvalued for anyone seeking absolute returns. There are of course, a number of different comparisons that one can make between equities and bonds, but for CAAM’s Boulier, the most useful is the risk premium obtained through a Gordon-Schapiro type dividend discount model. CAAM look at the departure from the average discount rate. “I would tend to select a premium of 4-5% of equities over long-term bonds. When you calculate it today, you get 1.5% higher,” according to Boulier.
owever, as Watson Wyatt’s Frost points out “current yields may be low, but the bond markets will not go away. Over the short term, they may look expensive, but you need a strategic viewpoint as well as a short-term tactical viewpoint.
Market timing is not easy!” ECM’s Joe Biernat also adds the point that “we are in a low return world. Equities will have a tough time repeating the strong returns seen in the last 10 years. In a low return world, fixed income does well.”
Implementing anLDI frameworkin Europe that takes into account views on relative valuations requires three components: access to independent high calibre advice; the ability to deal in European derivatives such as interest rate and inflation swaps; and the ability to manage investment portfolios geared to absolute return targets rather than relative returns.
The most difficult of these is obtaining unbiased advice. BlackRock according to Scott Thiel, has had success, particularly in the Netherlands, in using its modelling skills to try understand the nature of liabilities and then constructing tailor-made benchmarks for portfolios of bonds and derivatives.
Going forward following the recent merger with Merrill Lynch Investment Management’s (MLIM), the two firms fixed income capabilities will be merged into the enlarged BlackRock capabilities with UK and European mandates being managed from Europe. Few fund managers however, have the resources to provide LDI advice and even fewer see it as offering any additional fee income. Such advice as there is, has been mainly the preserve of investment banks.
Given the substantial fees from associated derivative transactions on nominal sizes of assets that could easily be in the billions, “free” advice from this source may be seen as less than wholly independent! This may explain why the take up of derivatives by pension schemes has been far less than the expectations of the investment bankers, despite the potential benefits in many cases.
Key trends - growth of ABS market
Both investors and bond managers are facing a rapidly developing European debt marketplace that is increasingly demanding more sophisticated approaches to management of European bonds. A key characteristic has been a great increased liquidity across all product areas according to BlackRock’s Thiel, with central banks diversifying away from US debt markets and increasing exposure to Europe.
However, for European pension funds according to Frost, “there has been too much reliance on inflexible government bond mandates, which are just playing duration and the yield curve. The playing field in Europe will change with more mandates including credit as a benchmark.
“There are no reasons we can see as to why the European markets should not become more like the US markets, with investments in all sorts of credit up and down the capital structure as well as asset-backed securities (ABS). UK pension funds in particular, need to think globally since the UK government and credit markets are actually quite small.”
This is a view echoed by ECM’s Biernat who asks the question “why do UK pension schemes just buy sterling. Why don’t they buy a broader mix and hedge it into sterling?” The growth of the credit derivative market will also play an increasingly important role in this, giving managers the ability to go both long and short of specific credits, although as Stéphane Fertat of Fischer Francis Trees & Watts (FFTW) points out “you need to educate clients and it can become complicated in terms of investment guidelines.”
The ABS market is growing very rapidly with “a huge demand which far outstrips supply” according to Biernat of ECM, which has 15% of its main fund in ABS. Watson Wyatt’s Frost sees ABS as “well understood by non-European analysts” and she adds that “the two areas where we always see demand for high calibre analysts are ABS and also financial sector credit analysts. Financials are the biggest part of the corporate market and also the most complex in terms of capital structure with Tier 1, Tier 2 and subordinated layers to consider. The challenge for European managers is getting credit teams skilled and experienced and retaining their staff. The credit and ABS areas are growing faster than some managers can keep up.”
It is not surprising that firms with existing US capabilities are responding by transferring staff from the US to Europe, with Aberdeen relocating Paul Magura, a member of its US ABS team from Philadelphia to London, while BlackRock is transferring Scott Thiel to lead the merged BlackRock/MLIM European team.
The current tightness in the spreads of corporate bonds has led to many managers increasing their weightings to ABS, even though they are not as yet included in indices such as the widely used Lehman Pan European Aggregate. This has instead, a weighting of 14% to Pfandbriefe and other securitised issues which Aberdeen’s Magura feels “does not offer as much value as the ABS market”. In their European portfolios, Aberdeen favours AAA rated ABS bonds.
FFTW, according to managing director, Simon Hard, is also large holders of ABS securities and typically would combine floating rate ABS bonds with bond futures to be able to give a high rated yield pick-up to government bonds. However, European ABS are still relatively expensive compared to the US where, according to CAAM’s Boulier “the ABS market is astonishingly large and diverse and quite cheap. In Europe, it is desperately different. There are so many buyers that spreads are very low. In the US, you have a spread of 20-50bp for AAA over government bonds. In Europe, it is 4-15, so it is really expensive but we tend to buy it in preference to a corporate with low spreads.”
He goes on to add that “the growth of the European ABS market could be very high and it will go in the direction of the US. In 2004 and 2005, there was more issuance of ABS than corporate bonds, so with an average life of four to five years, the ABS market will rapidly overtake the corporate bond market in size. A lot of new mortgages are now arising from brokers who will securitise them so there is a separation between distribution of mortgagees and financing. In France, a third of mortgages are through brokers. Once the channel has been put into place within large banking groups for ABS investment, then it opens up a major investment area. Collaterised debt obligations (CDOs) based on portfolios of ABS are also very popular in the US. Whilst we cannot do it in Europe as yet, it will be popular in the future.”
As bond managers become more familiar with ABS, they also become more willing to move down the credit spectrum. “At the moment, we are large investors in AAA and we will go down the credit curve when we are confident enough to estimate the risks,” explains CAAM’s Boulier. Whilst liquidity, particularly in the AAA trenches may be acceptable, it becomes increasingly less so as one goes down the credit ratings. Out of the 3,400 European outstanding floating rate ABS securities (there are a further 1,600 fixed rate securities) only 90 or so securities have active two way markets on any given day. The sheer number of securities outstanding means that very few of them actually trade on any given day.
As a result, according to one trader, “the majority of the prices are based on trying to come up with a comparison to a benchmark that has traded recently and ‘recently’ can be misleading, we could be talking about weeks”.
Clearly, pricing of ABS bonds can become an issue, and whilst investors may have a buy and hold strategy, this still leaves them with a requirement for accurate estimates of fair value.
One option that may become of increasing relevance is the use of external third party providers of evaluated prices of ABS, particularly the lower rated tranches. Standard & Poor’s, for example, have recently announced the inclusion of ABS to their evaluated pricing service for bonds.
The lack of widely acceptable benchmark indices is also currently a drawback in the ABS marketplace. There have been a few attempts at setting up ABS indices, the most recent being the tradable iBoxx ABS50, based on the prices of 50 of the most liquid ABS bonds from a consortium of dealers.
However, designed by and for traders, there has been little take-up by fund managers who, like FFTW’s Fertat, generally have the view that it is not working with little liquidity. Given the growth and increasing importance of the European ABS marketplace however, it is only a matter of time before other index providers develop their own attempts at providing both reference and tradable indices.
Fund management approaches
For Watson Wyatt, the different approaches that fund managers take to the management of European bonds can be divided into the three categories of i) low risk core, ii) core plus and iii) high risk satellite specialists e.g. emerging markets, high yield, convertibles.
Historically, much of the European bond mandates have been low risk core mandates for insurance companies and pension funds, and European bond managers have had strong franchises and large asset pools built around the government bond markets, focussed on strategies such as EU convergence trades.The problem many face, as Frost points out is that “the single currency is only a recent phenomenon, barely 7 years old and as a result, the quality of credit research in Europe is not what it is on the US and UK.
ow there are burgeoning credit markets which require more sophisticated and deeper analysis. The credit teams in Europe are competing with the US and UK. Can managers in France, Germany and the Netherlands emulate their peer group in the US and the UK?” She goes on to add that “the problem is not one of numbers of people or their methodology, it is just the experience. In the US, you have managers with 20 years experience of credit markets and this has also percolated into the UK. In Europe, prior to the single currency, there was not much corporate issuance.”
With the US home to 50% or so of the total global bond markets, it is not surprising that firms such as BNP Paribas have reacted to the demand for more global and sophisticated bond management skills by acquiring specialist US bond managers. Hard, managing director of FFTW, a BNP Paribas affiliate, explains that whilst specialist euro funds are managed by BNP Paribas Asset Management (BNPP AM) in Paris, FFTW is the provider of US and global bond products for the BNP Paribas Group.
FFTW’s Fertat adds that BNPP AM itself has a strong franchise with European government bonds in Northern Europe, Benelux and Italy, but the two operations are kept separate. Clients however, are increasingly looking for more alpha in bond mandates. He points out, “to pay 30bp when yields are 6% is not a problem, but when yields start heading towards 3%, they are not so keen”.
Extracting more alpha means having the ability to access a global universe whilst retaining a domestic benchmark. As Hard points out, “the benefit is not so much diversification of bonds but more a matter of widening the opportunity set since markets are generally more correlated than before and yield curves are of a similar shape these days”.
Active bond management with flexible guidelines makes sense if the managers have the skills to enable global bond inputs with local benchmarks that may be just in the local currency, reflecting the local liabilities. But for European clients, Watson Wyatt’s Frost points out that “there are not many European managers that are skilled in that way. As clients become more interested in global bond opportunities, it plays to the strengths of non-European managers”.
BlackRock for example, sees its core strengths as “the ability to take relative value bets across different sectors within aggregate mandates”, according to Thiel. Aberdeen also sees itself as a beneficiary of this trend, following the acquisition of Deutsche Bank’s non-domestic asset management businesses.
Patton explains that Aberdeen has two types of mandates - firstly those with a domestic index such as many of their UK clients and secondly those clients, many in continental Europe, who have a traditional manager undertaking the core management, but wish the portfolio to work harder with the use of more sophisticated strategies incorporating the use of derivatives for example to give global overlays.
This places them in competition with the large US managers such as PIMCO and Western Asset Management, who are also challenging the more traditional franchises in the UK market.
Despite the low valuations relative to equities, European bond markets are seeing a pace of change that clearly offers attractive opportunities for the more sophisticated US and UK fund managers and also increasingly, the investment banks. Whilst many bond managers may struggle keeping up with the new opportunity set for European bond mandates, European pension schemes may have to struggle even harder to decide whether any advice they get on LDI is sensible or just a derivatives sales pitch.