What will scare Goldilocks?
Corporate bond spreads are at historical lows in a scenario of low government bond yields and almost non-existent default rates. At this year’s World Economic Forum in Davos, Laura Tyson, professor of economics at the University of California, made the point that the world is no longer dependent on the US economic engine to pull it along. As a result the current ‘Goldilocks economy’ - which is getting neither too hot nor too cold - is set to continue for at least another year.
For corporate bond investors, this is reassuring news even though there are perhaps primeval fears that the dark woods may contain surprises that will drive the bears into the marketplace. But investors have to be aware, as Howard Marks of Oaktree Capital Management described at the recent Super Return private equity conference in Frankfurt, that there is a pronounced credit cycle at work with a clear positive correlation between the level of defaults in any one year and the returns on funds founded in that year. In other words, there is a very strong tendency for the market to overreact in each direction.
Today’s scenario of easy credit at low spreads and low absolute yields with virtually no covenants may therefore be sowing the seeds of future disappointment. “Given the asymmetric nature of credit, whereby upside is generally limited despite the risk of large capital loss in the event of default, we are of the opinion that there is potential for near term moderate mark to market losses on the back of spread widening,” says Paul Shuttleworth, fixed income manager at Black Rock.
While investors are right to be wary of a market environment that may not persist for many years, active bond managers may be longing for a sharp rise in spreads to give them the headroom to show off their skills. In the meantime, it is “goodbye boring bonds”, according to Jean-Francois Boulier of Crédit Agricole Asset Management (CAAM), describing the wave of innovation that is transforming the credit markets.
While “bull markets produce products like corporate hybrid securities - if you are happy with the company, why not go farther down the capital structure” is a view often prevalent in the marketplace, according to Payden & Rygel’s Serena Schwan, who adds the warning that “as these products evolve, there is the risk that investors simply go for the yield rather than properly evaluating the underlying risks”.
But it is not surprising that fixed interest managers are desperate to find more complex products that enable them to utilise their credit and portfolio management expertise more profitably. At current levels of spreads and yields, it is difficult for them to generate much more than 30 basis points outperformance in the next year in a conventional credit portfolio, and with fees at around 25 basis points, investors may be wondering whether it would be far cheaper getting exposure to the corporate bond markets by just investing in a few short dated government bonds or AAA money market funds and rolling over the Swapnote contracts traded on Euronext.liffe, which are essentially bond futures on the corporate bond markets.
In a world of low reward for taking any sort of investment risk, demand for corporate bonds is both strong and sustainable among particular investor segments.
Boulier sees the investor universe as broken down into three main categories: first, yield seekers such as insurance companies. “What is important for them is to focus on credit quality and the long-term stability of credit quality with essentially a buy and hold strategy with a low turnover. Structured credits also come into this category, such as managed CDOs that provide upside without too much downside risk.”
The second category is traditional benchmarked portfolios with fund managers seeking to add alpha on top of the benchmark. However, Boulier sees that “there has been a downward trend for demand for benchmark portfolios. This is typical of the situation you get when you have interest rate rises where the asset class has a negative sentiment associated with it. While this situation will not last forever, the strong appetite seen in the 1990s for benchmark portfolios is over.”
Finally, and more recently, the third category is the absolute return orientated investors. These encompass the traditional long only investors such as banks which are usually long credit in a positive yield curve environment as well as long/short hedge fund players. Robin Cresswell of Payden & Rygelalso makes the point that a significant source of demand “comes from those that are increasing their total allocation to bonds for the purpose of FRS17 and other capital and regulatory purposes. For many with long-term liabilities, even quite
small increments in yield can have a disproportionate effect on the amount of capital or commitments that must be made today.”
Central banks can also be regarded as being in this category as they turn to credit easier than equities, as it is much closer to their natural asset class.
The key issue for any investor in corporate bonds is whether the current level of spreads is justifiable given the risks. BlackRock’s Shuttleworth expresses a consensus view that corporate bond valuations are increasingly looking stretched, with the market pricing in “too much certainty” in the continuation of the benign credit environment, modest growth and the contained inflation, that the asset class has enjoyed since 2003. Aberdeen’s Nik Hart says: “Corporate bond spreads are compressed like in 1996-97. Everything is as rosy as it is likely to get. However, while there is fantastic credit quality for everything we are looking at, three to four years down the road the environment could change.”
One issue is whether risk spreads have been compressed so much that there is little extra reward for taking on non-investment grade risk. Stone Harbor’s David Torchia makes the point that “if we look at spreads at high yield and emerging market, and investment grade they are all tight, but investment grade is the only area that has some room against the all time highs; 77 basis points is the spread of investment grade on the Lehman index. At its tightest, it was in the high fifties during 1996-97.”
Despite the concerns on getting adequate reward for the risks, the sheer pressure of demand is not likely to vanish easily. The way that Schwan likes to explain the phenomenon of tight credit spreads at this stage in the business cycle is that “fundamentals are deteriorating, albeit off a strong base, but the technical back drop largely overpowers any marginal fundamental weakness.”
For Schwan, the key risks that credit market investors need to be wary of are:
q high leverage;
q deteriorating fundamentals in a rising rate environment;
q low volatility perhaps set to rise;
q increasing event risk as management teams try to please the equity shareholder after years of tending to the bond holders (increased dividend payouts and share buyback programmes);
q increased M&A and private equity activity;
q slowing US GDP - otherwise strong in Europe, UK, China and India; and
q an increase in delinquencies in sub-prime lending due to a weak US housing market.
“Given the increased issuance in high yield deals over the past few years, a two-year lagged rise in defaults may be looming,” adds Schwan.
Boulier is also worried about “all the liquidity that is being provided to homebuyers and consumers, especially by institutions that are not strongly regulated. In the US and also the UK, we are seeing more delinquencies in ABS pools.”
Despite the dangers that may lie beneath the surface, Schwan adds: “Given management teams have been extremely diligent in preserving the strong balance sheets they worked hard to create back in 2002-03, even if they deteriorate they are on very solid footing.”
David Buckle of Principal Global Investors argues that the global imbalances have caused a huge amount of liquidity to enter financial markets. As a result, capital is chasing investment rather than the other way round and this is seen in the enormous increases in foreign reserves holdings by Asian and Middle-Eastern central banks. “This expansion in global liquidity arrived at a time when short-term interest rates were extremely low and therefore investors have chosen to bear risk in order to gain a higher return,” he says.
“In fact as liquidity becomes more prevalent, more risk is being taken for ever lower yield. Risk premiums in all asset classes have shrunk, with the credit markets being no exception.” He adds that “absent an increase in default rates, for me the primary risk to the credit market is then a removal of this global liquidity”.
The increased liquidity in the marketplace is clearly a danger in itself as private equity firms take advantage of cheap financing with minimal covenants to take on larger and larger deals.
But Torchia explains: “Private equity has been a source of frustration. The market is over-cautious and became whipped up by rumours, 95% of which were spurious. Investment grade bondholders have won a few victories. We have seen an increase in issuance of bonds with a change in control clause, although this is still a drop in the ocean, but a whole list of issuers have done that. While some people do a relative spread analysis on this, it is difficult to price how much such a clause is worth since the spread differences have varied from 10 to 50 basis points in comparisons between bonds issued by the same entity with and without the clause.”
Boulier is relatively sanguine about the impact of private equity, pointing out that “as long as equity prices are not too high, it is fine”. But he adds: “Once the market price is too high relative to fundamentals, the goodwill component increases which is not good.”
For Schwan, the private equity surge is just another factor that has to be incorporated into the analysis on a macro and micro level. “Firstly, the sheer amount of funds that have accumulated globally, $100bn (€75.7bn), is taken into account in the first decision - is there value in the credit market and what are the risks in that market?
“Secondly, on a micro level, what individual corporates are most susceptible to a private equity takeover? A company would flag up as a
potential candidate if its equity share price is languishing, if it has low debt levels and if it gives off substantial amounts of free cash flow, making it easy for a private equity firm to leverage up the company and pay down debt on its own cash flow.”
t is probably fair to say that European fixed income fund managers are playing a game of catch-up with their US competitors when it comes to developing global credit capabilities encompassing the US, Europe, other developed markets such as Japan, as well as emerging markets and high yield, and investment grade.
The development of the high yield market in Europe requires new organisational approaches to maximise multiple synergies within a firm such as between investment grade and high yield and even between bond and equity research departments. CAAM for example, with offices in Paris, London and Milan, is organised along sector lines with high yield and investment grade sitting close together so that, for example, when GM went to junk status, credit research was ready, according to Boulier.
A key issue for European fixed income managers is often whether to buy or to build a US capability. BNP Paribas bought Fisher Francis Trees and Watts, while Société Generale bought TCW, which might give some indication as to the likely strategy of CAAM. Aberdeen has benefited from the far-sightedness of Morgan Grenfell which started a US operation in 1989 that engaged in domestic US mandates, which subsequently became part of Deutsche Asset Management and which was then sold off to Aberdeen as part of their acquisition of Deutsche’s fixed income asset management activities.
US managers developing European capabilities have been able to transfer the expertise developed in US investment grade, high yield and ABS markets into the rapidly growing European debt markets.
Pimco’s Ivor Schucking declares controversially that “our global model is in sharp contrast to many of our competitors, who generally have limited links between their analysts globally and generally follow more of a silo approach”. He adds: “A global research effort requires three key ingredients - a rigorous process, effective communication and teamwork. We are organised first by geography and second by industry. Analysts cover the entire ratings spectrum, from investment grade to high yield, and they look at both bonds and bank loans.”
Stone Harbor, according to Torchia, “adopts a global sector approach, where our 10 corporate bond analysts are organised by sector and look at issues spanning the investment grade, high yield and emerging markets world. They are charged with covering and assessing the fundamental credit picture for the sector and individual corporates. They are looked upon to generate trade. The portfolio managers are watching the market in real time and have an immediate grasp of how issues are trading and where the technicals are.”
Fixed interest divisions that are part of multi-asset fund management groups often make a play on the interactions with their equity colleagues. Shuttleworth describes their credit philosophy as “looking to add value through a rigorous process that combines both top down and a bottom up approach. Portfolio managers and credit analysts work together in an interactive and joint decision-making process, complemented by the additional insights provided by our equity research colleagues - this is a huge value add.”
Hart sees a great benefit in having deeper access to senior company management. “We see 12 or more companies a week and the equity team meets a similar number. As a bond investor, I usually see the treasurer, but if the equity team is meeting the CEO, I will try and join them,” he says. “We are all capital holders in the same business. We all look at issues such as what are the cost drivers, acquisitions, how much leverage. As an investor in a company, we are looking at return on enterprise value, the future returns and future risks. Where it diverges is on the upside of business. As a bond investor, I don’t care about the upside. I do care about the downside.”
Corporate bond investors are facing an asymmetric risk profile. Howard Marks of Oaktree Capital summarises perhaps the fears of bond investors with the five things that would keep him awake at night, namely: a recession; a closing of the credit window with lenders becoming less willing to provide capital; something systematic such as the failure of a few hedge funds; an external surprise such as a dollar collapse, an oil price rise or a terrorist attack, and the fifth and most important set of worries which he declared as “everything I can’t think of” that will knock the confidence of the market.
The recent volatility seen in the equity markets does provide some evidence that Goldilocks should not become too complacent: the bears may be all too ready to wake up from their hibernation.