“It has been grim. We haven’t seen conditions like these for years”, says Pictet’s Rajeev de Mello, “and no we don’t think there’s light at the end of the tunnel.” As a fixed income fund manager shouldn’t he be happy with rates continuing to fall? Is he a hedge fund manager who’s been caught out shorting 30-year US Treasuries? No, De Mello is a fixed income fund manager but he, like an increasing number, also runs funds that need to invest in credit.
“Definitely a tough time and it feels like we are entering a whole new world,” agrees Christophe Tamet who is head of Euro Credit at Fortis Investment Management in Paris. “For the past year or so our job has been less about finding which investments to be in, but much more about avoiding those not to be in. And we all have to work to define the rules because it is really quite unknown territory, at the moment even if we do believe that one day we will go back to the ‘old rules’.”
Tamet goes on to agree with de Mello’s rather gloomy outlook, adding: “Yes, it is difficult to see the bottom and no, I cannot say that we are at that turnaround point. Let us not forget that it has also been a dreadful year for financial markets, not just credit.”
But credit has been a very tough cookie for a variety of reasons. “In the first few days of October, we saw something of a bloodbath in the autos,” describes De Mello. “That the Ford CDS five-year widened out by 150 basis points in just five days was pretty remarkable and it is now trading at well over 600 over. The stock price had been falling for a while but then the whole thing started to accelerate. Autos have been the worst sector, and Ford the worst within that, for a couple of reasons. Firstly, look at those incentives that the motor companies offered to lure their customers; sales were indeed driven up but the carrots have certainly cost the companies a lot. And then, like many other corporates, the autos are up against the rating companies who are pressing them to cut their costs and borrowings.’
As De Mello points out, the rating agencies do have a point about indebtedness for the car makers. “Ford has a vast amount of debt outstanding, some US$120bn which is more than twice that of Portugal.”
Ofcourse, it has not been just one way, with volatility in all directions remaining high, month after month. “It has been quite a good time in some respects,” says Clariden’s Martin Hueppi. “But you have to have kept up with all the news at all times and always set your targets. And in the domain of high yield you must, must set targets and be prepared to trade.”
Hueppi suggest that Europe had rather neglected the lower credit spectrum, not least because there just wasn’t the depth of market available to investors. “Single ‘A’ marked the end of the world as far as many investors were concerned, anything below was completely out of bounds. But now? Well we have all been forced to look deeper – there are plenty of ‘BBB’-rated paper issued by perfectly viable, proper companies. And, what is even better from an investor’s perspective is that there is a huge disparity between the best of the ‘A’ and worst of the ‘BBB’ paper so, if you do know your stuff then you can make money.”
Although being nimble has helped, there have not been many names that have not suffered in this environment, argues Tamet. “A look at the stock market tells us a lot: there is no growth to speak of out there and the whole world just has to face up to these realities.”
So what are the risks that the already nervous investor community are most worried about? Without much hestitation it is the prospect of war in the Middle East. “We really would like to see some clarity in the situation with Iraq,” says Pictet’s De Mello. “This huge geo-political uncertainty is a very heavy weight on the market. If we look to recent times of conflict, be it the Gulf War back in at the start of the 1990’s or the more recent conflict in Afghanistan it was the run up to actual exchange of hostilities on the ground or in the air that drove up risk premia. Once the battles had begun, then it became much easier to quantify risks.”
Another, rather less dramatic-sounding fear for future market recovery is voiced by Fortis’ Tamet. He explains: “One of our biggest worries is that the consumer will just stop spending and thus remove the economy’s last remaining source of demand.”
For some, it’s threat of the debtor’s worst fear becoming reality. “Deflation! Now that really would be my disaster scenario,” argues Hueppi. “With no pricing power companies would be suffering and can you imagine servicing all that debt as interest rates fell through the floor?”
Although many investors are not prepared to suggest that the worst point has been reached, even the gloomiest agrees that some good just might be appearing. Hueppi suggests that perhaps the bottom has been reached, but that it just won’t look like a flat line, and he for one does not believe that the world in general is about to go under.
There are many, many companies out there doing a decent job and they will certainly make it,” he states confidently, adding “and the risk /reward profile of corporate debt looks a great deal better than for stocks.”
But even some of those companies which enjoyed, and have survived, the worst of the excesses of the 1990’s and the borrowing bonanza appear to be beating those headwinds. “We are at last seeing deleveraging of many areas of the corporate sector and this has to be a positive sign for debt markets,” says Tamet.
And the once reviled telecomms seem to be winning back some friends because of their efforts to cut their (huge) debts. “I like the telecom sector,” states De Mello, “precisely because of the measures that we can see they are taking to cut down their debt mountains. For example BT selling MMO2. And they all have new CEO’s to lead them forward. Now we have Deutsche Telekom’s August announcement of up to 55,000 job cuts and the new management hinting that it wants to cut its debt by selling assets. One such disposal could be Voicestream in the US. This sector’s had its ‘accident’ if you like and is thus further ahead in the healing process.
“We think the deleveraging activities are really worthwhile and we are overweight telecoms. And we also think healthcare and euro-denominated energy looks pretty good,” suggests Tamet, adding cautiously, “But we think it still pays to stick with the good quality names, and we do not like the cyclicals right now.”
There remain plenty of sectors to avoid, including the aforementioned autos, and also the insurance companies, financials and the utilities in general although some investors argue that opportunities are starting to appear in this area.
For each of the investors quizzed here, however, the more important feature of today’s market is to keep one’s eyes open. Although bond investors are often accused of relishing doom and gloom, events of the past 12 months have shaken confidence and put everyone on high alert. The advice that most investors seem to be heeding? Stick to what you know and prepare for as many eventualities, including the improbably outlandish, as you can
“And our bear market (in credit) has been going on a lot longer than the one in equity market,” bemoans De Mello, pointing to the fact that credit spreads started to widen dramatically in 1999, before the stock markets began teetering and toppling over.
And if you need any more convincing as to just how scary it is out there, De Mello points out volatility as measured by the VIX index (implied volatilities in the prices of a basket of options on the S&P 100) is higher than it got to back when there were very real fears that the LTCM collapse could topple the US capital markets and is as high as it has been since October 1987.
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