Caveat emptor
Spreads may be widening in anticipation of the new issuance season starting this month, but the worsening macro data suggests bond managers can also expect to see an increase in defaults. Some are rightly nervous of cyclical credits and high yield, with Moody’s increasing its global high yield default rate to 2.5 percent in July from 2.1 percent in June.
Yet Luke Hickmore, an investment director at SWIP, says there may be a longer time lag before the defaults come through than in the past, because of the increased use of cheap financing with no covenants: “Triple C-rated bonds usually last three or four years before they blow up. In the 1970s or 1980s you might have had three or four bonds in this grade that defaulted in that time span, but now there are 300 companies in the triple C grade, so default rates will increase.”
The popularity of ‘covenant light’ may stave off defaults until mid-to-late 2009, when economic conditions are tougher and companies are trying to refinance, but Hickmore is expecting a default rate of 10 percent for the end of next year. He also expects to see more problems amongst US regional banks, especially those with only one business, such as commercial real estate: “Those won’t get rescued by anybody. It will be the same if they only have a small number of deposits.”
He points out that the Federal Deposit Insurance Company has already used up a quarter to a third of its total resources through banks failing in the US, so the premiums the banks pay to the FDIC will have to go up next year. “Next year you could easily see an aggressive move by the Federal government to close down some of these ailing banks,” he adds.
Rising defaults
Difficulties are also apparent in certain segments of high yield, with 11 defaults of Moody’s rated issuers in July, the first double-digit monthly tally for five years. All but two of these were US issuers, the exceptions being Canada’s Ainsworth Lumber Company and the French wine and spirits group Belvedere SA. Moody’s is forecasting that the global default rate will rise to 6.3 percent over the next 12 months, and go as high as 10 percent if there is a protracted US recession.
But defaults are likely to be lower in Europe than the US, where high yield issuance is more cyclical and consumer-oriented, so some managers are willing to venture into lower grades. James Gledhill, head of fixed interest at New Star Asset Management, believes the market is discounting too great an increase in defaults: “The ITraxx Crossover is at about 550 now, which suggests that about 18 out of its 50 members will default over the 5-year index, which I don’t think is true,” he says.
“The maximum bang for your buck is to be had by investing in things that trade very wide that other people think will default, so we have a few of those, but in general we are trying to invest a bit back from that in things that trade a bit tighter. It is difficult to argue that it will recover quickly – but you are being paid to wait and there is lower volatility than in equities.” Other managers, such as BlackRock’s Owen Murfin, and Pimco’s Luke Spajic, say they are staying north of Triple B, particularly in cyclicals, which will suffer more as the economy slides into recession.
“The asset class has been shaken to its core,” says Spajic, head of pan-European credit portfolio management at Pimco. “Things are cheap for a reason, and you need to read the tea leaves a bit and understand what has gone wrong.” Pimco remains very defensively positioned, and is accumulating credit slowly. Whilst the new issuance season may provide fresh pickings, secondary trading remains very illiquid.
Hickmore adds: “Even if you’ve got a position in what used to be a triple A insurance-wrapped bond, such as Telereal [a subsidiary of BT] – which has downgraded to double A because its monoline was downgraded – the price hasn’t moved because no-one has been able to sell any. Everyone who wants them has already got them.”
Hamstrung market
The secondary market is still hamstrung by a lack of capacity – over the last year there have been no new entrants to the market, whilst a lot of traders have left post-credit crunch. Banks and brokers are still trying to deleverage and aren’t prepared to house the risk. “So there are few people who are buying, other than the distressed debt buyers who are bottom fishing,” says Adam Cordery, head of European credit strategies at Schroders.
The new issuance season is expected to bring some new names to the European market, with a big issuance backlog, particularly in the banking sector. This year some 75 to 80 percent of new issuance has come from this segment, and September is expected to be no different. But the close of August also saw corporates such as France Telecom, Eon and Daimler come to the euro-denominated bond markets, as treasurers have started to worry that conditions are likely to get worse before they get better, and that banks won’t be in a position to help them, the later they leave it.
This is something of a turnaround, as for a good part of this year issuers have been going to the dollar market instead. “There has been a lot of support for new issues in dollars and they have been able to get decent sizes away,” explains Hickmore. “So you’ve seen Deutsche Telekom, M&S and Cadbury’s do dollars because it’s cheaper and they can get the size they want. But we think that is becoming quite exhausted and now the balance is swinging back to the UK and Europe.”
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A question of perception
When is an emerging market no longer an emerging market? Is it when it attains investment grade status? Or is it more philosophical, more abstruse than that? For specialist debt investors like Jerome Booth, head of research at Ashmore Investment Management, it’s a rather specious issue.
“You don’t go from being an emerging to a developed market because your creditworthiness improves,” he says. “That’s a total myth. You go from being an emerging market to a developed market because the investor base allows you to deteriorate your creditworthiness if you want.” For example, Romania recently joined the EU, and is therefore viewed as becoming “developed” but is heading for a 14% current account deficit this year. “There is no way that they would be allowed to get away with that if they were an emerging market. It is about risk perception,” Booth argues.
Booth says that the credit crunch, triggered by the implosion of sub-prime securitised debt, has put the real value of unleveraged emerging market paper into perspective. “No one ever bought Brazil without thinking it was risky – including Brazilians. But I believe Brazil has a lower default risk than Italy over the next 10 years. If Italy does leave the euro, one of the obvious ways to do that is to translate all the bank accounts into new lira, which would be an active default.”
Booth argues that corruption is not just an emerging market phenomenon but in emerging markets, the risk is priced in. For Booth, this is one of the fundamentals of investing in this space: “Where we see political and macroeconomic developments impacting asset prices, we can use our expertise. But where the domestic investor base doesn’t even think about their country’s own sovereign risk, that is not an emerging market, and our skills won’t add any value.”
This is also why he sees the credit crunch having an important impact on asset allocation – it’s a case of rethinking the map. “Pension funds will have to accept that in the next 15 years emerging markets will be much more important, but they are still massively under-represented in institutional portfolios.” Booth wants to see institutional investors allocating some 35% of their portfolios to emerging markets, across asset classes. “This isn’t just peripheral any more. This is a wake up call for asset allocators – maybe they shouldn’t be buying so many US Treasuries or US and European corporates.”
Corseted currencies
The current opportunity in emerging market debt revolves around the anticipated appreciation of emerging market currencies against the dollar, and this has led to high inflows into local currency paper over the past year. “A lot of the emerging markets have got semi-pegged exchange rates, or there has been restrained appreciation, and like a corset, that has forced a lot of the dollar’s weakness against the euro,” says Booth.
He expects to see greater currency appreciation in the next 12 months as emerging markets try to get inflation under control. “The US needs to be realistic about what is possible,” he warns. “You can’t expect these countries to appreciate their currencies without selling dollars and that’s going to be painful. But there comes a point where you don’t want to be throwing good money after bad.”
Some two-thirds of foreign capital flows into emerging market debt is going into the $3 trillion local currency sovereign bond market at present. But there is also a growing sub-segment of corporate debt, worth some $2 trillion. The longer-standing hard currency sovereign debt market is worth about $1 trillion, but doesn’t offer great value, according to Stuart Culverhouse, chief economist at Exotix, a broker for frontier market securities.
“Up until the credit crunch, spreads had narrowed across most emerging market hard currency debt so there was less value there. That reflected better fundamentals and liquidity conditions,” he says. “Since the credit crunch, these have widened out a little but not as far as developed high yield or investment grade corporate credit, so this is still not seen as offering great value. For example, you are looking at 7% to 8% yields for low ‘B’ rated credits in Sub-Saharan African countries and people would generally expect more from these markets, such as 10% to 12%.”
Some investors have instead sought to add value by picking up some of the new corporate issuance which has come onto the market recently. At the start of the year, corporate issuance was down, but in Q1 this rebounded, especially out of Russia. “Those deals were interesting, but with some reservations,” says Claire Husson, portfolio manager and research analyst in emerging markets debt at the Franklin Templeton fixed income group.
She adds that corporate debt from former state-owned enterprises often offer an interesting credit risk premium, but a number of financial issuers weakened following the credit crunch, and are now coming back at attractive levels. “This is the sector where we see the highly leveraged names and this is where the risk could erupt,” she warns.
New issuers
Although she has some exposure to corporates, Husson favours a mix of sovereign debt from established and new issuers in frontier markets in Africa and Central Asia. In the past 12 months new issuance has come from sovereigns that don’t necessarily need to borrow, such as Georgia and Gabon: “They are coming to market to access relatively cheap financing, and by doing so, expect to raise the profile of their industry and banks, thereby stimulate the economy. That has been an interesting development in Africa and Central Asia,” she says.
Husson believes that these small upcoming economies, who want a piece of the globalisation pie, tend to be much more prudent than people might expect: “They make strong efforts to disclose their financials and are improving their corporate governance. They are also fine-tuning their loan systems so that potential creditors have some recourse in the event of default.”
But Booth says Ashmore prefers to invest in these markets via real assets, through its Global Special Situations Fund, or originating its own transactions in is Emerging Market Corporate High Yield Fund. “Traditionally the Special Situations Fund was distressed debt, but now a lot of it is private equity,” he says. “Over the last 10 years the average rate of return on exited deals has been 37 percent, and that is all non-leveraged. And because it is event-driven it has not been impacted by the credit crunch at all.”
He expects these assets to be supported by a flow back of funds from emerging markets investors who have traditionally put money abroad. But he concedes that it is not easy to get access to the good deals – a constant refrain for Western investors hunting for real asset investments in emerging markets.
“A lot of money is chasing the infrastructure deals but in a lot of cases the spreads are very unattractive,” he says. “To get the really high rates of return you need to have a strong relationship with decision-makers in emerging markets going back years.” He says the fact that Ashmore specialises in emerging markets has proved advantageous in terms of getting deal flow.
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Local bonds for local people
When does a long-term structural shift become impossible to ignore? For index providers, the resurgence of the East and the rapid expansion of local currency debt has thus far proved difficult to accommodate. Asian domestic bonds now form the fourth largest bond market after the US, EMU and Japan, but they are still under-represented in bond indices, and so attract lower levels of investment. For example, whilst Asia ex-Japan now accounts for 7 percent of the global domestic bond market, compared with 16 percent for Japan and 24 percent for EMU, it is only 0.7 percent of the Citi WGBI index, compared with 27 percent for Japan and a whopping 43 percent for EMU.
“This new asset class has been growing at a phenomenal rate – it is now bigger than Germany, but it is very little known outside the Asian markets,” says Rajeev de Mello, head of Singapore operations at Western Asset Management. China, South Korea, India and Taiwan are currently the biggest markets, and de Mello says that ratings are improving all the time. In 2007, the Asian corporate bond market alone grew by 20 percent, with the South Korean market expanding by 22 percent and the Chinese market by 38 percent, although this was from a lower base.
But size is not necessarily an indicator of liquidity. Anthony Michael, head of fixed income, Asia, at Aberdeen Asset Managers, says that the most liquid local government markets are South Korea, Hong Kong, and Singapore, whilst the others are more variable. It also remains difficult to access some markets. “China has been involved in a fairly large exercise to manage its currency, and to mop up excess liquidity though the issuance of government bonds. So you’ve seen a substantial increase in the size of that market, but access is difficult for offshore investors,” he says.
To gain access, foreign asset managers need a Qualified Foreign Institutional Investor licence, and although the quota has recently been increased to $30 billion from $10 billion, Michael says this is peanuts when you consider the size of the market. “China doesn’t want to encourage more capital inflows at a time when it is already facing massive offshore inflows and there is pressure on the currency to appreciate,” he explains.
De Mello agrees that accessing many of these markets remains the big challenge. “Hong Kong and Singapore are very easy, but it is more difficult in China. In South Korea you just register with the government and it takes about a week, but it is difficult in India.”
But foreign investors are increasingly prepared to wrestle with bureaucracy because Asian issuers are benefiting from improved economic fundamentals. A large number of markets are now in surplus, and currencies are expected to appreciate as productivity increases. For a dollar- or sterling-based investor, an investment in appreciating Asian-currency denominated bonds gives a greater return when translated back into dollars or sterling.
Inflationary pressures
However, there are some risks to be aware of, not least, rising inflation. “Rising interest rates are not good for bond prices, which is why we see this more as a currency play,” says John Beck, co-director of international bonds, Franklin Templeton Fixed Income Group. “But in Korea interest rates have risen already, and it is running a current account deficit rather than a surplus. So here we have government bond exposure rather than currency exposure, as the currency is unlikely to appreciate, and interest rates are more likely to fall.”
Michael is also concerned about inflationary pressures. One of the biggest problems for many of the Asian economies is the rising price of food and energy, which make up a larger proportion of the CPI basket in places like the Philippines than they do in developed markets. But if food costs come down in H2, this will give central banks more freedom to ease.
“We look at the Philippines, Thailand, South Korea and possibly India as having the potential to ease,” says Michael. “Even China should ease up on its tightening policies. So there are some good rallies to be had in some of these markets.” But he adds that Indonesia’s bond market recently sold off by a couple of hundred basis points just on near term concerns about inflation.
Once through this inflationary period, Aberdeen believes the currency story is still a very good one. Michael’s highest conviction in the currency space for the near term is for the Malaysian ringgit and Singaporean dollar to perform well. “We’re short the Korean won but we’re long the Korean bond market as Korea is probably more exposed to slower (US) growth,” he adds. “Some of the more open economies, like Hong Kong, Korea, Singapore, and Taiwan, will slow faster than economies like India and China where exports make up a smaller proportion of GDP. So we think the game is to be long markets like Korea, Hong Kong and Singapore for now, but to be short the won against an overweight bond market position.”
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Waiting for the next domino to fall
Bond managers have suffered horribly since the credit crisis started to bite. With liquidity hard to come by and treasuries yielding little, it has been difficult to know where to turn. Such was the unhappy picture until euro zone spreads obligingly began to widen out from German bonds, providing a splendid spread trade opportunity.
Bond traders have also tried to identify suitable macro trades, in order to ride the yield curve down. But generally bond markets look expensive, as government bond yields have fallen so far on the safe haven bid. For example, short term government bonds are giving only a 1 pct yield because they are being used as a place to hide. “The hedge funds who started to pull their collateral from Bear Stearns went into Treasuries because they didn’t want to see that collateral disappear into a bank bankruptcy,” said James Gledhill, head of fixed income at New Star Asset Management.
He doesn’t see this changing in a great hurry. “Government bonds will remain at a premium, but as the banking system stabilises and inflation remains stubbornly high, they will start to look poor value. Inflation is bad for government bonds – some of those commodity price increases are bubble induced, but some of it is permanent.”
Bond managers like Scott Thiel, global co-head of fixed income at BlackRock, and Thomas Kressin, senior vice president, global bonds at Pimco, are particularly frustrated by the continuing lack of liquidity in the fixed income markets, which has made it harder to execute strategies. This liquidity drought relates to continuing market fears over counterparty failures and the downfall of Bear Stearns last week has merely accentuated this. “These days you can’t trust anyone as you don’t know if there will be another bank failure – you don’t know which will be the next domino to fall,” says Kressin.
Thiel adds that bid/offer spreads, and the amounts that are tradeable at particular prices, have all deteriorated much more than he would have anticipated, even in June or July of last year. “That all comes back to balance sheet usage by dealers, and the dearness of government bonds. We are all a bit surprised by how illiquid bond markets have become. If you look at the currency markets, they have remained liquid and I would argue that the stock markets have been. So it’s an interesting development for a market that was once the bastion of liquidity.”
In this environment, Thiel says managers are forced to take a longer term view: “We’re investors, not traders so we have time to put a position on and have it come good. But these conditions make market making very difficult, and for traders relying on short-term price movements, the amount of transaction costs or slippage can sometimes become too onerous. It forces us to look at relationships and transactions and think about them in a more strategic and longer-term way simply because the transaction costs will be higher and the return has to be higher per unit of risk.”
He says that BlackRock is pretty neutral duration in terms of overall exposure right now, but it has some important country allocation trades. For example, Australian government bonds look attractive as the Reserve Bank of Australia has been in tightening mode whilst other central banks have been easing, so rates are high. If global economic growth slows the RBA may have to cut, so these bonds offer value versus US government bonds.
Thiel adds that European government bonds are one of the cheapest markets available as the ECB has been quite hawkish, but it should ease monetary policy as it begins to feel the effects of the US slowdown.
For the US, Sebastian Mackay, senior economist at SWIP, sees a bottoming out towards the end of the year as residential investment eventually finds a floor, but adds: “We think yields are going to be a fair bit higher in 12 months’ time. They’ve been supported by the financial crisis and the bid for safer assets and some of that will unwind over the next year. So we see 10-year yields back up at 450 on a year’s horizon.”
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Time to pay
April 22, 2008 at 3:00 pm (Bonds, Macroeconomic commentary, UK equity markets) (banks, credit crunch, recession, UK equity markets)
Market commentators are fond of historical parallels. As the UK consumer is finally waking up to the fact that one day the bill really does fall due, economists and asset managers are torn between likening this downturn to that of the early 1990s – when house prices tumbled – and the 1970s – when inflation ran amok. I’ll let you know when we get a consensus.
John Beck, co-director of international bonds at Franklin Templeton Fixed Income Group, says that August 2007’s credit crunch is only now hitting the wider economy, and despite the measures that are being put in place to help UK banks over the hump, further pain is likely.
Last week’s breakfast meeting at Downing Street quashed hopes of a quick fix, with the Bank of England offering its collateral swap facility only at a significant haircut, whilst the capital risk will remain with the banks rather than being shouldered by the groaning taxpayer.
No such thing as a free breakfast
Under the terms of the special liquidity scheme, banks can swap high quality mortgage-backed and other securities for UK gilts and then use these bonds as collateral for loans from other banks. But the banks need to provide the Bank of England with assets of much greater value than the Treasury Bills they receive. And if the value of the assets falls, or are downgraded, the banks will need to stump up the difference, replace them with better assets, or return some of the Treasury Bills. “This is the most expensive breakfast those bankers have ever had,” says Beck.
But as Howard Archer, an economist at Global Insight warns, for the scheme to have the maximum beneficial impact, several other developments need to happen in tandem. These include greater transparency from banks on their losses and exposures to the sub-prime crisis; steps by the banks to improve their balance sheets, such as the rights issues by RBS; and a commitment by banks to quickly reflect any fall in market interest rates in their products and loan rates to customers.
Beck believes the RBS rights issue will be the first of several capital-raising exercises. “With the banks we are potentially at a turning point similar to what we saw with the telcos in 2003, when their debt was downgraded. There was vast excess capacity in the telecoms industry and the bond markets had been paying for it. Now I think we are getting to the point where the bond markets and the regulators have got fed up with the banks, and will only let them raise capital at penal rates.”
Although he sees the move towards raising equity capital as good news for debt-holders, he doesn’t expect an improvement in the economy for some time. “Debt spreads are still very wide for banks and stock prices haven’t recovered. Now we are seeing the consumer impact. The first round was the write-offs from securitisation. Now the write-offs on loans to consumers are coming.”
You are now entering a recession – please take care
Not surprisingly, UK equity managers are gloomy. “The economic data has been much worse than expected and the credit crunch has been deeper and more long lasting than we expected six months ago,” says F&C’s Ted Scott, manager of the UK Growth & Income Fund. “My view now is that the UK will have a recession, whereas six months ago there was a chance that we might avert a recession or it would be a pretty shallow one.”
But with the financial system still frozen and banks reluctant to lend, the housing market is beginning to implode under the pressure of unsustainable price rises and higher interest rates. “In the US, house prices have fallen 30% or so and it’s quite conceivable that in the UK we will see a fall of over 20% peak to trough,” Scott argues.
With home-owners struggling to meet their mortgage payments, other spending is expected to dry up. “They will be cutting back quite severely, and that’s going to have a big effect on the economy.” And Scott believes the recession could be more severe if unemployment rises from its current relatively low level of one million.
“Back in the last recession it got up to about three million, so if we start to get a lot of redundancies that would make it worse,” he says. “At the moment the problems are confined to the financial sector but if it’s a wider economic problem we could find that lay offs increase sharply.” With the credit crunch still ongoing, he draws a comparison with the 1970s and the UK’s secondary banking crisis, which took place against a backdrop of rising inflation and oil prices, pay freezes, and the three-day week.
Mark Lovett, co-CIO of European equities at RCM, is also pessimistic, but adds that RCM has been quite negative on the UK consumer since the beginning of 2007. “We’ve been concerned about the ongoing pressures on disposable income and the fact that the savings rate is so low, and how that will affect consumer spending.”
He sees the UK growing at below trend for two or three years, with a sharp V-shaped recovery in 2009 or 2010. “We don’t think this is something that will be resolved quickly, and below trend growth will probably be quite healthy in terms of unwinding some of the consumer debt and the low savings rates that have been so prevalent.”
Bear-market rallies
Ironically the market has roared ahead in the last month and is up nearly 10%, but Mark Lyttleton, manager of Merrill Lynch/BlackRock’s UK Dynamic Fund, remains wary. “People are saying that the worst has happened and that this is reflected in the valuations already. And now they see some solutions to the credit crunch. But it’s not just about getting the banks to lend to each other, it’s about all the losses they have made, and actually announcing them,” he says.
“If you’re prepared to take a two-to-three year view, there is probably some value in some of the bombed-out UK discretionary names. The problem is the news flow is going to get a lot worse before it gets better. So you have to decide how much of that is in the price and whether you can afford to wait. There will be some speculative rallies when some of these sectors will bounce back up, but I’m playing it quite cautiously.”
And although the markets have recovered in the last fortnight, and the VIX has been less choppy, Lovett does not believe that this reflects a change in confidence levels. “The average market participant is still very nervous because of the lack of visibility about the economic environment, and I expect volatility to remain high through the rest of 2008,” he says.
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