Adjusting for Risk in Post-Crisis Markets

Risk was out of sight and out of mind for nearly two years up until the summer of 2007. As a result, when the subprime mortgage crisis triggered panic redemptions in certain credit products, global bond managers were caught off guard. Two years and a global recession later, risk is being scrutinised like never before. As part of the multi-boutique Natixis Global Asset Management Group, Natixis Global Associates is uniquely positioned to draw perspectives from a deep selection of global fixed-income affiliated investment managers, each with their own views on monitoring risk and the credit market at large. Ibrahima Kobar, director of fixed-income and structured credit at Paris-based Natixis Asset Management, believes the credit crisis reminded investors of the basic risks inherent in the credit markets, including default risk, liquidity risk, and mark-to-market risk. “Today we are very conscious of these risks and the fact that adverse market conditions could cause panic redemptions again,” Mr Kobar says. David Rolley, global credit manager at Boston-based Loomis, Sayles & Company, points out that before the credit crisis, many people paid insufficient attention to liquidity risk. “In the bond market, the corporate bond performance was very badly impacted by the fact that corporate bonds trade over the counter with broker dealers. And broker dealers were at the vortex of the credit crunch, so they did not have capital to put on dealing desks. No capital, no trading. So suddenly we had a broken market. Now that is liquidity risk,” he says. Liquidity risk in private equity is another area expected to be closely scrutinized as managers rebuild portfolio strategies. “We witnessed a different kind of liquidity risk in private equity when there was an inability to get prices or to transact. And so a lot of private equity positions suffered. They were frozen because there really was no secondary market. You couldn’t really make a portfolio decision. You couldn’t really change things. As a result, people had very adverse return experiences,” says Mr Rolley. Making adjustments In the credit default swap (CDS) market – which was at the centre of some of the biggest market traumas over the past year – Mr Kobar says there really were no risk management strategies for liquidity, because everyone thought the CDS market was very liquid. Taking into account investors’ small appetite for risk today, he says Natixis Asset Management now sells liquidity premium in cash bonds on hold-to-maturity products. About three-quarters of asset managers expect to make adjustments to their risk management policies due to the extreme market volatility in 2008, according to a recent report by Cerulli Associates¹. At Natixis Asset Management, Mr Kobar says he has already implemented three practices into the asset management process for collateralised debt obligation (CDO) and other structured fixed-income portfolios. Those measures include larger granulising of portfolios, equalisation of assets and liability, and utilising more over-the-counter (OTC) derivatives to help protect portfolios from counterparty risk. “We have found that granulising – having very small exposure to a larger amount of names, around an average of 0.6 per cent exposure on about 150 names – is more efficient than managing portfolios with higher concentrations of 30 to 50 names.” Equalisation of assets and liability is another measure that Natixis Asset Management has implemented with its hold-to-maturity funds, which have become popular in France. “For those who have a hold of seven years, they are entering into a fund with a defined maturity, so there is no gap between the assets and the liability,” Mr Kobar explains. At Loomis, Sayles & Company, Mr Rolley’s global fixed-income group is taking a closer look at relative sector performance. “Up until September 2008, we had never seen investment-grade corporate bonds underperform Treasuries by more than around 4 per cent in a 60-day period – and they underperformed by 14 per cent last fall. So clearly if you have a treasury-only benchmark you are going to reconsider how much spread product you are going to set against that from a sector architecture strategy.” Besides making adjustments for innovations in modern finance and new market realities, Mr Rolley stresses Loomis Sayles’ continuity of research and disciplined investment management. “We have a research culture that goes back over 75 years – of doing the homework one company at a time, one government at a time. We will take credit risk, but we want to do our homework. And if we are comfortable with what the money is going to be used for, then we will be in a position to buy their bonds.” After witnessing severe counterparty risk in 2008, Mr Kobar says there is a clear need for greater transparency and market oversight in several areas, especially the CDS market. “One of the main issues in the crisis was the lack of transparency regarding credit exposure and the use of leverage by each market player.” He believes new regulatory oversight will be enacted in Europe and will look much like the reform plans proposed by the Obama administration in the US – which include comprehensive regulation of OTC derivatives markets, including CDS transactions. In fact, in early July the European Commission outlined a plan to overhaul the regulation of the OTC derivatives market. The arm of the European Union came out in favour of widening the use of clearing houses for derivatives transactions. These measures are expected to improve price transparency and strengthen risk management. Along with greater credit market supervision, European investors are also looking for less complex fixed-income structures in the post-crisis world, Mr Kobar adds. As a result, he expects CDO products to be simplified. Finding opportunities Both Mr Rolley and Mr Kobar believe recent tightening of spread levels may be a sign of a recovery in the credit markets. In Europe, Mr Kobar has witnessed the ITRAXX 5-year index move from an all-time low of 20 basis points in June 2007 all the way up to the 200 level in March 2008. In early July 2009 the spread level was back down to 115–120 basis points. As of Q3 2009, Mr Kobar favours investment-grade corporate bonds with strong fundamentals. In a U-shaped economic recovery scenario, which the Paris-based Natixis Asset Management believes we are witnessing, Mr Kobar says quality corporate bonds should be positioned to offer some of the best opportunities. He remains cautious about the overall emerging market space and high yield bonds due to current volatility levels. As the economy improves, investors could see pretty strong performance by global credit, according to Mr Rolley. He believes that three spaces in particular – financials, cyclicals, and emerging markets corporate – are offering attractive opportunities. “The subordinate debt of financial companies – so long as it’s clearly bonds and not equity – can represent value, so long as the bank has shown an ability to access the stock markets and its equity cushion,” Mr Rolley says. “Bondholders like to see an equity cushion under them and in some cases the banks have done a great job of improving that.” He also sees value in cyclicals. “The cyclicals came down the most in the downturn and so there are probably some that are positioned to show impressive earnings revival on the upturn. Again that is a recovery bet. So you can tell some cyclical stories where there is still a lot of yield in those names because the rest of the market is in wait-and-see mode.” There may also be some opportunities in the emerging markets corporate bond space, which was badly punished by illiquidity and a lack of sponsorship in the downturn, and which has names that are still trading at substantial discounts compared to the ratings or the earnings power or the underlying value of those companies, according to Mr Rolley. Recovery may present significant investment opportunities. But following a period of tumultuous market activity it makes sense to find an expert who can help you pursue attractive yields with limited risk and it is important to consider a diverse range of opinions before you make an investment decision. ¹ The Cerulli Edge, April 2009, Rethinking Risk Management