Approach with much caution

Corporate bonds are no longer considered a safe haven for investors, but, as Roxane McMeeken writes, there have never been so many tempting opportunities. The reputation of corporate bonds has taken a battering following a string of downgrades and defaults. The world’s biggest pension fund, the $136bn (E140bn) Californian Calpers scheme, has just cut its fixed income allocation by 2 per cent, opting to invest the funds in private equity instead. Corporate bonds were once viewed as a save haven. The asset class was the destination of those embarking on a “flight to quality” as the equity markets began to tumble. Now, “fallen angels” such as Alactel, Ericsson, and Vivendi Universal – whose bonds have all been downgraded – have left high net worth investors questioning whether corporate bonds deserve a place in their portfolios at all. The answer appears to be that credits do still belong in most portfolios, but they need to be re-evaluated in terms of the higher risk that they now carry. It is ironic that at a time when corporate bonds are facing increasing scepticism, the opportunities for investing in them have rarely been so abundant. European issuers have been forced to diversify their sources of funding away from traditional banking relationships in order to cut the cost of borrowing and ensure access to liquidity should banks restrict the availability of credit. Since 1985, the number of corporate bonds rated by Moody’s has grown at an impressive annual rate of 26 per cent. However, the number of defaults in Europe has shot up in recent months. Between 1985 and 2001 a total of 43 issuers rated by Moody’s and 35 unrated European issuers defaulted on E22bn of bonds. But, in 2001 alone, 16 Moody’s-rated and eight unrated European bond issuers defaulted on E11bn of bonds, according to Sarasin Investment Management, the funds group of the Swiss-owned private bank. The pace has accelerated in 2002 with 14 Moody’s-rated issuers defaulting on E24bn of bonds. Sarasin found defaults were concentrated in particular sectors:

• The telecom industry accounted for 54 per cent of Moody’s defaults by volume during 1985-2001, despite accounting for only six per cent of issuers.
• Over the same timeframe transport accounted for 18 per cent and technology 10 per cent of defaults.
• Of the 14 issuers defaulting in the first half of 2002, nine were telecommunications companies and these make up over 95 per cent of the bond volume. All this would be less frightening for European bond investors if recovery rates, determined by the trading price of debt 30 days after defaulting, were strong. However, according to Sarasin, Europe’s recovery rates average a meagre 22 per cent. John Godley, head of global fixed interest at Sarasin, puts the European situation down to “the relatively small sample (34) of issuers and the very large proportion of telecom and tech issuers, where the forced sale value of assets is expected to be low”. Admittedly, these factors could change in the future, but the fact remains that both US and European corporate bonds are risky bets in the present conditions. Even more alarming is the fact that numerous amounts of credits have been downgraded from high quality, low risk “investment grade” (AAA, AA and A) to poorer quality, more risky “speculative grade” (B and below). One of the most recent examples is UK transport group Stagecoach, which Moody’s demoted from investment grade to “junk” status last month. In 2001, Europe saw 6.8 per cent of corporate bonds re-graded at least one notch for the worse and the US saw 10.6 per cent of corporate bonds downgraded, according to Swiss-owned fund manager Sarasin Investment Management. Some of the highest profile companies have suffered. France Telecom, Deutsche Telecom and British Telecom were among those to be downgraded, but remain within the investment grade universe. Meanwhile, Alactel, British Airways, Ericsson, Marconi and Vivendi slumped from investment grade to “junk bond” status. Sarasin shows that such “transitions” are the most serious problem corporate bond investors face. “The chances of an investment grade company actually defaulting are very low and a part of the capital invested in these companies has historically been recoverable: 43 per cent in the US and 22 per cent in Europe,” says Mr Godley. The greatest danger, argues Sarasin, comes from transition risk, particularly when investment grade credits are downgraded to speculative status. This is because the change in the grade of the bond may require forced sale at depressed levels in order to fulfil the requirements of the portfolio’s strategic asset allocation, despite the limited risk of eventual default. So corporate bonds are clearly an asset class to be treated with caution. Nonetheless, Mr Godley insists they still have a key part to play in the average portfolio. He says that historically, low points in the bond markets have always been relatively short-lived. And he points out that European credits are particularly attractive since they are less likely to default than their US counterparts, based on past experience, and their ratings have been more stable. Diversify exposure Gerben Jorritsma, head of discretionary portfolio management at ABN Amro in the Netherlands, is more wary of corporate bonds. He admits that they bring diversification to a portfolio and carry less risk than equities, but he warns that at the more risky end of the credit scale, high yield bonds have in recent years become more closely correlated with equities. “Both have been affected by the market in similar ways,” he says. As a result, Mr Jorritsma never recommends that the high yield percentage of a corporate bond portfolio be above 10 per cent. He advises investors to hedge their junk bond exposure against the fact that the asset class is dominated by the US dollar by exposing the portfolio to other currencies. He also ensures his clients diversify their exposure to high yield bonds by finding between 80 and 100 different issuers. With potential returns of 7 to 8 per cent, even Mr Jorritsma admits that for some investors high yield bonds are worth the – carefully mitigated – risk. He says the risk-return function junk bonds perform in his clients’ portfolios is similar to that of hedge funds. With potential returns of at least 4 per cent, investment grade corporate bonds must be approached with similar caution, according to the ABN Amro philosophy. Mr Jorritsma argues that AAA rated corporate bonds offer only limited diversification away from government bonds, which share the same rating, but he says “there is still some diversification, so they are still attractive to an extent”. Moreover, in the case of US treasuries, the associated withholding tax means that AAA US corporate bonds are a preferable means to AAA US exposure. Mr Jorritsma’s cautious position is evident from the fact that he advises his clients to limit corporate bond exposure to between 15 and 20 per cent of the overall bond portfolio. He explains: “High net worth investors are very sensitive to absolute returns. Therefore you have to be cautious.” Generally, he encourages clients to be overweight in bonds rather than equities, but with the lion’s share of the fixed income portfolio in government bonds. Bias towards quality When it comes to corporate bond sectors, again Mr Jorritsma errs on the side of caution. He says “you should be biased towards quality. Avoid technology and media – this is crucial. Telecoms is a big sector in the bonds market, so it’s hard to avoid, but you have to be selective.” He adds: “You have not only to diversify, but also to go into detail about the companies and especially to find out about their debts”. So it seems that corporate bonds still belong in the portfolio, but they are more risky than was perhaps thought. As a consequence corporate bond portfolios must be treated with more care – they should possibly be downsized or at least the companies they contain should be subject to tougher due diligence – and clients must be made to understand that credits are not necessarily the safe haven they once were.