Crunch widens spreads

Few parts of the investment universe have escaped the effects of the sub-prime crisis and the credit crunch that started last year and whose ramifications are still feeding through to the real economy. Euro denominated bonds issued by good quality companies have certainly not escaped. Over one year to 11 February 2008, for example, the Lehman Euro Corporate index returned 1.73 per cent compared to 20.48 per cent over five years. The impact of the sub-prime crisis and credit crunch is reflected in the widening of spreads of euro denominated investment grade bonds over treasuries during the past few months. Hervé Boiral, head of credit at Credit Agricole Asset Management (CAAM), says spreads have widened whatever the rating, from AAA to BBB. The average spread of the iboxx corporate bonds index, for example, was 180 basis points at the end of February 2008. The CAAM Funds Euro Corporate Bond fund now has an over-weight position in the financial sector, especially subordinated paper, banks and insurers, following the widening in spreads. The fund is under-weight corporates and has become “very selective” when investing in bonds of smaller companies by focusing on those with sufficient liquidity. “The average banking spread is wider than the average spread on corporates,” says Mr Boiral. “But banks finance corporates so this is not sustainable for a long time. “We believe spreads are too wide, especially in the financial sector. For example, there has not been one default among investment grade bonds in the financial sector for the past 10 years.” In the high yield market, defaults are only around 1 per cent at the moment, says Mr Boiral. While Moody’s expects the default rate to rise to 4.5 per cent in 2008, Mr Boiral says spreads are currently pricing in a 9 per cent default rate. It is hard to say what the catalyst will be which will prompt spreads to narrow, adds Mr Boiral. But he believes a rally in the equity markets would help to achieve this. The credit crunch has also led to a substantial reduction in the issuance of investment grade bonds over the past few months. Mr Boiral says this is partly because the market is looking for a high price for new issuance, which is often 20 or 30 basis points higher than current market spreads. Mr Boiral believes new issuance will remain low for the next two months at least. He adds this has not impacted the CAAM Funds Euro Corporate Bond fund because while there have been inflows they have not been strong. “If inflows were to be strong, it could be more difficult to invest cash without much new issuance.” Philippe Dehoux, manager of the Dexia Bonds Euro Corporate fund, says the fund was overweight financials at the beginning of last year. By March 2007, this overweight had been reduced and was a neutral exposure by June. This became an under-weight exposure over the summer of 2007. Currently, the fund is neutral on non-financial bonds and over-weight financials. “Over the short-term, we expect the volatility in the bond market to continue,” says Mr Dehoux. “But over the long term, we believe investment grade bonds offer attractive investment opportunities. The average spread of the iboxx corporate bonds index is 180 basis points at a time when the US Federal Reserve is cutting interest rates and banks are finding solutions for the credit problems. “The opportunities are even greater in financials than non-financials. The average spread of financials is 195 basis points whereas it is 155 basis points for non-financials bonds. In particular, the spread on Tier 1 subordinated debt is 325 basis points. We give preference to banks with good business models, strong balance sheets and large retail branch networks. “The spread of 325 basis points implies that defaults on this asset class should rise to more than 14 per cent on a five-year horizon, which is higher than the peak in defaults seen in non-investment grade bonds in 2001 to 2002. We believe defaults on investment grade bonds will remain close to zero.” Predicted rises Richard Ford, joint fund manager of the Morgan Stanley Sicav Euro Corp Bond fund, believes the default rate will rise from current levels. “While it is true that Moody’s predicted rises in the past that did not occur, now most market participants are predicting default rates will rise. Market volatility is being driven by the uncertainty of the magnitude and timing of these increases.” Mr Ford says there are valuation opportunities in investment grade bonds. He says current spreads indicate default rates of 8.6 per cent over the next five years. “Yet the peak level of default rates has been 3.6 per cent over the past 30 years. Therefore, we do not believe default rates will reach these higher levels. “But we are expecting a rise in default rates so we are focusing on good quality companies with strong balance sheets, a strong business profile and good cash flow.” Mr Ford points to the fact he has been finding opportunities in the telecom sector. “There is good cash flow in the sector and companies such as France Telekom and Deutsche Telecom have learnt from having leverage when the cost of capital rose in 2002,” he says. “They got through this to become cash generative and to have strong balance sheets.” However, before the value in investment grade bonds is realised, the market needs some kind of certainty, says Mr Ford. “This could be more certainty about economic growth and corporate profitability. We would expect another two to three months of volatility as the market responds to continued bad news.”

‘The average banking spread is wider than the average spread on corporates, but banks finance corporates so this is not sustainable for a long time’ - Hervé Boiral, CAAM	‘The credit crunch has changed fixed income markets dramatically, turning many high quality asset types into not at any price asset types’ - Paul Lavelle, Fidelity	‘Over the short-term, we expect the volatility in the bond market to continue’ - Philippe Dehoux, Dexia

When analysing forward looking indicators, there are still negative signals, says Mr Ford. “There is concern about slowing economic growth and inflationary pressures. “But there are also some positive signals. These include stimulus being produced by the US government in particular. For example, there have been multiple interest rate cuts in the US and the UK has begun to cut rates. There has also been fiscal stimulus in the US.” Paul Lavelle, manager of the Fidelity II Euro Corporate Bond fund, also says visibility will be key to spreads narrowing. He says: “The credit crunch has changed fixed income markets dramatically, turning many high quality asset types into not at any price asset types. Many asset backed securities (ABS) have been hit particularly hard. “In several cases, the most important factor for ABS products was not the default rate of underlying assets but the total and sudden absence of liquidity in the market, which immediately affected the ABS market price. This is how a good quality product can be severely mispriced for some time. “The ABS market will recover eventually. Once the market starts to see that defaults outside of the low-end mortgage-backed market are not an issue, fundamentals should begin to drive valuations again. The dislocation in other credit markets will also start to subside. The financials sector may still be under pressure but visibility will improve and, as it does, spreads should start to come in again.” Mr Boiral says there are two stages to the investment approach of the CAAM Funds Euro Corporate Bond fund. The first is a top down analysis that is driven by macro economic factors, including interest rates and credit valuations. This leads to a market view on credit, long or short, and an allocation between credit sectors. The next stage is to fill the allocation of these sectors through a bottom up approach in selecting individual bonds. Eighteen analysts select credit through their individual focus on particular sectors. The only analysts not divided on sector lines are those who look after ABS and high yield bonds. The analysts give a forward rating to each bond on a nine-month to one-year horizon. The forward rating is based on fundamental factors such as cashflow, the management teams, mergers and acquisitions and the companies’ competition. The forward rating is then compared to the implicit rating given by the market. CAAM uses these ratings to analyse those bonds with a forward rating below that of the implicit rating. The fund manager analyses the reasons for the differences in the ratings and holds around 100 bonds. Mr Boiral says the CAAM Funds Euro Corporate Bond fund is likely to out-perform over four years, the fund’s investment horizon. The fund holds bonds with a maturity of one to 30 years but the average is five years. The CAAM Funds Euro Bond fund out-performed the sector average over five years to 11 February 2008 but under-performed over three years. Mr Dehoux says the Dexia Bonds Euro Corporate fund, which out-performed the sector average over one year to 11 February 2008, implements different investment strategies. The view of Dexia Asset Management on interest rate movements determines the fund’s exposure to duration. For example, if Dexia expects interest rates to fall then duration will be increased via the futures market. A team of credit analysts evaluate the investment grade bond market through top down and bottom up approaches. The top down strategy determines the allocation between financial and non-financial sectors. “This credit allocation strategy is based on long-term and short-term drivers and the strategy is the result of a mix of fundamental factors, such as the business cycle, leverage cycle, risk appetite and flows analysis, and quantitative analysis,” says Mr Dehoux. “For example, if our fair value model for financials gives a spread of 100 basis points and the forward spread in the market is 90 basis points, we will assign a positive score for this element. “The credit committee also conducts a bottom up issuer selection based on the assessment of the credit quality and credit valuation. A quantitative model attributes a rating for all issuers, which has to be validated by the sector analyst based on a fundamental analysis supported by quantitative tools to assess the issuer credit quality. A credit valuation analysis is also done through a relative value analysis by comparing cash and the credit default swaps market of the issuers.” Equity volatility Mr Ford uses quantitative tools and fundamental research to construct the Morgan Stanley Sicav Euro Corporate Bond fund. Research by Morgan Stanley has identified a correlation between equity volatility and the widening of investment grade spreads. “Equity volatility is highly correlated to the widening of spreads and is a predictor of a rise in default rates,” says Mr Ford. “Therefore, equity volatility is a key factor that we review in trying to predict a widening in spreads. In deciding whether to invest in a corporate bond, we look at whether we are being paid for the risk given the macro economic environment and the volatility in the equity markets. “We also consider qualitative factors to decide whether to invest in investment grade bonds. These include the financial and business risks. These incorporate the leverage used by the company, the stability and the quality of the management, cash flow and liquidity. We analyse the risk profile and the sustainability of the business including valuations.” The Morgan Stanley Sicav Euro Corporate Bond fund also takes a top down macro economic view. These include such factors as economic growth, inflation and interest rates. The fund under-performed the sector average over one year to 11 February 2008 but out-performed over three and five years. “Our relative performance was strong until October 2007,” says Mr Ford. “Owning corporate bonds offers attractive relative returns but in the short term we expect some volatility.”