Playing down a US slow down

The global economy appears to be heading for a slow down, led by the US, in 2007. Such a scenario could provide a negative environment for corporate bonds if it means weakening balance sheets and reduced cash flow and profits. There is disagreement, however, over the extent of the potential economic slow down and few economists are predicting the possibility of a US recession. Indeed, the International Monetary Fund believes global economic growth will only fall from 5.1 per cent in 2006 to 4.9 per cent in 2007. Fund managers are optimistic about the outlook for euro-denominated bonds, primarily because of strong company fundamentals. Furthermore, there is general consensus that there is only likely to be one more interest rate rise by the European Central Bank (ECB) in 2007 before it reaches its peak. Raffaele Bertoni, manager of the Pioneer Euro Corp Bond fund, which is the largest cross-border fund in Europe at ?1.8bn, says rising interest rates in Europe have been priced in by the market. He expects the ECB to raise rates by another 0.25 per cent in the first quarter of 2007, but for this to be the last increase. He adds that this is good news for the corporate bond market. “The fundamentals of the corporate bond market are strong and there is no catalyst for spreads to widen significantly in 2007. Corporate balance sheets are strong and we are seeing the first signs of re-leveraging in some sectors. We also expect the strong demand for corporate bonds to continue.” Mr Bertoni plays down the threat of a US economic slow down on the euro denominated corporate bond market. This is because he believes the US economy will still grow at a rate of 2 to 2.5 per cent in 2007. Of course, a rate of around 1.5 per cent would be more serious but Mr Bertoni does not believe this is a realistic scenario. More selective Nevertheless, Mr Bertoni says that at this stage of the credit cycle, investors need to be more selective about where they invest in the corporate bond sector. “We are cautious about some of the companies re-leveraging.” Peter Sass, manager of the DWS Euro-Corp Bonds fund, says investment grade spreads in Europe tightened again in 2006 partly because of the growth in synthetic credit instruments. “The overall yield in the eurozone also increased a bit in 2006. A 10-year bond yielded 3 per cent in 2005 and 3.75 per cent in December 2006.” The historically tight spreads have been supported by positive earnings growth and low default rates. “Spreads may widen by a few basis points but no more than this in the near future.” Mr Sass also believes interest rate rises have been priced in by the market. “In any case, even if rates rise by more than expected in Europe next year that means the economy is performing strongly.” He does not believe the expected economic slow down in the US will spill over into the corporate bond market in Europe either. “A slow down would affect some sectors, such as mortgage lending and specialist finance. But the corporate bond market will only be significantly impacted if the US economy heads into recession.” Mr Sass does not believe this scenario is likely, especially as the Federal Reserve can reduce rates to boost consumer demand. Default rates are at a historically low level of 1.8 per cent at the moment. Mr Sass does not expect these to rise significantly in the current environment. “Every three months, rating agencies predict default rates will increase over the following three months. But I cannot remember an investment grade company defaulting over the past two years.” Mr Sass is particularly optimistic about the financial sector. “These are cyclical businesses. Banks’ earnings and cash flows are good.” He has also been investing in steel and basic materials companies. Further rises Paul Lavelle, manager of the Fidelity II Euro Corp Bond fund, says the consensus on one more rate rise from the ECB in 2007 could be proved wrong by stronger domestic and global economic growth, higher wage settlements and asset inflation. This could cause higher consumer inflation and therefore lead to the ECB raising rates further than expected. He suggests this is an unlikely scenario, however. “Oil and other commodity prices have fallen, Chinese and emerging market demand has abated, European wage settlements have come in below expectations and tax rises in 2007 could dampen growth, causing inflation to under-shoot.” Mr Lavelle adds that bond yields tend to peak between three and 12 months before the first interest rate cut. “If investors wait until rates actually fall, they could miss significant positive capital returns from the European bond market.” European corporate bonds could benefit from investors switching allocations from equities to bonds, says Mr Lavelle. This follows the out-performance of equities since March 2003. From March 2003 to the end of September 2006, equities delivered a total return of 126.5 per cent in euro terms. In contrast, bonds returned 15.8 per cent. “It is natural for investors to seek to take profits from out-performing assets and reinvest in under-performing assets,” says Mr Lavelle. “Even a moderate switch out of equities could have a major positive impact on European bond prices. We saw this occur to some extent in May 2006 as inflation worries drove equity markets down worldwide and assets were switched into bonds.” Mr Lavelle argues that bonds are attractive because company fundamentals remain strong. “There is a wealth of investment opportunities. “There is ongoing consolidation in the banking sector, continuing growth of structured products and asset backed securities and a shake-out in the European telecoms sector. “There is also the benefit of emerging Europe, through its growth and its businesses being bought by Western European companies.” He adds, however, that credit analysts believe there will be a marginal weakening in the corporate environment in 2007. “This could lead to a pick up in default rates although this would be from historically low levels.” While yield spreads on corporate bonds are tight, Mr Lavelle says they still provide an attractive premium to government bonds. He points to the fact that euro-denominated BBB corporate bond yields are 90 basis points above equivalent euro government bonds. Three areas of value Adam Cordery, manager of the Schroder ISF EU Corp Bond fund, says he believes he can add value for investors in three areas. The first is through stock selection. The main factors that Mr Cordery and the 22 credit analysts at Schroders consider are cash flow and asset values. The analysis results in a portfolio holding between 50 and 100 bonds. The fund invests in euro denominated investment grade debt but can also hold non-euro debt and high yield. The second area is duration and interest rate management. “It is a good time to buy corporate bonds, for example, because we are nearing the peak of the interest rate cycle,” says Mr Cordery. “The rate of inflation is very low while the oil price and commodity prices have fallen over the past couple of months. Cheaper imports from the US are helping to keep down inflation in Europe as well.” The third area is making allocations across sectors, themes and asset classes. For example, 12 per cent of the fund is invested in high yield debt at the moment. This is because of the risk that Mr Cordery believes leveraged buy-outs (LBOs) are adding to investment grade bonds. LBOs are generally taking place among investment grade bonds, which is why Mr Cordery has increased his exposure to high yield debt. The leverage used in LBOs has gone up from around five times three or four years ago to eight times in 2006. Another reason for preferring high yield bonds, says Mr Cordery, is the strong rate of global economic growth. “High yield is more geared to global growth than investment grade bonds.” Another area of concern, says Mr Cordrey, are the new issues of investment grade debt. He says that generally the quality of new issues has been falling and they are using more leverage than two years ago. “If default rates rise in three years’ time, it will be these new bonds that will be defaulting. “This means investors have to adopt a stock selection strategy with investment grade debt. Three years ago, you could have bought the market and enjoyed the rise. Now you have to be more selective and manage a more concentrated portfolio of the best ideas.” New opportunities Nevertheless, there are still plenty of investment opportunities, says Mr Cordery. “We bought Vendex 18 months ago, for example, and have made a 6 per cent capital gain from this high yield bond.” In 2007, Mr Cordery believes there will be a compression of returns between the different asset classes in bonds. “From the start of 2006 to early December, investment grade returned 1 or 2 per cent compared to more than 8 per cent by high yield.”

Peter Sass, DWS Euro Corp Bond fund In 2007, he expects government bonds to return 4 to 4.5 per cent against 5 per cent by investment grade and 6 to 7 per cent by high yield debt. While many funds focus on euro-denominated investment grade debt, there are differences in their investment approaches. Around two-thirds of the Pioneer Euro Corp Bond fund is invested in euro denominated investment grade bonds. These range from AAA to BB. The final third is invested in other fixed interest, such as high yield debt, government bonds and emerging markets debt. “The fund can invest wherever we find value,” says Mr Bertoni. The investment process uses both a top down and bottom up approach. By analysing the macro economic environment, Mr Bertoni says he decides the asset and sector allocation first. “We then seek companies within these asset classes and sectors whose cash flow, balance sheet, earnings and profitability are improving but have not yet been found by the market. “We produce an internal rating of every bond for the next three years. We look for catalysts that will lead to capital gains from bonds.” Among the factors that Mr Bertoni and the Pioneer team analyse are whether a company’s earnings are cyclical, is the labour market flexible, regulatory risks, vulnerability to an increase in the price of raw materials, the environment in which the company operates and its market position against its peers. “We analyse the profitability and financial flexibility of companies,” says Mr Bertoni. “We also consider the strength of the company’s balance sheet, how much debt it has and the governance of the company. The main factors are industry risk, the competitive environment, profitability and financial flexibility and capital structure. Mr Sass says he invests in euro denominated investment grade bonds as well. These include non-European companies that have issued debt in euros. The fund can also allocate a proportion of the portfolio to BB debt and below, emerging markets and asset backed debt. “This is designed to add some risk to the portfolio and enhance returns.” Upgrading expectations The fund takes a bottom up investment approach. As part of the credit analysis conducted by the fund, Mr Sass stresses the importance of finding bonds that he expects to be upgraded by the rating agencies. He also emphasises the analysis of free cash flow generation as a proportion of the total capitalisation of bonds. The relative performance of the DWS Euro-Corp Bonds fund has been less impressive over one year compared to three and five years. “Over the past year, other funds have performed better because they are less constrained by the index. We hold weightings close to the benchmark.” Comparing the performance of funds in the corporate bond sector against a benchmark can be misleading. This is because of the flexibility that funds typically have in asset allocation. Rather than just holding European corporate bonds, many will also invest in government bonds, high yield debt and emerging market debt, for example.

Raffeale Bertoni, Pioneer