Spreads proving attractive

Credit funds have experienced record inflows this year as investors shun expensive government bonds and the low rates available on cash. The corporate bond sector is an asset class where yields on investment grade of 7 per cent are possible, and with little further downside risk, as the markets have already priced in pessimistically high default rates. “There are keen buyers for these funds from two pools,” says Ric Ford, portfolio manager of Morgan Stanley European Corporate Bond Fund. “The first are those investors looking to switch out of Government debt, and the second are those with big cash balances looking to switch into credit. There is enormous demand for supply,” he adds. Investment grade “Money market rates have dropped down dramatically and will probably not rise again this year but will stay low for a long period,” predicts Jan Van Parys, fund manager of KBC Corporate Eurobond fund. “Whereas an investor might achieve 1 per cent on a money market fund, he can invest in corporate bond fund and get 4-5 per cent,” he says. “So what you’re seeing is investors moving out of money market funds to corporate bond funds, which coincides with some better signs for the economy as the rate of deterioration is getting slower,” adds Mr Van Parys. The incentive to move to investment grade has similarly proved attractive to life assurers, which are guaranteeing 4 per cent to their policyholders, and pensions funds, which need 4 per cent to maintain pensions in payment. Multi-asset funds have also been big buyers as the asset class remunerates well for risk. A large part of the attraction is that bond spreads are unrealistically wide compared with gilts. “Currently spreads of 500 basis points in investment grade indicate that one third of all European investment grade issues are expected to default in five years,” says Raphael Robelin, senior portfolio manager at BlueBay Asset Management. “These valuations are attractive because they are already pricing in the worst possible economic outlook,” he explains. Even during last year’s difficult conditions, the default rate on investment grade was 0.4 per cent, weighted by issuer. Calculated on a debt basis, despite Lehman's $200bn (E147.5bn) of debt, the default rate was limited to 1.4 per cent. The current market spread is implying default within one year on senior debt of 19.5 per cent, assuming a recovery rate of 30 per cent. “We believe the expected default rate on investment grade credit within one year will be no more than 1 per cent, so the remuneration largely exceeds the underlying risks,” says Isabelle Rome, head of credit strategy at Dexia Asset Management. In high yield, the forecast as implied in spreads is for a 23 per cent default rate in a year, assuming a recovery rate of 20 per cent. Ms Rome’s estimate of default in the high yield category is around 18 per cent, so this spread is again pricing in more than her forecast. Marked improvement The market has improved a great deal since it hit bottom in mid-March. The iBoxx Euro Corporate Investment Grade index is now 415 basis points over Government bonds, but was 515 basis points in early April. In the high yield space, the Merrill Lynch High Yield Index of BB+ to CCC-rated bonds, shows a risk premium of 1845 basis points over government bonds but had been over 2200 basis points in mid-March, while the benchmark iTraxx Crossover index, which reflects 50 mostly junk-rated credits and is an important indicator of sentiment, has rallied significantly – up to 800 from 960 in mid-March. Latterly, however, there have been some creeping fears over the sheer volume of new issues this year. The value of euro-bond sales in the first week of May set a new weekly record with issues from Swedish utility Vattenfall, oil major Royal Dutch Shell, French car manufacturer Peugeot Citroën and hypermarket chain Carrefour raising €14.1bn of bonds. This has taken the total issuance this year to €146.8bn, the third-highest value of euro corporate-bond sales in any full year, according to Société Générale, which says the primary market is on course for a healthy and robust new issue pipeline for the rest of 2009. While the issues, which are all high quality names, continue to be heavily oversubscribed, the risk of oversupply has risen abruptly. That bonds are being bought not in the secondary, but in the primary market, will somewhat limit the ability of the market to rally, predicts Bluebay’s Mr Robelin. “It is a healthy dynamic, but it does mean investors can afford to be picky and need not be rushed. They can wait for the next primary issue rather than having to use the secondary market, so we are less likely to see a big squeeze in credit spreads,” he explains. Most managers are bullish over the medium term, however. “Policy works,” says Mr Ford at Morgan Stanley. “Both monetary policy and fiscal policy are currently accommodative and I believe we will come out of the downturn with low growth and low inflation.” He concedes however that there is a risk that macroeconomic data will weigh on the markets over the summer. “How the data comes out relative to expectations is key,” he says. “The markets sometimes rally because the data is not as bad as expected. Recently corporate results have come out and although the underlying business may not have improved, the news has not been as bad as the market expected,” explains Mr Ford. “Towards the summer people will have higher expectations and the risk is that the data has a tougher hurdle to get over,” he adds. Positive signs Questions remain whether the broad deleveraging process will continue to impact the economy and whether the stimulus benefits will be short-lived. “The leading indicators still point to below zero GDP growth but they came from worse positions and are better than expected,” says Jan Van Parys of the KBC Corporate Eurobond fund. “New manufacturing orders have improved markedly and if you compare them with inventories they have improved even more. Inventories had been a big drag on GDP growth, but now production can start again at a more normal rate,” he says. “Another very good sign is the loan officer survey which indicates whether lenders are more or less willing to grant loans. After tightening lending criteria post Lehman, the percentage of loan officers saying they are stricter is large but has reduced from last year,” says Mr Van Parys. “In the last quarter of 2008 some 84 per cent of loan officers thought loan criteria was getting stricter, but in May only 39 per cent said it is still tightening. That is high in absolute terms but far below last year,” he adds. While implied default rates are overly-pessimistic, partly a result of the liquidity and uncertainty premium created by commentators talking about the worse recession since the 1930s, nevertheless, default rates are rising and the likelihood is that the number of rating downgrades in the investment grade space will far exceed ratings upgrades in 2009. The incidence of fallen angels – investment grade issuers being downgraded to junk – is expected to rise as well. Wide dispersion This will continue to produce a wide dispersion in returns between top 10 per cent of bonds and the bottom decile. Last year, for example, the difference between the top 10 per cent and bottom 10 per cent average performance was 60 per cent. It is unlikely to be as elevated this year but judging by the first quarter of 2009, and the years 1999 and 2002, huge dispersion is a feature of difficult times, and the greater the dispersion, the more alpha it is possible to generate by stock selection. The majority of funds performed poorly last year because active managers wrongly identified banking as a safe sector, and were overweight in certain cyclical sectors as well. Many of those positions were probably accrued in 2005 when fund managers felt more confident in a regulated sector and believed Governments would not let banks fail. With so many more sellers for every buyer, these funds could not sell their legacy positions last year, and the more redemptions they suffered, the larger the portion of their remaining holdings the banking sector accounted for. Those funds that did well were the ones that were less constrained by any benchmark to hold stocks about which they had little, or no, conviction. “A second positive is in the flows,” says Mr Robelin at Bluebay. “Last year leveraged credit investors became forced sellers when their assets were seized and sold at auction, so there was very little new buying of investment grade credit in 2008 and an imbalance of forced sellers versus buyers. “This year there is far less forced selling and while hedge funds have still been seeing outflows, many have put gates on, so while there may be opportunistic selling, there is no forced selling on the worse day of the year,” he explains. Overweight financials Many of the funds remain overweight financials, and are now happier to be in this position. “There is still a lag between premiums on financials and rest of the market,” says Ms Rome at Dexia. “In early April, the iBoxx Corporate Financials Index was 700 basis points above Libor and it is now 550 basis points. Undated Tier 1 spreads have particularly narrowed. In non-financial bonds, spreads were 275 bpts in April but are now 223 basis points – the drop is there but it is less impressive,” she explains. “Spreads will go lower on financials because concern has been overdone and investments are still very well rewarded.” For example, the risk premium on bank debt is still attractive, Ms Rome says, pointing out the 350 basis point spread offered on a LloydsTSB senior debt, which roughly equates to the spread on a mid BBB-rated bond. She does not anticipate much investment grade default – only regional banks have looked vulnerable recently, so instead of 1 in 5 defaulting, she thinks the true number will be closer to zero. “In an environment where recovery is better than the market expects, high yield could give investors a better return,” adds Mr Robelin. “But investors are happy to move to investment grade as they are not convinced the market will bounce in a sustainable way and the yield on investment grade at 7 per cent is high enough,” he explains. “There is also the once bitten, twice shy phenomenon as people caught out last year continue to have a low appetite for risk.”

Isabelle Rome, Dexia Asset Management