Greek crisis dictating market

The downgrade of Greece’s debt to junk status dominates the backdrop for corporate bonds. For a year, the markets watched as the drama unfolded; the country’s deficit ballooned, its GDP slumped and local banks suddenly faced soaring funding costs. Germany and even the UK are benefiting from safe-haven flows, while peripheral eurozone economies such as Italy, Portugal, Spain and Ireland have seen yields rise sharply.

Most global corporate bond funds do not of course own lowly-rated Greek or even Portuguese banks and in Spain they own only the internationally-focused banks BBVA and Santander. The fear is contagion across the sector, and events have been moving rapidly, with investors beginning to shun company debt on concern that the €110bn rescue package will not solve the Greek deficit crisis.

Investment grade spreads have jumped back to 160 basis points, 590 for high yield, harking back to the end of 2007, when unprecedented economic conditions led investors to demand around 180-190 basis points for the risk of holding investment-grade corporate bonds, and over 500 basis points for holding speculative paper.

With interest rates likely to remain close to the current low levels until the end of the year, and with modest economic growth widely anticipated, current spreads arguably represent an attractive opportunity, as they are a good deal more than an investor will earn on deposit in a bank and the renewed positive growth outlook for businesses increases the likelihood the coupon will be paid.

The days of a beta play in corporate bonds are long gone, however, and the focus has turned emphatically to careful name picking.

“If growth continues to pick up, and interest rates slowly begin to return to normal, then the recovery will be good for bonds because balance sheets will strengthen,” predicts Robin Creswell, managing principal at Payden & Rygel.

Tightening spreads

“There will also be room for spread tightening, so investors will receive the coupon and potentially capital growth. Spreads could come in by as much as 30-40 basis points by the year end.”

Many managers had been reaching down to BBB or BBB- rated bonds where they were compensated by incremental spread. A-rated companies such as utilities might earn 70 basis points over gilts, but BBBs had been offering nearly three times that.

“Quality rotation is the name of game,” says Mr Creswell. “If the outlook stays stable, most [BBBs] are in a good position because, for example, they have taken measures to repair their balance sheets by reducing Capex, shareholder dividends and buybacks, which all help to conserve cash and cut ongoing costs. The lack of complacency about economic recovery has helped the outlook for bonds.”

Although spread tightening is already taking place, he likes BBB names in consumer retail, such as M&S, Next and Kingfisher, and in automotives, business services and internet media.

But although some managers are delving deeper into the credit ratings, some are also boosting their diversification and reducing their risk by increasing the number of their holdings. Standard Life Investments’ European Corporate Bond Sicav currently holds 6 per cent in high yield. The mandate allows up to 10 per cent, but although the economy is slowly improving, manager Craig MacDonald believes some companies will not be able to pay down their debt.

Mr Macdonald has increased the fund’s diversification from approximately 100 companies in early 2007, to more than 150 companies, given the level of economic uncertainty and the asymmetric risk of bonds, where the upside is limited to the yield and the downside is typically a 60-80 per cent loss, which is so different to equities.

Most managers are also looking for companies with above average exposure to growth in the US, which has now seen employment growth for the third consecutive month, and in emerging markets, which are not grappling with the challenging systemic issues of the West. A typical example is basic materials geared to infrastructure development in China. Mr MacDonald, for example, likes export companies like Xstrata, US-facing car manufacturers such as ABB or materials companies such as HeidelbergCement.

Global fund managers are also keen on emerging market debt itself, particularly use of local debt as currencies across these regions such as the Brazilian Real have been strengthening.

Banking sector

There is less consensus about the outlook for the banking sector, where spreads have widened reflecting uncertainty about the regulatory forces at work and the potential break up of big banks. Arguably, they may also suggest a certain complacency pre-crisis.

Jan Van Parys, KBC Asset Management

The US SAFE Banking Act will cap each bank’s deposits at 10 per cent of total deposits in the country, forcing the majority of US banks to dispose of operations to reduce their size, while another proposal is to force them to spin off their swaps desks. Such measures could be far from catastrophic for bank bondholders, however, and may even represent a positive development for corporate credit as banks are forced to strengthen their capital positions. The sector has already proved surprisingly resilient and starting to heal.

Most asset managers will in any event be quite cautious and less inclined to investment banks such as Goldman Sachs and more inclined towards diversified operations such as Bank of America, Citi and Morgan Stanley.

Bryn Jones, investment manager at Rathbones, agrees new legislation and regulation around banks and insurers such as Solvency II is throwing up opportunities. “Subordinated bonds did not protect capital during the credit crisis, so banks are issuing new corporate bonds that will have a trigger to convert to equities if core capital falls below a pre-determined level,” he says. “Existing subordinated debt will sit above all this messy stuff and looks attractive in comparison.”

“Historically financials trade on spreads of 100, and they went below 50 in 2003-7,” says Jan Van Parys, Fund Manager at KBC Asset Management. “They are now 160 and won’t get as low as 50 again because of issues around subordinated paper.”

While historically no one expected a bank to default, now if a bank has received State intervention the EU can stipulate that its coupon won’t be paid, as it already has in a few cases.

“The impact of capital risk from the point of view of the equity holder is very different from the bond holder,” points out Mr Van Parys. “There is a different view of risky but lucrative products. Success depends on each bank’s pricing power and ability to raise prices in some markets. Banks could become a safer sector.

“It’s clear that a lot of asset managers are overweight financials and the least subordinated of subordinated bonds. There are crowded trades, that’s for sure.”

Recent weeks have seen a dearth of bond issuance as investors retreat, but corporate bonds may not be crowded by gilt issuance from cash-strapped governments. Mr Creswell at Payden & Rygel points out that, if you look back over previous periods of high fiscal indebtedness, governments generally resort to high borrowing in the first two years and there is surprisingly little correlation between a government’s need to borrow and the rate of interest it has to pay. Interest rates do not balloon upwards because of a flood of supply.

The reason for that is, in this initial period, governments take a lot of trouble to demonstrate their market credentials, such as by introducing austerity packages.

“Talking broad brush, the Government will need to borrow more money and to demonstrate to the market that they have control and discipline for spending cuts and raising taxation,” says Mr Creswell.

“There is also other action they can take – they can say they will buy any government bond where the yield rises above a certain percentage. Central banks have many tools to keep Government interest rates low, so opportunities for corporates to borrow should not be tarnished.”

As economic data improves, default rates should come down, but so far this year the cost of protecting European corporate bonds from default has surged, according to The Markit iTraxx Crossover Index of companies with mostly high-yield credit ratings, which has been climbing since December.

In preparation, investors are turning away from defensive sectors, and looking for riskier high beta sectors. Utilities and telcos have also been seen easy targets for Governments to clobber with higher taxes, and some have big stakes from sovereigns whose ratings could go down.

“Typically it is hard to lose money when default rates are modernating quite quickly,” argues Johannes Jooste, a strategist at Merrill Lynch Wealth Management.

“In the 1991 credit crunch and the wave of defaults that followed the collapse of Enron in 2001, there were spikes in defaults like last year, followed by a quick recovery,” he says.

“Some lower rated companies (may hit the buffers) but the general picture is that defaults have peaked, and although some tightening has already taken place, 2009 can be seen as a massive anomaly and investors can still be happy to take exposure now.”

Ever-changing climate puts focus on diversification

While the easy money has gone out of fixed interest, investors can still earn around 5-6 per cent on corporate bonds, and compared with rates on cash, that 500 basis points of carry is well worth taking. In addition there is potential capital appreciation, and investment grade spreads are expected to come in by at least 20-30 basis points by the end of the year.

Aside from the problems of Greece and peripheral Europe, economic growth in the US, emerging markets and even the rest of Europe is encouraging, but events are moving rapidly. Bryn Jones, investment manager at Rathbones, believes private clients could buy strategic bond funds such as Legal & General Dynamic fund and Threadneedle Absolute Return bond fund to take advantage of factors such as supply risk and individual event risk.

However, Johannes Jooste, a strategist at Merrill Lynch Wealth Management, believes strategic bond funds come into their own when the rate cycle settles.

“Movement is good as long as it is in trends, but random and unpredictable moves make this a difficult and dangerous game. If the manager’s calls are wrong, these strategies could be whipsawed by the markets,” says Mr Jooste.

He recommends the well-populated shorter duration bond fund universe where managers aim to take advantage of pricing anomalies rather than trying to make money from trends.

The minority of private investors who hold individual bonds tend to keep them longer than a fund manager and they are being advised of the prudence in diversifying away from G7 currencies.

Index linking is also a focus as UK inflation is rising. “For the first time we can recall, we have clients such as family offices looking for unhedged global inflation-linked bonds,” says Robin Creswell, managing principal at Payden & Rygel. “Unhedged, because sterling investors reason that if they want exposure to global inflation then it makes no sense to hedge out a weak currency susceptible to inflation.”

Mr Jooste likes inflation-linked bonds as they are poorly correlated to other classes and a good diversifier, but in the short term, three to six months, he is not persuaded to be aggressive with them, believing they are fair value in line with pricing pre-crisis.