Credit roundup

While strategists are optimistic that corporate credit quality will in general improve in 2003, bondholders say sorting the winners from the losers will be a lot more complicated. Credit asks the buy and sell side their views on credit in the year ahead.

What is your credit outlook?

Neil McLeish, Morgan Stanley: What is essential for credit’s performance next year is whether companies continue to improve their credit quality, in terms of debt to cashflow. That process started in 2002, but is it going to be sustainable? I am positive on 2003; the post-bubble repair process is under way but not complete. And though we are overweight European credits and think credit quality in aggregate will improve, not every industry or company will improve.

Matt King, JPMorgan: I would say things are beginning to turn round. We have seen progress on debt reduction, particularly in the US. But to see stability in debt to profits or debt to cashflow, you actually have to see profits stabilise and that has not happened yet.

But we are optimistic about next year because for the first time we are seeing companies focusing on their balance sheets and debt levels. They don’t want to do anything that will destroy their creditworthiness. So unless the economy falls apart and profits fall, credit should do very well.

Michael Markham, Investec: We are ending 2002 with a rally in what were seen to be the riskier sectors, partly thanks to deleveraging in those sectors. That trend should continue because many companies now see debt holders as an integral part of their capital structure. This change has been forced on corporates because they are obliged to pay what they perceive to be too much for the debt that they want to carry on borrowing.

However, I am not particularly positive about global economic growth. It has been remarkably strong of late but I am concerned that much of the poor returns we have seen in the equity market will knock the consumer.

Alok Basu, Gartmore: I recall at the end of 2001 a number of analysts were taking a very bearish view on the economy and that was in synch with a negative credit environment. This year, if you simply look at downgrades to upgrades, the credit environment has continued to be negative. But at the same time both the US and UK economies have been remarkably strong and the indications for next year suggest a relatively robust macro picture – with the exception of Europe. And in terms of corporate performance there was something of a turnaround last year. So one has to ask where the negative credit pressures come from. I, frankly, do not actually think there was anything particularly novel about the blow-ups in 2002; it was just their scale that surprised people and the fact that they came from traditionally safe sectors.

Ian Fishwick, CSAM: I am actually quite bearish on the outlook – but I should say that I am bearish about everything! I think the equity markets will have another volatile year. They may not end the year lower but they will go all over the place in the interim, which will not be helpful for bond spreads. I basically agree that companies are retaining cashflows and paying down debts and this will continue. But I do not think companies are going to get rewarded for that en masse – it will be sector specific and company specific.

Gary Jenkins, Barclays Capital: By most measures of credit, specifically the upgrade to downgrade ratio, 2002 has been a poor year. But the equity markets are coming back, economic indicators look quite good and credit spreads have tightened, so you get a feeling that things have turned around. You could make the point that those are pretty much the same conditions we saw this time last year.

We don’t think we will see credit quality turning around quickly. It’s been absolutely hammered over the last three years and it is a bit like an oil tanker – it tends to turn round very slowly. Also companies’ balance sheets have deteriorated to such a degree that their flexibility has been eaten up – if they were cats they would have had eight of their nine lives. The average rating has dropped so much that the capital markets are now very fragile: one bad decision could have a compound effect on the credit quality of a company.

And so, for us, credit next year will depend on a couple of factors. And most important will be US unemployment, because of consumer spending. If it stays where it is, credit should perform very well, but if it starts to rise, credit could have a pretty volatile year.

Michael Markham: I agree that credit quality in terms of the number of downgrades to upgrades is likely to deteriorate in aggregate over the next six months. But spreads are mainly dependent on investors’ perception of credit, so perhaps there will be buying opportunities if there is real deleveraging while the rating agencies are slow to react.

Gary Jenkins: I guess our worry is this: if you go back 12 months, Standard & Poor’s downgraded Ford by two notches and said there wouldn’t be any other rating movements for a long time. Then 12 months later they downgraded Ford another notch on negative outlook. And if sales of cars trend below 16 million a year, it’s unlikely Ford will meet the targets S&P has set them. In that case you start getting near low triple-B. Because of the sector’s size in the major indices, this could have a negative impact on sentiment on the market as a whole.

There is a worry that, as with a few weeks ago, the auto sector could tighten and you could get quite severe underperformance and, on a breakeven basis, it looks very attractive. But that was the same 12 months ago [for the telecom sector] and at times this year breakeven spreads have been one day’s trading movement. Things have been very volatile indeed and it will be interesting to see how quickly investors get comfortable with autos risk if we do see sales trending lower.

So which are the sectors to watch and which should be avoided?

Neil McLeish: My sector of choice is the European telecom operators. The four largest borrowers in the sector reduced debts by 7% in the third quarter of 2002. To my mind there is no reason that should not continue over the next 12 months and the sector still trades over 60bp–70bp wider than the corporate average in Europe.

My pan would be the autos sector. The industry has not addressed the fundamental problem of overcapacity and as such we recommend a flat or underweight position.

Gary Jenkins: I agree. For me credit’s performance next year will be determined by a couple of sectors. The telco sector is number one and the key there is France Télécom. It now appears the French government is going to step up to the plate and recapitalise France Télécom’s balance sheet. If that happens, telcos will have a very good 2003.

For the autos we are more cautious. For the last three years, auto sales in the US have been running at record levels – around 17 million – and in that time Ford has been downgraded four notches and General Motors three. What is going to happen if sales trend lower?

For us you can distil it down to those two sectors.

Matt King: It is difficult to say which sectors will tighten the most because the deleveraging is on a company-by-company basis. However, in general companies that need to deleverage are lower-quality ones. In terms of our outlook we say risks remain, but we can very easily see 60bp–70bp on triple-B spreads by the middle of next year.

To what extent will the utility and telecoms sectors swap roles in 2003, with the utility sector borrowing more and telecoms paying down debts?

Neil McLeish: I would rather have telecoms than utilities in my portfolio personally.

Alok Basu: It depends which market you’re looking at. In the UK you could put forward the argument that although utilities have made their downwards migration, there are quite big structural risks, particularly in the water sector.

In Euroland, deregulation and liberalisation of the market is going to usher in an era of lower ratings. The only question is timing, and with the sort of yields you are getting on these companies, it’s not the most compelling way of outperforming an index.

The telecoms sector will depend on how much further you think the rally has to run. With credits that have rallied a long way, like British Telecom and Deutsche Telekom, you could argue that we should be cutting and running now. But you are still getting better yields on them than you would with a lot of other corporates. France Télécom is more interesting and I guess the outcome there could be more binary, influenced by what the French government chooses to do.

Matt King: The telcos sector is a classic example of deleveraging, but the deleveraging is not quite complete. In utilities we are seeing the sector splitting. In Europe the better-quality names are still doing acquisitions and leveraging themselves up. But increasingly there are US and European names like Iberdrola doing asset disposals and focusing on their balance sheets.

Alok Basu: Actually, I would suggest that neither of the big companies in the UK are particularly safe given what’s been happening to the generation market after TXU. Just how much do Powergen or Innogy really want to depend on parental support?

Gary Jenkins: Also for the biggest borrowers in the telecom sector there is implicit or explicit state support and clearly that does make a difference. If France Télécom does get state support, and for me it is inconceivable that the French government would walk away from it, then next year telcos could perform exceptionally well. It might be a volatile ride.

Alok Basu: I would like to go back to the negative comments on autos for a moment. We have seen a fantastic rally in auto spreads in the last few weeks, and those analysts who went out with a sell recommendation after spreads had blown out clearly got the short term wrong.

This highlights a problem with sell-side research. It is all very well being negative on a sector or credit but how do you make money out of that on a practical level? If you underweight sectors that you think are riskier, like autos, you end up losing yield relative to your index benchmark.

Take the sterling market: the non-gilt index’s average spread is 100bp, you need to beat that by a good 20bp–30bp. How do you do that just by saying ‘sell this, sell that’ or ‘we think this is too risky, we think that is too risky’?

Michael Markham: I think it is a matter of degrees. We picked up Ford at the wider levels and we were relatively comfortable. It had a good yield and plenty of cash on its balance sheet. But do I like Ford as a long-term credit? No. It has been a fantastic year for car sales but the autos sector has not made any money. So when it is a bad year for sales, it will be atrocious for the sector.

Matt King: Every portfolio manager has this dilemma. Do you ask your analysts to comment on credit fundamentals and then make a relative value decision or do you ask the analysts to comment on valuations? The problem with the first is you will tend to only pick the safe credits – good in a bear market, you avoid the blow-ups, but in a bull you miss out on higher yields. So I think most investors are tending towards the second model. Nevertheless, it is an extremely difficult issue.

We were overweight on Ford during some of the widening and so had a lot of pain on the way up. And when it was at relatively wide spreads we formally reduced our recommendation to neutral.

And anyway these recommendations may be of limited use for investors in real bonds. If they want to go overweight a credit they may not be able to find it in the secondary market. And therefore, investors are trying to get permission to trade credit default swaps.

Which investors here can invest in credit default swaps or credit-linked notes?

Michael Markham: We could if compliance signed off. But given that most of the funds we have are long only it would be difficult for us to use a credit-linked note to go short. We might be able to use credit default swaps to hedge positions and underweight a credit, but we would need to ensure that it was the most efficient way and we have not done that yet.

Neil McLeish: I think this is one of bond investors’ frustrations: the feeling that it is not a level playing field. There is a lot of variance in what investors are allowed to trade and how – from only being able to go long cash bonds to being able to go long and short all asset classes.

Take WorldCom’s collapse as an example. If I was an investor who could go long and short credit and equity and had WorldCom bonds when they were falling, I could sell WorldCom equity and create a hedge. There is very little a long-only manager can do in the same situation except watch the credit go down and hope it comes back up. And the banks also have more options than bondholders, like demanding security.

Michael Markham: I agree there is a problem with being a long-only fund manager and having a benchmark index. We are constrained by the fact that the way the indices are made up is by market weight, so all the worst credits tend to issue most debt. And really bad credits automatically get sold out of the index when they are downgraded, and it doesn’t matter whether investors can actually find a buyer at that price. If Ford, which is 2.5% of the European high-grade corporate bond index, really does blow up then that will really hurt the European market, but that will not be seen in the index because when it was downgraded to double-B, the index got out at 90.

Ian Fishwick: The price at which some of these things disappear from the index is a real problem for the market as a whole because clearly not everyone can sell at the price the index has used. So what is it reasonable to expect from bondholders? It really does come down to mandates. If you have a long-only fund that is allowed very little deviation from benchmark in terms of names and duration, you can’t expect it to outperform the index by 300bp of performance – to be honest 50bp is probably doing well.

Neil McLeish: You probably expect underperformance. There’s a pretty big mismatch in terms of the returns on credit relative to investors’ ability to manage the risk. And I think it is a very valid challenge to ask how do you manage that risk. That is why in October we had €70 billion of bank loans for non-financial corporates versus €3 billion of bond issues. If spreads had stayed where they were six weeks ago, this market would have ceased to exist in two years’ time because no companies were issuing bonds and banks were quite happy to lend because they could manage the risk when the corporate bond market could not.

In response we are seeing a lot more real-money investors using credit derivatives or getting approval to use them. You have to be able to be long or short; you don’t want to manage credit from a long-only perspective.

It comes back to who is best positioned to take different types of credit risk. Ultimately if you believe in efficient markets then if a certain group of investors cannot access the right tools to manage credit risk, capital will be shifted away from them towards investors that can. That could be banks or investors that can go long and short.

Matt King: Is the difference in spreads between loans and bonds because the banks are more efficiently managing their portfolios, or are they subsidising the loans hoping to win more business? And if it is the latter, how can investors tackle that kind of distortion? Some of it can be justified because of differences in covenants and security on the loans side but a lot is down to banks still being prepared to subsidise loans.

Michael Markham: Shouldn’t the bond market be offering borrowers a different product from the banks? Loans are in many senses senior in the capital structure to bonds – they are more secured and more onerous on reporting – and can therefore demand lower spreads. Bonds offer different terms that I am not sure the banking market is equipped to cope with.

I think the low bond issuance is a short-term phenomenon where they have been crowded out of the cash market. Things will right themselves when pricing comes back to whatever a fair level is for the different kind of flexibility that you can get in the cash bond market, like longer maturities.

Gary Jenkins: I also think the banks lending today are probably hoping the bond markets are coming back and they will be able to get out of these loans through the credit markets. The amount of short-dated loans in the past few years has grown hugely. As the European credit market grows, banks will be able to lend short-dated and then shift it into the credit markets. The banks are taking the view that the credit markets will be there in some shape or form. I don’t think the banks with all the new regulation going on would want to lend money at these spreads unless they thought they would be out within 12 months.

Matt King: And yet didn’t Hutchison have a seven-year maturity and Saint-Gobain a five-year one? There has been a huge increase in the short-maturity stuff. An undrawn loan with less than 365 days’ maturity does not need capital put against it. But we are still getting these longer-maturity things done, which suggests that the syndicated loan teams have been very happy to compete for the business in the hope of winning the ever-dwindling amount of M&A there is. There is to some extent a difference in market and a difference in product but that doesn’t account for all of the spread difference out there.

Neil McLeish: That reflects the fact that banks, like some investors, manage credit on an economic basis. They don’t have to sell if it goes to junk, they do not have to outperform an index and they can manage distressed situations. The banks are overcapitalised and they want to subsidise loans but the lower spreads are also caused by banks’ greater flexibility. I agree the closed bond market is a short-term phenomenon; ultimately what will happen is real-money investors will get the ability to be long or short. The days of the long-only credit investors trying to manage corporate bond risk versus an index are virtually consigned to the history books.

Matt King: In which case you are presumably implying that fair value for triple-B credits is closer to the 50bp we have consistently seen in loans over the past five years rather than the 200bp the bond markets demand.

Neil McLeish: Yes, quite possibly. The high-grade/high-yield boundary is an artificial cost imposed on investors.

Matt King: In the mean time, would it not be better to have a better-constructed benchmark? A constrained index where all the weightings are around 1% so there is less blow-up risk. And you can go overweight in big borrowing names without taking unacceptable exposure to them; yet the weightings still more or less replicate the broader market, mimicking the sector exposure and credit quality exposure.

How will pension deficits affect credit performance next year?

Ian Fishwick: It comes back to the equity market. Quite a lot of major companies, particularly in the UK and the US, have significant pension fund deficits. These could become problematic when the pension scheme is big relative to the size of the company and the pension is running an unmatched position, where the liabilities are not matched by bonds of an appropriate term, type and currency. And there are a number of examples of this, so how do you factor that in? Obviously it is different for each company but for a handful it is a serious problem. In the end most will deal with it by changing their pension schemes but some are probably too far down the curve already.

Will pension deficits be as serious a concern for investors next year as accounting irregularities were this year?

Ian Fishwick: Yes I think they will. I think we will see a number of companies really surprising us with the scale of their deficits.

Neil McLeish: It is extra leverage, and leverage always plays out the same way: if the world gets better, who cares about leverage? If it does not, leverage becomes a problem. Pension deficits are a special type of leverage; it is not like a bond where people will want their money back when it matures, but it is leverage and it should be analysed as such. You have to distinguish between different jurisdictions but if you get the credit call wrong and the credit has a pension fund deficit as well, it is just going to exaggerate the problem.

Michael Markham: From the other side this will provide a long-term support for demand in the credit markets because the way to actually match your liabilities and assets in a pension fund is to have lots of long-dated fixed-income assets. Also the demise of defined benefit pension schemes is something to be mourned. But they will be killed off because they are inherently very difficult for companies to manage.

Neil McLeish: Defined benefit pension schemes are too expensive. They are a very expensive commitment to give, and now we are realising that.

Alok Basu: I guess you only need to look at what has happened in the life assurance industry and argue that pension funds are a more extreme version of that. And you are right, ultimately it’s going to be positive from a perspective of demand for credit.

How will asbestos and other litigation risk affect the markets next year?

Gary Jenkins: As US lawyers are now after McDonalds, we have to imagine that anything they can get their hands on they are going to try. You have had it with tobacco, you are having it with asbestos and now fast food chains. What next?

Neil McLeish: Drug companies, mobile phones.

Michael Markham: The problem is that it is a potentially uncapped liability, which puts the fear of god into investors. At least with pension fund deficits, some actuary has come up with a few rules to accurately say what the damage is. With litigation risk you are not really sure how much it will be. The only way to resolve this in the long term is to have a change of regulation in the States.

Gary Jenkins: You are at the mercy of 12 good men and true. Over the past few years you had a period when the court cases were actually quite favourable for tobacco. And suddenly out of the blue there was one that was almost unimaginable in the size of damages awarded. That is a problem and it is very difficult to analyse.

Neil McLeish: Exactly. No one can say which companies will and will not be subject to litigation next year.

Ian Fishwick: It’s just another form of event risk.

Alok Basu: I think an interesting question this raises is whether investors should be assigning a risk premium to European companies with US exposure, in the same way they assign one to a European company with emerging markets exposure. But, I guess, at the moment the danger is unquantifiable.

In the asbestos situation, the more lethal form of asbestos and the various cancers deriving from it account for less than 5% of the claims before the courts. More than 95% are defined as non-malignant – that is, you only need to be within walking distance of a factory that happens to be generating it in order to put in a claim. And that is what is really killing a lot of the firms. It seems to me settlements may be best for investors and claimants since genuine claimants could die before anything is resolved in the courts.

But what is clear is bond investors will vote with their feet first when they hear asbestosis anywhere near a credit. You sell first and ask questions later.

We have also seen the increased use of synthetically created collateralised debt obligations in 2002. So how do investors feel about CDOs? Are they just banks offloading big debts and fund managers looking for more funds or do they offer attractive diversified products?

Ian Fishwick: The answer is probably yes to both. There is not much of a secondary market, so I do not find them particularly attractive but I am not going to say there is never a right price to buy them at. But intrinsically I don’t like the products.

Neil McLeish: There’s a large amount of information asymmetry, which is quite difficult to bridge.

Matt King: They have tended to have a bad press because some of the early deals were ill-structured and not well diversified, and mainly because they are a leveraged bet on credit. And therefore as credit has been sold off in the past six years, it has had a magnified effect on CDOs. But for investors who want a leveraged product that gives a diversified portfolio of, what we see for valuation reasons, the sweet spot in credit – triple-B/double-B – then CDOs are perfect. At the moment they look attractive.

Neil McLeish: Are we talking about managed CDOs? You can buy the market or you can buy a CDO but how do you bridge the information asymmetry over the structuring and the asset manager’s skills? And why does a sophisticated investor want to invest in CDOs rather than just going out and investing in 300 credits and getting 150bp over Libor for the sweet spot?

Matt King: Investors wanting to boost returns by taking the equity tranche and either managing it themselves or taking a tailor-made portfolio –so there is no gap – get paid for the outperformance.

Michael Markham: The problem with this asset class is lack of information from the managers, lack of support from the issuing houses and lack of liquidity. In principle I think they are a very good way for investment houses that want to have exposure to loans or the sweet spot to meet their investment requirements. But making that decision means you are saying you do not want to have expertise in a certain part of the credit market. You do not want to buy the 300 names so you subcontract that to someone else. But if you want the exposure, you could just hire a fund manager and subcontract it in a non-leveraged way. Also it might be the sweet spot for two years but after that it is just a bit of paper that no one wants and without support from the issuing houses.

Neil McLeish: I do not think anybody is representing CDOs as a tradable asset. We seem to be back to this theme of an efficient market and where credit risk should be assigned. Maybe in CDOs very skilled managers should take the risky equity tranche and a commercial paper conduit should take the triple-A part. I think that is where the value kicks in, but CDOs are certainly not for active investors, they are hold-to-maturity assets.

Matt King: Investors might say there is part of my portfolio I know I am never going to need to sell, so I would like to gain an illiquidity premium on that, therefore I am prepared to allocate it to an asset class that I know I will have to hold till maturity.

These things started out from people wanting to dispose of assets on the balance sheet. Now increasingly they are issued because investors want to buy a tranche with these characteristics. As an asset class it’s here to stay.

Michael Markham: So they’re not split capital investment trusts under a different name?

Matt King: Different investors take different tranches. Traditionally the low-quality tranches, the equity tranches, are being bought by people who have non-mark-to-market requirements and who also need a high return; for example, the insurance companies that need to earn a certain guaranteed amount.

Ian Fishwick: You wouldn’t back a guarantee with the bottom end of a CDO would you?

Neil McLeish: No, I wouldn’t back it with equities either.

Thank you all for your time.