The year of the bear

Ambitious valuations towards the end of last year have led to a stagnation in European corporate bond spreads. Credit takes a look at the factors that will shape the behaviour of spreads throughout the remainder of 2004

After a storming 2003, the European credit market has had a reality check since January. The inexorable tightening of the market has come to a standstill and there has been a drift towards widening. As Stephen Snowden, fund manager at Old Mutual in London, notes: “Two months ago most people in credit would have told you that all was well in the world. That is no longer the case.”

But does this mean the party is over? And where will fund managers be making their money in the next 18 months?

To understand what might happen in the rest of 2004 and 2005 we need to go back six years and look at the rollercoaster ride of sentiment. “In 2002 the market was oversold: it had endured [the collapse of hedge fund] LTCM in 1998, mega-deals like Deutsche Telekom in 2000 which turned sour, September 11 and then accounting irregularities,” says Snowden.

When that succession of calamities ended in late 2002, the market embarked on something of a buying spree. With this new-found optimism, the market was able to take events like Parmalat in its stride. “Parmalat was not a nightmare,” says Jean-Pierre Leoni, head of credit at Axa Investment Managers in Paris. “It was only an event.”

That buying spree was not unfounded, argues Louis Gargour, hedge fund manager at Rab Capital. A recent Standard & Poor’s report showed that the 12-month rolling issuer-weighted speculative-grade default rate in the EU fell to 3.03% at the end of January 2004 compared to 6.99% in June 2003, and 13.87% at the end of 2002. That decline has given investors more incentive to move into lower-quality credits. Gargour says that the corresponding economic improvement has made it easier for companies to deleverage and reinforced investor confidence.

Turnaround

But the rallies now appear to be over and since the turn of the year there has been a stagnation of European corporate spreads and a significant widening in UK spreads, especially lower-rated, longer-dated bonds. For example General Motor’s 2033 €1.5 billion bond issued in June last year is a good bellwether bond against which to measure the market. On January 1 it was being offered at of 204 basis points (bp) and bid at 199bp but by mid-March it was 268/263bp – 60bp wider.

Admittedly 30bp of this had occurred since the Madrid bombings, but even before then the bonds had been remarkably volatile. The widening does need to be seen in context; in October GM’s 2033 bonds were trading at around 300bp and in July around 400bp. But for the fund managers watching profits slip through their fingers the widening is still very real.

Michael Markham credit fund manager at Investec in London believes that part of the cause for the widening in 2004 is the realisation that the credit market tightened too far in 2003. Much of 2003’s performance was led by fundamental improvements, especially among lower-quality credit. But the market moved ahead of those improvements. As Scott Vincent, senior research analyst, investment management and research at Russell Investment Group, notes, “Five-year triple-Bs have come in to 80bp from 190bp in one year. Managers feel that positive scenarios have already been priced in.”

Valuations had become ambitious by the end of 2003, agrees Rob Marsden, head of fixed-income manager research at Mercer Investment Consulting. “Portfolio managers looked at the portfolios at the end of the year and asked themselves where they could add alpha,” he says. “They saw that some of the credit that had tightened during the year had not been driven by fundamentals.”

Marsden believes that there is also an element of market psychology driving spreads. “The real-money accounts didn’t want to be the last ones to get out before spreads widened,” he says. “Necessarily that feeling feeds on itself.” By the time the New Year hangovers had receded there was a growing consensus that the market was overstretched.

But does being overstretched mean that the European credit markets are set for a period of slow widening? “Hedge funds and money managers are poor long-term holders and therefore often exaggerate volatility,” says Markham. “But regardless of their activity the long-term trend is for broadly stable spreads in the UK market.”

Old Mutual’s Snowden expects that 2004 will end with the credit market tighter – but only marginally. “There has been little material shift from equities into bonds yet: it has still to come and that will have a significant impact.” Didier Haenecour, portfolio manager at Cigna International Investment Advisors, disagrees: “Spreads will be wider at the end of the year but spread products will outperform government bonds.”

“The European market has reached a state of equilibrium where risk and return are in balance,” says Rab Capital’s Gargour. “The directional aspect of spread tightening has now gone and bonds will trade sideways until there is a new view on economic fundamentals.” Axa’s Leoni agrees: “Spreads are tight but liquidity is good. We will see the market trade in a range for some time.”

The big question is whether we are now in a bear market. Terry Wilby, managing analyst, credit and derivatives flow at Informa Global Markets (IGM), says: “We are not in a full-blown bear market at the moment. There has been little follow-through to any widening push and it has always come back.”

But is the gradual widening taking place because of fundamentals? “This is a very difficult environment for top-line growth,” says Cigna’s Haenecour. “The lack of it in 2003 didn’t stop the market from having a spectacular year thanks to a mixture of fundamental improvement and technical factors: essentially cleaning up balance sheets and cutting costs on one hand and the search for yield in 2003 on the other.”

Crucially, the drivers of improvement in 2003 were linked to internal improvement at individual companies and liquidity in the market rather than the broader economy. “Now it remains to be seen if the growth is going to support the current credit spread,” says Haenecour.

What’s more the equity and credit markets seem to disagree on what the prospects for economic and corporate growth are. According to Roveen Bhansali, vice president, business strategy at Barra default models suggest that credit risk should be lower, on average, due to rallying equity prices and a decrease in equity volatility, but credit default swaps are wider, suggesting more credit risk. “It could be technical factors driving this, such as increased trading volume in credit default swap indices, as well as hedging driven by collateralised debt obligations,” he says.

Robert McAdie, head of credit strategy at Lehman Brothers in London, explains: “In the past, banks have had to source credit risk to hedge themselves when issuing CDOs but issuance is now switching to iBoxx/Trac-x to hedge out exposure.” By switching away from single-name credits, CDO issuers could be helping to send credit default swap spreads wider.

Interest rate movement There has been a flurry of news coming out of the European Central Bank (ECB) and the member governments indicating that European economic recovery is likely to remain uncertain, according to Roveen Bhansali, vice president, business strategy at Barra. The ECB has left rates unchanged amid concerns that consumer confidence may be flagging, and export growth remains tepid. The likely outcome now appears to be that the interest rate regime in Europe will remain conducive to bond investors with rates remaining stable in the short- to medium-term, according to Louis Gargour, hedge fund manager at Rab Capital. Bhansali agrees: “Interest rates are likely to remain stable in Europe and the UK, given the non-inflationary outlook for those economies. If anything, it seems like ECB has an accommodative bias at this point, which argues for a stable to lower rate environment.“ Rob Marsden, head of fixed-income manager research at Mercer Investment Consulting, says that having examined former curves, Mercer has moderated its perception of a rate rise. “The strength of the euro and the jobless recovery in the US are tempering expectations of a rate rise,“ he says. “The ECB is between a rock and a hard place. It is reluctant to lower rates because it doesn’t want to be seen to pander to politicians’ wishes. But at the same time the fundamentals appear to indicate that a cut should be on the cards. The high euro is choking export growth.“ Even if rates do rise, that need not be bad news, according to Scott Vincent, senior research analyst, investment management and research at Russell Investment Group. “The impact of rate rises depends on why they are implemented,” says Vincent. “If the curve starts to sell off because the data suggests that things are looking better then maybe it’s not a concern. But if the ECB were to tighten and the market thought it wasn’t warranted, that could have a significant impact.“

The good news: fund flows There may have been a recent slowdown in money flowing into corporate bonds as managers’ appetite for risk has reduced but, as most investment consultants will tell you, corporate bonds still remain the place to be. “There continues to be ongoing risk reduction among pension funds and life insurers, which are still switching from equities to fixed income – of which credit is an important part,” says Rob Marsden, head of fixed-income manager research at Mercer Investment Consulting. The arguments for increased investment in bonds are well trodden but seem especially pertinent following the bombing in Madrid. “In times of economic uncertainty bonds provide income and diversification,” says Roveen Bhansali, vice president, business strategy at Barra. “However, government bond yields worldwide remain at their record lows, so by necessity managers have to move into corporate bonds.” Furthermore, despite the current accommodative monetary and fiscal policies, the long-term global economic outlook remains uncertain. “Sustainable growth will likely remain a challenge, and European consumers are unlikely to provide sufficient demand to offset excess global productive capacity,” says Bhansali. “So bond yields are unlikely to ramp up too much, and spread products will remain a mechanism for picking up yield.” Finally – and perhaps most importantly in the long term – asset allocation strategies are increasingly being designed to provide returns that will meet a future liability. Pension plans are starting to realise that bonds can offer a higher correlation to liabilities than equities – and provide vital yield. “The switch to fixed income hasn’t been played out,” says Scott Vincent, senior research analyst, investment management and research at Russell Investment Group. “There is significant interest in liability matches and we are seeing managers putting together new systems to allow them to do that.” Nick Horsfall, senior investment consultant at Watson Wyatt, agrees: “Clients will sell a lot of equities to buy a lot of bonds over the next few years. We are still a long way from halfway in the process. Our clients were selling equities and buying bonds at the rate of ?10 million a month but in the last five months that has come to a halt. It will resume at a later point though. The change is inevitable.” While the recent trends in the market mean that there may be in better times to make the switch to credit, it remains the right switch to make, according to Horsfall. “And to a large extent short-term volatility is not an issue for many of the clients we advise: they are not concerned about mark-to-market. If you don’t buy into credit then you’ve got a negative carry. We are constantly trying to find the right entrance points.”