When Prudential announced on March 19 that it planned to move at least £1 billion of its funds out of credit and into equities, it highlighted an issue that most observers of the credit market have talked about for months. Notwithstanding the widening in spreads seen in European markets in the latter half of March, has the market tightened so much that it no longer offers value? And if there is still value, in which sectors and ratings does it lie?
As Andrew Chorlton, investment manager at Axa Investment Managers, notes: “People have asked the question, ‘is there a bubble in credit?’ frequently over the past few months and certainly spreads have got very tight.”
A spokesperson for Prudential says the rationale for its move out of credit was simple: “Portfolios are rebalanced from time to time in line with where we see the greatest opportunities.” Although Martin Brookes, portfolio manager of Prudential’s £61 billion with-profits fund, was not available for further comment, he was recently quoted in the financial press as highlighting the “drastic” narrowing in bond spreads.
The backdrop to Prudential’s move is well known. Inflows to the credit market have increased in recent years as with-profits funds (a low-risk retail investment unique to the UK) and insurance have shifted out of equities. This equity exodus followed the collapse of the stock markets at the beginning of the decade and pressure from regulators to reduce equity exposure and better match liabilities. In the meantime, money from the retail side has poured into corporate bond funds drawn by strong returns.
How soon is now?
To paraphrase Winston Churchill, investors need to ask themselves whether the Prudential’s move is the beginning of the end for the rally, or the end of the beginning. Ben Bennett, credit strategist at BNP Paribas, feels Prudential is atypical. “Both insurers and pension funds continue to move out of equities and into bonds,” he says, adding that it’s less clear whether that money will go into corporate or government bonds.
Although some years have passed since the equity crash, many investors were not able to move out of equities immediately for technical reasons. For example, the rate at which some investors discount their liabilities was based on an assumption of up to 9% growth in equities. Switching into bonds would have crystallised losses as they would have bought bonds with a set return – and a lower return than equities at that.
Two things needed to be in place before the shift began: a recovery in equities, so that the asset/liability mismatch would be reduced; and an increase in bond yields. Now that these have both occurred, funds have flowed into bonds – and this should continue, according to Axa’s Chorlton. “As the pension funds’ funding position looks better, they are more willing to immunise their risk, which will mean further flows into bonds,” he says.
BNP Paribas’ Bennett says that without the support of the equity to bond shift, the credit market would look distinctly more bearish. “The wall of cash looks like it will continue for at least another year meaning the technically driven market will continue also,” he says. “While on balance fundamentals have probably deteriorated slightly in the last couple of months, the weight of money has brought spreads tighter as there has been very little supply.”
These factors usher in a positive medium-term outlook for credit. But Chorlton is keen to point out that the fundamentals of the market are not excessively unbalanced. “The backdrop remains supportive for credit with cash balances at high historic levels, earnings growth remaining robust and low capex,” he says. “Therefore credit quality has improved. The ratio of upgrades to downgrades looks good.”
Bennett agrees: “Based solely on default rates, spreads look attractive. You don’t need very much spread in order to be compensated for default. While there is a risk that spreads could get ahead of themselves, this is not the end of the line for the rally.”
But what is essential – and has been since the beginning of 2004 – is stock picking. “We’ve never believed in saying, ‘just buy the sector’ – that never works,” says Raja Visweswaran, head of international research at Bank of America in London. Rather investors need a detailed understanding of underlying risk so that they can construct a portfolio that has the optimum combination of spread versus risk.
Visweswaran points out, for example, that higher-volatility names in the US, excluding auto and auto parts, have tightened despite widening in the overall market. “The problem is that some of the investors in the market today don’t have a long history of owning credit – they previously owned equity or government bonds,” says Visweswaran. The temptation for investors who lack the necessary experience in credit is to resort to blindly tracking the indices.
Mehernosh Engineer, credit analyst at BNP Paribas, agrees that cash bond buyers have to be selective about what they buy. “It’s no longer possible to generalise about rating categories,” he says. “Look at triple-Bs: within that you have insurance, telecoms, autos, tobacco and retailers and on average they have come in. But they have all come in at different rates.”
BNP Paribas believes that there is value in banks, especially lower tier 2 players, while telecoms are also attractive. “Utilities are probably just going into a leveraging cycle and are less attractive. Non-cyclicals such as retails are vulnerable to the bursting of the real estate bubble,” says Engineer, adding: “We’ve almost reached the inflection point and there are signs of leverage starting to pick up, such as German energy firm E.ON planning to make a big acquisition and rumours circulating about Union Fenosa being acquired by venture capital company CVC.”
Axa’s Chorlton says that investors need to think laterally about investment opportunities. For example, US investment banks and brokers are likely to see some pick-up under Basel II as their risk weighting changes. “There’s also a lot to be said for old-fashioned stock selection as a means to add value. If you look at any sector there can be big discrepancies between the expensive and the cheap names. Credit investors should welcome the volatility now in the market because it offers opportunities to outperform,” he says.
There are many additional reasons to believe that the market overall will hold its ground or tighten further. The oft-cited impact of the structured bid is a good reason not to fear substantial widening.
Chorlton describes the structured bid as the “accordion effect”, where as soon as spreads widen too far structured products become more attractive from a structuring point of view. This causes issuance to increase, which feeds through to CDS and then cash bonds.
Similarly, Visweswaran highlights a long-term macro, or sovereign versus corporate, play in Europe. “We expect sovereigns to significantly underperform in the medium term because leverage is not going to decline for structural reasons such as underfunded pensions, therefore there will be a perpetual supply,” he says. “Meanwhile corporates are substantially deleveraged and much of their pensions liabilities get transferred to governments. So from a core long-term liability perspective, European corporates don’t look bad.”
|Value in the maturity curve |
While it might not be possible to generalise about finding value in sectors or rating categories, it is clearer where there is not value along the maturity curve. “In the UK curves are fairly flat so you are not really being compensated much for the difference between 10-year and 30-year risk,” says Andrew Chorlton, investment manager at Axa Investment Managers. “So the way we’re positioning ourselves is to try and get the same return for less risk.”
Similarly, the fate of the Telecom Italia 2055 deal launched on March 8 reminded the market that although there might be a natural bid for longer-dated assets, that bid is not necessarily for credit. “Just consider how the default probability of telecoms has changed in five years. Yet you are getting just 106bp over the French government bond for a triple-B rated bond,” says Chorlton.
From a historical context the European long bond yield should follow the US with a resultant steepening, which would indicate good long-term growth prospects and therefore improvement in credit quality – making longer-term credit more attractive. But because Europe has low organic demand growth, higher oil prices could have the opposite effect and cause the economy to contract. “Recently there has been a significant flattening in the Bunds curve in support of that argument,” says Raja Visweswaran, head of international research at Bank of America. “You don’t want to own long-dated credit under those circumstances.”