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When Standard & Poor's downgraded Mannesmann
from single-A to BBB+ on November 24 following the German company's
bid to buy the UK mobile-phone operator Orange, it caused howls of
pain in the offices of bond fund managers all over euroland. Many
had considered familiar names like Mannesmann to be the safe way to
transform their government-bond holdings into a credit portfolio.
Instead, they realized that Europe's soaring M&A activity can
hurt creditors of higher-grade companies. Shareholder value can
mean bondholder losses.
Bond fund managers have also struggled with the fact that
while they typically have to manage risks against a bond index,
euro corporate indices are poorly diversified and patchy in their
liquidity. Disintermediation in Europe has happened at an uneven
pace so far: while telecoms companies and financial institutions
have embraced the corporate bond market, the same isn't true for,
say, consumer goods manufacturers. The heaviest bond issuance comes
from the sectors with the most mergers and acquisitions. Once
again, the M&A dynamic has made fixed-income investors' lives
difficult.
With the first year of the euro corporate bond market
complete,
Euromoneyspoke to a group of leading fund managers about
their investment methods, experiences in euro credit so far, and
hopes for 2000. The debate that emerges is polarized between
believers in bond-picking, and those who think investors need to
focus more on portfolio design in order to manage M&A-related
event risk more successfully than last year.
The latter school think investment banks have got their
research focus wrong. They want to invest by following strategic
themes, not single credits. Marino Valensise of Baring Asset
Management concludes: "What many investment banks are missing is a
corporate strategist working with the credit analyst."
Michka Kovats and Mark Wauton, UBS Brinson
Mark Wauton
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Michka Kovats and his colleagues like
to invest strategically, rather than saying yes or no to single
bonds. "We don't believe so much in cherry-picking," says the
director of private-banking investment services: "We focus much
more on what an asset class brings to the portfolio on a
risk-return basis." He believes it's an aspect of investing that is
neglected by many European asset managers, to their clients' cost.
Mark Wauton joined UBS Brinson as joint head of European
fixed income last May, after leaving Commerzbank's fund management
operation. He found a house that had taken a relatively light
exposure to the new euro corporate bond market. Wauton explains:
"The problem was that spreads were very tight, because many
investors were disinvesting away from government bonds into
corporates. There was too much new money chasing the market." Many
investors bought a slice of whatever pie was offered them. This led
them to have a high exposure to the telecoms sector. Only in the
autumn, when Mannesmann spreads widened out in response to its
acquisition ambitions, did the risk posed to undiversified
portfolios by M&A events become clear. "It is a reflection of
the inexperience of the market as a whole," says Wauton.
This year, investors ought rationally to demand more
compensation in sectors affected by leveraged acquisitions and
credit downgrades. Europe is undergoing the same transition away
from double-A-rated corporates towards middle-grade ratings that
the US experienced 25 years ago.
Wauton believes credit spreads need to rise before there is
value in euro corporate debt. In the first quarter of this year,
new issuance will be intense as investment banks try to position
themselves after the millennium lull. Bearing in mind heavy supply,
a downward trend in ratings, rising M&A-related event risk, and
the rise of shareholder value, Wauton argues: "Spreads are going to
find it very difficult to tighten significantly."
Instead of embracing corporate euro issues more
enthusiastically, Brinson likes a range of other non-government
bonds. Wauton says: "There are a number of spread markets. We're
not forced to buy corporates, because there are always
opportunities in Pfandbriefe or asset-backed." The firm is also
heavily overweight in yankee bonds, and "in the US we have been
well rewarded holding agency paper".
Brinson's selection method is not purely top-down. Within its
corporate bond holdings it is forced, like others, to accept the
reality that most of the important issuers are in the telecoms and
financials sectors. Diversifying by boosting the weighting of more
marginal sectors might introduce new risks, such as widening
bid-offer spreads, rather than reducing the risk profile. Wauton
says: "It's a balancing act. You shouldn't buy a bond purely for
diversification." You also need bottom-up research, he explains:
"and confidence in the management."
In other words, you can't make top-down allocations if the
view from the bottom up isn't good enough. This makes it hard to
build a satisfactory portfolio in Europe, says Wauton. Indices are
hard to follow: "The problem is that a lack of liquidity makes it
difficult for fund managers to build up positions apart from
supporting new issues. There are no more than 30 to 40 corporate
bonds that are actively traded, but there are a lot more than 40 in
the indices."
Some investors believe that the answer to the rising risk of
M&A events and credit downgrades is to have a barbell strategy:
outside your triple-A investments, go for low-rated corporates
including in the high-yield market. Where these issuers are
operating in fast-growing and restructuring industries, they are
more likely to be upgraded as a result of M&A activity. For
example, Orange received a higher rating from S&P when it
accepted Mannesmann's takeover bid, just as the German acquirer was
downgraded.
Wauton believes European high-yield is not yet safe enough
for a barbell strategy. In the US, where you can diversify enough
in high-yield to create a synthetic investment-grade bond with a
high coupon, it is proven to be one of the best risk-adjusted
investment strategies of all. But Wauton says: "European high-yield
is not large enough to express that type of strategy. The problem
we encounter in Europe is that high-yield is dominated by telecoms,
and the diversity scores are too low. Spreads are if anything too
tight, because investors aren't compensated for the lack of
diversification." European high-yield functions best, he believes,
as part of a global sub-investment-grade portfolio.
In the corporate bond market of 2000, Wauton hopes to see "a
greater emphasis on sector analysis, relative value, and on the
decision-making process of how we diversify away from government
bonds. Investment processes relying on bottom-up stock-picking are
not sufficient." Investment banks could do better, he argues: "It's
been a learning experience for them. It's no longer appropriate to
bring new issues to the market. Investment banks have to offer
advice on portfolio strategy, sector analysis and relative value.
The level of research has improved, but it needs to go further."
Above all, he says, banks could help by promoting more sectoral
diversity of issuance.
Marino Valensise, Baring Asset Management
Marino Valensise
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Marino Valensise, Baring's head of credit holdings, is a
former Commerzbank colleague of Mark Wauton at UBS. And Valensise
too believes you need to combine bottom-up analysis with top-down
themes. Baring makes use of diversity scores, a concept invented by
the rating agency Moody's, to allocate its funds within the
corporate bond market. "When we have defined our optimal sector
allocation," says Valensise, "we fill each industry with selected
corporates via traditional bottom-up analysis. We feel that the
portfolio-structuring part of the business, diversifying across
industries and across ratings, is extremely important."
The problems Baring has with this are twofold, says
Valensise: "There are not so many industries represented at
present. We don't follow the industry weightings of the index."
Secondly, about two-thirds of the euro corporate bond universe is
rated triple-A or double-A, compared to the US, where the majority
of bonds are single-A or triple-B. "You cannot buy enough triple-Bs
in the euro market, because only a few issues exist," says
Valensise. He hopes that the effect of intense M&A activity
will be to rectify that situation. The Mannesmann downgrade is be
part of a pattern, Valensise says: "On a 12- to 18-month horizon,
the distribution between rating buckets will be very different."
Baring's most rewarding play in euro corporate debt so far
has been spotting rating migrations. Valensise says this points
towards a focus on low-rated credits. "If you've invested in Aaa/Aa
corporates, you can only migrate down. Other issuers in expanding
industries have a chance of being bought by bigger players and
being re-rated upwards. We are trying to barbell between the safest
credits, ie agencies and supranationals, and the low-rated
newcomers." Here's where he differs from his friend Wauton.
"You have to have exposure to high-yield as an asset class,
because its profile of rating migrations offers more opportunities
than high-grade corporates. The spread compression for companies
which migrate from non-investment grade to investment grade is
massive." Valensise can quickly name his favourite corporate bond
of last year: "We had an excellent call on Orange." When Baring
invested in the mobile operator, it was a junk bond; by the time it
reached investment grade, its spread to governments had fallen from
about 350 basis points to 150bp.
From this investment perspective, it is paradoxical that most
European investors have been keenest on names like Mannesmann,
Deutsche Telekom and France Télécom, which were eager to buy stakes
in non-investment-grade companies. France Télécom's pursuit of a
stake in NTL heralds more such exposures, thinks Valensise.
Many euroland investors are too conservative about low-grade
corporate bonds, thinks Valensise, in part for cultural reasons,
but also because they are acting under the constraints of their
mandates. "They are managing money for institutions which do not
allow investment in lower credits. I have the feeling that they did
not really appreciate the risk: not of default, but of credit
migrations in the current context of European consolidation."
What of UBS Brinson's argument that European high-yield is
too immature for a safe portfolio? Valensise agrees that
diversification is needed to reduce the risk of being skewed
towards telecoms. "In a timeframe between three and five years, we
may have the kind of diversity in the index that you have in the US
high-yield indices. Investment banks have to get the industrials on
an aggressive path of issuance."
He is brutal about the mistakes of many investors during the
first year of euro corporate bonds. "The market was extremely
excited, and we saw a lot of issuance. However, issuance was not
much diversified among industries. There was a rush to invest in
corporate bonds just because investors had to increase their
corporate exposure. Investors did not realize that event risk and
industry concentration were significant factors. Having built
poorly-constructed portfolios, they have been extremely
disappointed by their corporate investments."
In today's market, Baring is more enthusiastic about
corporate bond valuations than UBS Brinson. Valensise argues that
euro credit spreads are not as overpriced compared to the US market
as it may seem, because credit spreads have two components: the
spread of swaps over governments, and the spread of specific
corporate bonds over the swap market. The latter part is generally
wider in euros than in the dollar or sterling markets; but swap
spreads are significantly tighter. This is because swap spreads
correlate to the supply of government bonds. In the US, there is a
shortage, which drives up the price of treasuries compared to
swaps. In euroland there is no such pressure, since governments
still run big deficits, while the European Central Bank accepts
corporate bonds alongside treasury bonds as repo collateral. "So I
would say that in Europe, credit is not mispriced," says Valensise.
Alex Veys, Fidelity Investment Services
Alex Veys
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Fidelity began preparing for its assault on the euro
corporate bond market in 1998, when it started to build a large
European credit analysis team, based around veterans of the US
credit market. The firm also put together a strong trading team,
led by experienced Boston hand Paul Lavelle. "They can move a lot
of exposure without damage," says Alex Veys, Fidelity's head of
European corporate bonds. That's a necessary strength, given the
way Fidelity's exposure to euro corporate bonds has gone up and
down like a yo-yo.
Fidelity's investment method is "very much a bottom-up
process, in line with how we manage equities", says Veys. But a
top-down tendency creeps in when Fidelity doesn't like the overall
state of the market, and risk positions can be scaled down sharply.
This happened last August, when new issuance died and swap spreads
became volatile, indicated a loss of credit-risk appetite by
investors in general. "We have been fairly deft," claims Veys.
So did Fidelity also avoid the widening of telecoms spreads
following M&A moves in the autumn? "If you've been in telecoms
at all, you've been hurt by the widening of virtually all names,"
says Veys.
He disagrees with the argument put by UBS Brinson and Baring
that investors need to focus more on portfolio structuring and
diversification, rather than being driven by views on individual
bonds. "If you take that to the nth degree, you create a rod for
your own back, because you're forced to buy bonds in a particular
sector." Besides, argues Veys, top-down management either equates
to risky and volatile betting on macro themes, or else it boils
down to an aggregate of bottom-up analyses. "Our belief is that to
do your top-down research, you have to know about the individual
companies in the sector. You can't understand the sector without
knowing what companies A, B and C in it are doing."
In 2000, Fidelity will continue buying the individual issuers
it likes, while keeping an eye on the technical situation in the
market in order to adjust its overall weighting. It hopes to
encounter more individual bargains like last years' Tecnost
floating-rate note, which was priced so generously to ensure the
successful LBO of Telecom Italia that its value immediately rose by
two percentage points after launch.
Ironically, the Olivetti-Telecom Italia battle also supplied
Fidelity with its biggest single disappointment last year: it bet
on Olivetti's existing paper widening when the bid for Telecom
Italia was announced in February. Instead, the bonds tightened,
because Italian buy-and-hold accounts had hoovered up the supply.
Veys argues that the feeble level of secondary-market activity in
euro corporate bonds means the market doesn't always react to
events as it ought to. He complains of "the lack of price action
from members of the buyside. There's still a mentality to hold to
maturity. The buyside has an obligation to help with liquidity."
Christian Roth, MSDW Investment Management
Christian Roth
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The second fan of bottom-up management in our quartet of
investors is the asset-management arm of bankers Morgan Stanley.
Head of European corporate bonds Christian Roth describes the
operation as "heavily bottom-up." After picking the names that
offer the best total-return prospects, MSDW IM turns to balancing
out sectors to temper the exposure to event risk. But the problem
Roth, like other managers, has to struggle with is that the best
total-return stories often crop up in familiar sectors: telecoms,
banks and tobaccos are among MSDW IM's favourites.
Roth notes that the best bonds for yield and capital
appreciation are often to be found in the medium-quality zone of
single-A to triple-B. Higher-grade corporates in Europe offer less
attractive prospects, because the overall trend in credit ratings
is bound to follow the US down to the middle range.
High-yield is the most attractively priced segment of the
European credit spectrum, believes Roth. However the lack of
diversity makes it unsatisfactory. Ostensibly, MSDW IM has a
European high-yield bond fund, but as Roth explains, this means
that "the objective is to invest in European high-yield. At present
around one half is invested in the US high-yield market. Our
intention is to raise the exposure to Europe as the market
develops." This high-yield fund was the firm's fastest-growing
product last year. In 2000, says Roth, "we would like to see a
broadening of the market. A market that is roughly two-thirds
telecoms and cables makes it difficult to build a diversified
portfolio. Another thing is increased issuance full-stop. Deals
like NTL [a e810m issue last November] that are large, euro-only,
and placed only in Europe are a healthy development."
Euro corporate bonds are an asset class in need of improved
practices by all participants, Roth says. "We're somewhat
frustrated by the size of issues and the level of liquidity. Many
euro corporate bond issues are done in the e200 million to e300
million range. They have less liquidity than equivalent issues in
the US market. We need to see more e2 billion benchmark issues, and
greater liquidity in the secondary market as provided by all
parties."
Part of the liquidity problem, as Roth and his fellow
investors note, is that the biggest European buyers include
commercial banks who look at bonds as a buy-and-hold tool for
getting a spread over Libor and Euribor. But another dimension is
that few investment banks (perhaps excepting the major bond traders
Salomon, Deutsche and ABN Amro) put much capital to work to support
a liquid market. Euro corporate bonds are a victim of their own
success: issuance and new investors' money have grown far more
rapidly than the capital base of the dealers and intermediaries.
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