Not so long ago, the world of fixed-income investing seemed quite straightforward for many fund managers, certainly in terms of the areas they were expected to keep an eye on. “In the 1990s there were a small number of assets or asset classes that you had to look at, which were government bonds and currency,” says Ceris Williams, head of Fixed income and currency at Rothschild Asset Management in London.
Of course within those parameters there was a full range of countries and currencies with which to contend, each of which in the process brought with it a large number of cross-market plays and convergence trades.
Today, Fixed income investors still see government bonds and currencies as important drivers in adding value. “They are probably the two biggest potential contributors,” says Williams. However what should be borne in mind, he adds, is that they are also the two biggest contributors to volatility in portfolios.
The effect of this is that though volatility from these asset classes is substantial and value added is there to be had, the Sharpe ratio (by which a fund manager’s skill in producing returns can be measured against the risk taken to achieve them) is not likely to be as good as in the previously less volatile environment.
As a direct result of this, investment houses are turning their attentions to other asset classes in a bid to Find more consistent returns. “What we are doing is putting a lot of effort into those two key areas because you have to,” says Williams.
“But we’re also looking at other asset classes, for want of a better word, and they are clearly investment-grade credit, high yield and emerging markets.”
The traditional balance of power in fixed income is changing dramatically as issuance in mortgage-backed securities and corporate bonds rises compared with government bonds (see chart of UK example).
“All Fixed income managers have taken into account the fact that the availability of securities in our market is changing,” says David Jacob, managing director, fixed income, Merrill Lynch Investment Managers.
“The most notable thing is that government supply is decreasing while the non-government markets, and credit in particular, is increasing.”
Peter Moore, director of Fixed interest at Henderson Investors, part of the AMP group, which runs £30 billion worldwide ($43 billion) in fixed interest, says the firm is moving with the times. “Credit is the one area where there is most value to be added. We are moving away from government bonds,” he says, adding that there is a clear reason for this. “Globally government bonds used to yield 10% but now they only do half of that. We live in a low-inflation world,” says Moore. “People are looking to add value over government benchmarks and to do that they are looking to use credit.”
Another big factor in the change in the bond markets, particularly for European managers, has been the end of European convergence plays – once seen as a source of easy money. “The intra-European convergence play has gone and with the benefit of hindsight you can say that things like the Italy convergence trade was an obvious trade in which you couldn’t have failed to make money,” concedes Rothschild’s Williams. “There’s an element of truth in that and the opportunity is no longer there.”
However he adds that the most important method of adding value is in the relative government market call between the US, Japan, Europe and the UK. “Those cross markets are still very much there but they are much more difficult,” says Williams. “They are certainly not no-brainers. Therefore they will probably be much more volatile in terms of the impact on tracking error. But if you get Japan-versus-the-US or the-UK-versus-the-euro view right it’s really where your biggest kicker is going to come from.”
Caught in a squeeze
So fund managers Find themselves squeezed by the disappearance of old opportunities and the fact that the corporate market has had such a hard time of late.
Pam Holding, director of European investment research at Putnam Investments, sums up some of the problems facing investors.
“For the past year we have been reducing our exposure to the credit markets in the US. We reduced it in high yield but not enough in investment grade,” she says.
“My feeling, as far as the European market goes, is that the universal mobile telecommunications system (UMTS) auction in the UK has driven the whole telecoms sector down,” she says. “The European high-yield market is extremely important for all these start-up telecom companies and there were 15 to 20 of them trying to issue.” On top of that, she adds, there was a Flood of paper to the market. Now investors know they will have to Finance UMTS infrastructure and marketing.
What investors really want to see now, says Holding, is positive, forward momentum in business plans. Other more drastic turns of events will probably also be necessary for the markets to take off again. “I also think that a couple of these telecom companies will have to go out of business,” she says.
The survivors will be those that already have a good level of funding. “That is the key,” says Holding. “Those companies which don’t have to worry about going to the capital markets and can just focus on their business are going to do best because the markets now are effectively shut, although a few deals are still sneaking through.”
She adds that not everyone is yet aware of the depth of the problem in the high-yield markets. “People don’t realize how difficult it is on the high-yield side at the moment,” she says. “Deutsche Telecom has come to market to Finance the build-up of its system but it is also looking to spin off cable companies. It cannot spin them out because nobody is funding them.”
The problem has reached such an extent, says Holding, that investment bankers are even advising investors to avoid the public markets and look instead at private equity markets where at least there are plenty of deals going.
| Moore: credit is best area for adding value | ||||||
Rothschild’s Williams says his firm is not a high-yield specialist so it has little exposure to corporate high yield. Nevertheless he is still concerned by the current market environment. “We look at the emerging markets and sovereign markets and we’ve got quite a lot of exposure there with the likes of Brazil and Russia,” he says. “The dramatic sell-off we’ve seen in corporate high yield hasn’t really influenced us but clearly we have to ask ourselves whether it is indicative of something in the financial markets.” He continues to monitor the situation closely. “If the US high-yield market and the corporate market in general were to continue to have a severe sell-off then it would clearly be tantamount to a credit crunch,” says Williams. “Companies would find it very difficult to finance themselves and we would clearly be very worried about that.”
If the commercial banks become less willing to lend because the corporate bond market seizes up as a result of people not wanting to play in it, Williams will be alarmed. “If companies aren’t able to Finance themselves through bond issues, and they cannot get money from the commercial banks, that would be crisis time,” he says.
However he stops short of drawing a parallel with 1998 when the US Federal Reserve became very concerned about the mounting credit crisis. “I don’t think we’re anywhere close to that kind of crisis situation at the moment,” he says. “But it’s possibly the beginnings of the makings of one if the current situation was to continue to unravel in the way it seemed to recently.”
Merrill Lynch’s Jacob echoes Williams’s views about 1998. “With the Russian crisis there was a lot of talk about the possibility that the Financial system as we know it would end,” he says. “There was a level of hysteria in the marketplace but since then we’ve gone well through that.”
So despite recent troubles in the corporate market, credit remains an attractive long-term option for fund managers, although they understand also the proviso that the basics of Fixed-income investing still have to be adhered to, in order to produce appropriate returns in their portfolios.
“If you look at what domestic US managers would typically claim that they can add from investment-grade credit, I doubt if many of them say more than 30 or 40 basis points beyond the benchmark,” says Williams. “But they would say they could do it on a fairly consistent basis with a relatively low volatility so the Sharpe ratio is going to be very good.”
| Jacob: government-only investing is over | ||||||
So credit has the attraction for fund managers of offering them the opportunity to add small amounts of value consistently – the sort of performance, in fact, that will appeal to pension fund clients looking for a steady income. However, it will not generate the 100bp to 130bp that portfolio managers need to make to grab the market’s attention. The greater part of any outperformance, says Williams, will come from calling duration and currencies. Nevertheless, credit still forms a vital part of the portfolio. “If portfolio managers are making those calls then it is good and right to have a steady 30bp coming from corporates,” says Williams.
This year fixed-income investors have not been helped by corporate-bond markets. Spreads have risen to 1998 levels when Russia defaulted on domestic debt and the Long Term Capital Management hedge fund was bailed out to prevent a crisis in the US. Consequently the corporate-bond market has priced in the strong possibility that companies will default. Meanwhile volatility in the equity markets has pushed concerns over credit ratings.
So the high-yield market is down more than 3%, according to the Merrill Lynch global index, while a Moody’s analysis shows the highest level of downgrades to upgrades since 1989.
Best of both worlds
The investment-grade sector is faring better though it is still underperforming relative to government bonds. This point becomes particularly stark for those managers being measured against government benchmarks.
“Where they are managing against sovereign benchmarks and have been including credit on an opportunistic basis, managers have been struggling, says Bill Muysken, a Fixed-income specialist in William M Mercer’s investment consulting team in London. “Credit spreads have widened so non-governments have underperformed and it has been very tough for managers.”
However in those situations where they are managed against benchmarks that have included corporate securities they have obviously performed better relatively.
Some observers may feel that fund managers have tried to have the best of both worlds here. Using government benchmarks to begin with was supposed to make outperformance using credit relatively straightforward. Few would have forecast the problems of this year which have meant that corporates have underperformed government bonds.
The main thing most managers will agree on, especially in the current environment where issues such as telecoms have generally performed very poorly, is that it is better to try to spot trouble rather than go after the stellar performers. This is where good analysis can become gold dust.
“A very important aspect of the research is having the analysis that lets you avoid the blow-ups,” says Rothschild’s Williams. “If you look at the pattern of adding value from corporate bonds you add an awful lot more if you consistently avoid the worst 10% than if you consistently get the best 10% right.That’s because the best 10% typically don’t outperform the average by as much as the worst underperform.”
This leads to a big skew in the distribution of returns on corporate bonds, Williams adds.
“Clearly there will be a wide range of performance,” he says. “People who have been very gung-ho on credit and therefore more likely to be exposed to some of the worst-case stories, could be in a very grim situation.”
Merrill Lynch’s Jacob believes that, even thought the corporate sector has had a very difficult year in 2000 and fixed-income investors have been through a hard time, in the longer term the prospects are good.
“What has been driving value in the bond markets has not simply been focused on the underlying economics or the traditional economics, but increasingly driven by the supply and demand factors,” he says. “That includes the drying up of government debt and the increased issuance in corporates. We probably have two phases at the moment in the spread markets and really we have had a continuous widening in spreads versus governments for the last couple of years now.”
This has made the spreads market increasingly difficult to play in, Jacob argues. “Once the relative supply became an issue with a lot more issuance of corporate bonds and a lot less of governments, this is the First time we have had a credit discussion.”
However, he remains upbeat. “I think we’re pretty confident that over the long term investors are going to want to own non-government bonds,” he says. “I’m conscious of the fact that near term it’s going to be a bumpy ride. But the yields available at the moment, barring some economic catastrophe, are pretty attractive.”
Benefits of diversity
So with corporate bonds set to become increasingly important, and aggregate investing set to become the norm, inevitably the issue of benchmarks needs to be addressed. “From the point of view of adding value it’s better to have more diversity, more asset classes in the benchmark,” says Williams. “You’ve got more of an inventory that you can manage and crucially you can underweight as well as overweight so if you haven’t got corporate bonds in the benchmark you can own them. Every fund manager would prefer the opportunity to underweight as well as overweight.”
Putting corporate bonds or overseas bonds into a traditional benchmark is a good thing for Final total return, he argues. “You have the diversification of opportunities, so you get a better risk/return profile,” says Williams. “Over and above that your investment manager can then add value relative to that benchmark with the symmetry of opportunity. So hopefully you come out at the end of the game with your benchmark being a better risk/return benchmark than just the single index.”
Net, at the end of the cycle, the investment manager should be able to add more than he would with a non-symmetrical opportunity set, argues Williams. He favours variety in the benchmark as long as it does not go too far with lots of tiny percentages.
Merrill Lynch’s Jacob agrees that benchmarks are changing, which is good news for investors. “I think that’s definitely the way the market and the business is going to move,” he says. “We see it on a global scale with the interest in aggregate investing.”
The move away from government bond indices is being driven not just by the relative supply of government and corporate bonds but also by the increasingly large portion that is invested in Japan in the traditional government indices, he argues.
“When it was a US index with US bonds it was one thing,” says Jacob. “I think Japanese bonds, given their outlook and the difficulty they have had, are tougher for investors to swallow.”
However investors have also been hit by underweighting Japanese bonds when they failed to predict the yen’s strong recovery against the dollar.
So now the non-government universe has less allocation to Japan but Jacob falls short of believing there will be a wholesale change to the market. “From an investor’s point of view, I am of the opinion that we are not going to end up with disappearing government markets,” he says. “I think they’ll be around but I do think there’s a parallel with previous events. In the late 1980s in the UK there was some talk about the disappearance of the gilt market. It was much rumoured but it didn’t happen.”
There is another important difference between today and previously, says Jacob. “I think the difference this time is we have a deep enough corporate market and a deepening corporate market in Europe,” he says. “Everyone knows about the corporate market in the US but now there is a deep enough market outside. Corporates, or non-governments, are here to stay with the investor community so I think the days of the government-only investor have probably passed.”
However, despite this, there is a common view that the traditional investment methods need to change.
“No doubt the most challenged asset class is the traditional global bond business,” says Jacob. “The asset class has had a tough two years but it is in the process of transforming itself to include corporates which will widen the opportunities for investors as well.”
This inevitably means benchmarks will change, he adds. “The benchmark question right now is a hot topic,” says Jacob. “It’s a hot topic for us as investors in terms of when we set up a fund and what we use as a benchmark because we are in the initial phase of this rush toward non-governments.”
Scramble for analysts
One of the more obvious results of this widespread move into credit is that Firms, particularly in London, are looking for analysts to research companies. It is creating an over-stretched market that shows little sign at the moment of relaxing.
“For a while every Fixed income manager we met said they were looking for people to handle credit analysis and we did wonder where they were all going to Find them,” says William M Mercer’s Muysken.
One London headhunter confirms this: “Everyone is out looking for credit analysts at the moment. It is not easy for supply to meet demand.”
Rothschild is just one of several houses that recognizes the need to address this issue. “We are putting a lot of effort into research and people,” says Williams. “We’re trying to build up our credit analysis effort. We think we’re pretty well placed in terms of portfolio management implementation skills but we realize we’re a bit thin on the analysis side.”
As in other areas of investment management, the larger global houses, such as the likes of Merrill Lynch Investment Managers, have an inherent advantage in being able to draw on powerful existing resources.
Although unwilling to single out individual houses as being most successful at building global credit analysis, Mercer’s Muysken says: “Those who have probably done best in this area are those fund management operations that had an established US credit operation.” This gives them two options, he says.
“Either they could expand the universe of US credit to include other countries into the sectors,” he says, “or what some other Firms have been able to do is send experienced people over from the US to set up and build a European credit team.”
At Merrill Lynch Investment Managers, Jacob certainly does not suffer from any inferiority complex when it comes to his team’s credit analysis effort. Merrill Lynch has 35 analysts worldwide in its investment management arm. “We have done a lot over the last couple of years to focus on the credit side,” says Jacob. “My own opinion is that we have one of the strongest credit teams there is.”
He adds that although the firm is still looking to beef up this side of its resource, it is already strongly established. “Are we investing in credit? Yes. Are we putting our resources into this and bringing in people who can focus on credit? Yes. But we’re really supplementing what I consider to be a strong team,” he says.
According to Muysken, the larger global operations have stolen a march on the smaller investment houses. “The firms that have found it tougher going are the ones that have had to start from scratch,” he says.
Insurers’ advantage
Insurance houses, used to investing heavily in their domestic credit markets also had the foundations for global credit teams ready-made in-house. This means that in European markets such as France and Germany, the insurance powerhouses of AXA and Allianz have very strong positions.
The Australian insurance giant AMP is another good example. Through its Henderson investment arm it is gearing up its global credit product. As Moore says, the Firm is keen to hire people but is already strong in this area.
“Finding experienced and well-qualified people is always difficult but we are lucky because we have had credit as a large part of our operation for the last 10 years,” he says. “However we are increasing our efforts in this area because of the Flow of money into credit.”
However Rothschild’s Williams says the smaller Firms can still punch their weight in the market, despite being outgunned in staff levels. “The bigger Firms clearly have an advantage in sheer manpower terms when you’re talking about the US domestic market but just how leverageable that is globally is harder to say,” he says. “There are advantages to having that kind of manpower but there will be management and process issues to confront as well.”
So investors are confronting interesting times, not least with the wholesale shift towards a corporate market that is currently struggling.
In this environment, a need to produce the best research analysis will separate the good outfits from the bad. But will the advance of credit mean the end of traditional investment nous?
“As a market player, there is a different emphasis,” says Jacob. “People worry that the old skills are going to disappear. I don’t think they are, I think what we will end up with is a more balanced set of skills, a more balanced set of opportunities to add value in.”
Macroeconomics, which attracts most bond investors, according to Jacob, will still be an integral part of the process. “That is still such an important part of what we do,” he says. “But I think inevitably credit analysis and sensible portfolio construction, all of those things are going to play an increased role.”
