Fixed Income
Close-up on corporate credit
After a volatile summer, opportunities abound at home and abroad
Risk increased over the summer in corporate credit as a market correction rattled spreads and brought issuance to a standstill. But with lower valuations and an increasingly global fixed income world, investors are finding new opportunities, making the corporate bond market a compelling, ever more diversified investment arena.
The investment-grade corporate bond market went through a significant repricing starting at the end of July, with spreads widening to roughly 200 basis points as of the end of August from 140 basis points at the beginning of summer. "The widening has been significant," said Colleen Denzler, Senior Vice President and Head of Fixed Income Strategy at Janus Capital Group. "Corporate credit has really underperformed in August and early September, but as a result, many investors now view this sector as being more attractive. Companies with strong balance sheets and flexibility will do well. They don't need 2.5% growth to excel. Companies that aren't as financially stable will suffer."
August 2011 will likely be one of the worst months of negative excess return for credit, rivaling with the financial crisis of 2007 and 2008, say experts. But for investment- grade credits, although spreads have widened, yields have remained low and will likely stay low, benefiting from low Treasury rates, which makes the asset class attractive for both issuers and bondholders. According to Moody's Investors Service, the 2.79% average yield of single-A corporate debt as of the end of August falls far short of the historical median of 5.36%.
"All-in, yields remain very low, under 4% for the investment grade corporate market," said Steven Huber, Portfolio Manager in the Fixed Income Division at T. Rowe Price. "When Treasuries rallied, yields went below 3.5%."
During the market sell-off, financial services firms and cyclical corporations took the brunt of the pain with the basis between the credit index and the bank sector doubling to more than 100 basis points, according to Jesse Fogarty, Senior Portfolio Manager of Corporates at Cutwater Asset Management.
"There seems to be two different markets in investment- grade credit," added Huber. "Industrial non-cyclical companies have prompted a huge demand for new issues and so spreads are tighter. Financials have wider spreads because there are concerns with the economic recovery and the turmoil in Europe."But views differ as to whether bonds of financial services companies present attractive opportunities.
Huber thinks it is too early to invest in bonds of financial services companies. "In terms of value, we favor industrials over financials, but with the yield difference, at some point financials will be more attractive as the recovery progresses and their mortgage and legal issues are resolved," he said. Cutwater is more bullish and has selectively added to senior bank debt positions, in particular in the front of the curve where the firm believes the bonds offer good value, driven by strong fundamentals and a robust technical picture. "In the continual search for yield, investors can triple their yield relative to Treasuries by buying high-quality senior banks in the five-year part of the curve," said Fogarty. "From a fundamental perspective, banks are in a much different situation than the 2007/2008 financial crisis, with capital ratios at highs, leverage vastly improved, and much better asset books. Finally, increased financial regulation bodes well for senior bonds as banking entities become more utilitylike from a risk/return perspective."
Janus has made the case for months that corporations are in very strong financial shape and would be able to withstand a slowing in the growth of the economy. "We still believe that to be true based on our research. Given the relative attractiveness of the asset class in a low-yield environment, we believe corporate credit is still in a position to do well and offers the best relative yield and risk/reward versus other fixed income sectors, despite tighter spreads. We have been recommending our clients have more flexibility to allocate to spread products such as corporate credit to shorten the duration of a portfolio so it is less sensitive to interest rates, and afford more yield to protect capital in a rising rate environment," Denzler said. "In addition, the ability to move a significant allocation to cash and cash equivalents can be used as a hedge in volatile and uncertain markets."
Issuance slows in August, still strong for the year
The low level of yields has caused a lot of new issuance and has allowed companies to build cash, while the spread premium for investors has remained advantageous. "New issuance is strong this year because companies have taken advantage of lower rates and there's also very strong investor demand to gain additional yield over Treasuries without going too far down in credit quality," said Huber.
Broadly speaking, global corporate issuance, which came in at $126 billion in August, fell by 30% from July as a result of spread widening. The high-yield new issue market effectively shut down as investor risk aversion spiked and there was also a sharp contraction in financial institutions issuance, as noted by Moody's. The high-yield primary market only returned in the first week of September with the announcement of two deals, both of which remained subdued: These were a $200 million bond by refiner Calumet Specialty Products Partners and German healthcare group, Fresenius Medical Care AG, priced at $400 million, and a EUR400 million bond deal.
But despite August's weak issuance numbers, yearto- date issuance in 2011 is still slightly higher than last year. "Issuance has gone up in investment grade and in high yield," said Denzler. "With yields as low as they are, it's a great time to refinance. For the most part, there's been access to liquidity."For most of the year, corporations have used debt issuance in a conservative manner, mostly for refinancing purposes and to extend maturities. "But companies were also starting to raise debt for shareholder- friendly actions again before summer because they had already paid down so much debt," said Denzler.
In an Aug. 29 report, Fitch Ratings wrote that from a bondholder perspective, funds borrowed for purposes other than refinancing constitute a modest credit negative because managements are likely to feel pressure to eventually put borrowings to work to boost shareholder value through increased capital expenditures, share repurchases, dividend hikes or merger and acquisition activity.
Investment-grade companies that took advantage of low yields so far this year include Walt Disney Co., Coca- Cola Co., AT&T Inc. and Procter & Gamble Co. "Few of the entities that have issued debt at recent levels have earmarked borrowings for shareholder-friendly actions," the ratings agency wrote. However, Fitch notes that in many instances, issuer liquidity was robust prior to issuance and incentives to keep excess liquidity warehoused on the balance sheet may erode, as management eventually comes under pressure to earn their cost of capital. So far this year, mergers and acquisitions have represented roughly 20% of all high-yield issuance, still a modest level, according to Huber. He noted that it was around 50% in the 2006 and 2007 timeframe. "On the high-yield side, a lot of new issue activity has been for refinancing purposes," he said. "So far this year, roughly 50% or more of issuance is used for refinancing."
High yield credits hit harder
Companies aren't out of the woods yet. If spreads continue to widen, it could crimp earnings and limit access to needed capital, especially for high-yield companies, which haven't benefited from lower yields like their higher-rated counterparts. Earlier this year, strong mutual fund inflows into high-yield bonds and leveraged loans drew spreads in to the mid 500 basis points. But starting at the end of July, that trend began reversing, which drove spreads to the mid 700 basis points.
The yield on U.S. high yield bonds reached 8.45% as of the end of August, up 0.19% from its year ago level and 1.83% higher than this year's bottom. But thanks to the heavy refinancing activity in the past couple of years, corporations have the ability to wait out the current drop in liquidity, according to Moody's.
Additionally, in the first week of September, highyield mutual funds saw an inflow of $577 million, the first positive inflow since the end of July. Despite this reversal, bank loan retail mutual funds continued to see funds withdrawn.
The summer spike in high-yield spreads also lifted the number of issuers classified as distressed, which are defined as those with bonds having spreads in excess of 1,000 basis points. Such distressed issuers made up 8.9% of all issuers at the end of July, according to Moody's. The risk with having a greater number of distressed issuers is that the speculative default rate spikes.
"The five-year cumulative default rate implied by recent high-yield spreads is well north of the Great Depression peak default rate," said Gautam Khanna, Senior Portfolio Manager of High Yield and Global Strategies at Cutwater Asset Management. "Spreads are particularly attractive in the double-B segment with current spreads at 554 basis points and wider that are compensating investors for a 42% level of default that will far exceed the default rate within that credit quality," he added.
"During this spread sell-off, while higher quality has held in better in absolute terms, it has underperformed historical relationship-driven expectations. We believe the relative underperformance of higher-quality high yield is due to liquidity-driven technicals and presents us an opportunity to add to our high yield allocation in high quality credits at very attractive spreads."
The default rate also ticked lower in August. Moody's global default rate came in at 1.8% in August, down from 5.1% a year earlier. In the U.S., the default rate was 2.1% in August, down from 5.1% a year earlier. Moody's expects the rate to end the year at 1.5% before rising again up to 1.9% by August next year. Again, this low rate was made possible by easy credit, which has allowed companies to refinance and renegotiate their credit facilities and to avoid missing payments.
"Defaults are low, as companies have improved balance sheets," said Huber. "For a couple of years, a robust new issue market has allowed companies to refinance debt, extend maturities, raise cash on the balance sheets. This doesn't eliminate the risk, but puts them in much better shape to weather a slow growth environment."
Fixed income goes global
As investors learn from the mistakes of the 2008 financial crisis, they are increasingly seeking investment opportunities outside of the U.S. in addition to domestic investment-grade and high-yield corporate bonds. With the global economy stronger than in the U.S. in many ways, they are seeking to find investments all over the globe and in particular in emerging countries. While U.S. gross domestic product was $14.5 trillion for 2010, the same as Brazil, Russia, India and China, or BRICs, plus Asia combined, the bond market in the U.S. is $32.5 trillion, dwarfing that of the BRICs and Asia, which stands at $1.8 trillion, according to Dan Janis, Portfolio Manager at Manulife Asset Management.
"As Asia excluding Japan transitions from an exportdriven economy to a consumer-driven economy, the local bond markets will further develop to support the growth of the middle class in this region," he said. "That will present a massive opportunity in the next 10 years."
His firm decided to get exposure to bonds from outside the U.S. with its global multi-sector fixed income strategy, which holds $10 billion in assets under management. Although the strategy isn't new, it has gained traction in the last two years with institutional investors particularly focusing on it in the past nine to 12 months. "A lot of consultants want their portfolios to be dynamic," Janis said. "That's a different theme from five years ago when they wanted to be benchmark centric and put you in a box. Investors are looking for ways to diversify and take on more yield and managed risk."
Most demand has come from defined benefit plans, while there has been less demand from endowments and foundations, although it fits their risk/return profile. "I expect them to express an interest," said David Zielinski, Fixed Income Product Manager at Manulife. Investing on a global basis offers not only currency diversification and protection against rising interest rates, but also the potential for equity-like returns with fixed income volatility.
As of July 31, 46% of the Manulife portfolio was in foreign bonds, including some bonds from developed countries like Canada, Norway, Australia, New Zealand and Sweden, and some from emerging markets including Singapore, Korea, Malaysia, Indonesia and the Philippines. In these emerging markets, Manulife focuses mostly on corporate bonds or supranationals, mostly dollar- denominated because local currency bonds lack sufficient liquidity. "As local markets develop and liquidity improves, we expect to embrace more local currency bonds," said Janis.
Global investing has become an essential part of a well-diversified portfolio. "Going global offers investors a chance to generate income from a much broader opportunity set, in some cases with greater potential yield," said Denzler. "Just as more U.S. companies are tapping into markets abroad for greater opportunity and potential stability, bond investors can benefit from sources of cash flow that are less correlated to their domestic market."
The Barclays Global Aggregate Bond index is comprised of roughly 61% of non-U.S. bonds, compared with 34% in 1991. "The G7 economies are expected to lose approximately 10% market share of world GDP, on a purchasing power parity basis, over the next few years. A forecast of approximately 35% market share, down from 50+% in the early 1990's. This market share is being picked up by Emerging Asia, and the story there, not surprisingly is the growth of China and India. This is a structural change in the fortunes of the globe and not simply a cyclical phenomenon which we believe fixed income investors in a Global Portfolio should exploit." said Khanna of Cutwater. "The fundamentals of many of the well-established emerging economies have improved and continue to improve." He added that 70% of emerging markets tradable bonds are currently investment grade.
Some of the criteria Cutwater looks for when identifying emerging economies for fixed income investments include vibrant economies that are exhibiting sustained, above trend, GDP growth; countries with responsible central banks that are disciplined in fighting inflation; countries with stable to appreciating currencies; and countries with deep capital markets. According to Cutwater, Brazil fits most of these criteria, despite its high inflation, and so does Mexico, although Khanna thinks the trade has been mostly played out there, as well as in Chile, India and Malaysia.
"The diversity of circumstances within emerging economies argues for important country-specific differences within the broader cycle," said Khanna. "This is where systematic research and detailed monitoring of country-specific macroeconomic conditions pays off. Only exceptionally emerging market trades are good trades."
Huber at T. Rowe Price also likes Brazil and Mexico, where his firm invests in non-dollar sovereign bonds as well as corporate bonds. In China, it invests in currency forwards rather than bonds, since the bond market is less developed. "In countries where we want the currency risk but not the credit risk, we buy currency forwards," said Huber. But experts note that investors should be careful in seeking managers and should focus on those with longterm track records and with a global network of resources and infrastructure. Only once investors have found such skilled managers, will they be able to achieve enhanced returns and diversification, which has become increasingly important in the past several years.
"Diversification makes the most sense in a portfolio given the heightened uncertainty and higher volatility, and should ideally be global to take advantage of a more diversified universe," said Huber.
SPONSORS
