The panel debate whether this fixed income cycle is moving at a different pace
In this week’s Conjecture our panel discuss whether this fixed income cycle is different from the norm and how managers are positioning themselves going forward. The panel also examine changes in ratings.
This week’s panel comprises Bryn Jones, manager of Rathbones Ethical Bond fund; Mike Zelouf, head of international business at Western Asset Management; and James Mashiter, lead analyst from Standard & Poor’s Fund Services.
One of the interesting things about fixed income in this economic cycle is it feels like the sector has a lot further to go. Normally there is a fairly short rally in corporate bonds, everybody gets very excited for a year or so and then people get bored with fixed interest and go back to equities. It feels it has a lot longer to run this time. Is that summation correct?
Bryn Jones (BJ): To a certain extent yes. We are still seeing financial spreads wider than they were pre credit crisis particularly in some of the subordinated areas and some of those banks with government money in them. We still feel there is a huge amount of value to go in the financials.
In the corporate space, less so. We are looking at spreads that perhaps are getting near to long-term average, if not through long-term averages. Coupled with that, you have base rates and underlying government bond yields, which are very low and in some of those corporate names the overall yield is lower than pre credit crisis, so we are just a little bit wary about how we generate returns from here.
James Mashiter (JM): The last couple of years have been exceptional. In 2009 there was such a huge liquidity premium that any normalisation of conditions was going to see those spreads come in a long way.
Last year was very much a beta rally and I think the easy money has been made. 2010 is going to be more about idiosyncratic risk and discriminating between strong and weaker credits.
However, inflows are still pretty strong, the technicals are good and that is obviously supported by a near zero interest rate environment. But investors should not expect the returns they had in 2009.
Has the easy money has been made in fixed income markets?
Mike Zelouf (MZ): I would agree with Bryn and James in terms of the backdrop and like Bryn I still see value in financials, although I have to say one needs to tread carefully. I agree the focus is on the idiosyncratic risk.
What makes this cycle a little different is the extent to which the degree of indebtedness helped create the magnitude of the financial crisis that has now been socialised in public sector balance sheets. That problem has not gone away. Even on the Treasury’s cautious assumptions on the UK, debt is likely to double from about £740bn in the UK to about £1.4trn by 2014/15.
There is still that aspect and we have seen some shock waves from Dubai, Greece and other countries spilling over into the market. This is another element that needs to be taken into consideration, notwithstanding attractive valuations in financials.
We also see some pockets of value in things like high yield because we think default rates are going to drop. Also, some corporate issuers in the emerging markets space are still offering a decent premium over equivalent rated corporates in the US and Europe.
Mike, talk us through the way you have your portfolio set up at the moment.
MZ: One of the big shifts we made in the last year has been reducing our exposure to agency mortgage-backed securities.
Those are securities that suffered during 2007, but particularly 2008 with the problems in Fannie Mae and Freddie Mac. Essentially they are a government risk and when they were effectively nationalised, we thought they offered good value.
But as spreads have narrowed, we have reduced that and our focus has been more on credit. In Europe it has been in the financial sector, for some of the reasons Bryn mentioned. We do feel the liquidity premium in financials is gradually reducing, but they are still trading at a premium to, say, utilities.
Our thinking in terms of our overweight to financials is that in order for the system to work, financials need to be able to borrow more cheaply than industrials and essentially provide credit to the rest of the economy. We think those spreads will equalise and our focus has been on overweighting the financial sector and underweight industrials.
There is also a supply element with the Basel proposals. The use of hybrid capital, subordinated financials, will no longer be permissible and so banks are going to need to increase capital and the quality of capital on their balance sheets.
They are going to need to do that in ways other than the subordinated debt they had in the past.
So I think from a supply perspective, improvement in the balance sheet and reduced leverage, those are the things driving us towards maintaining a position in financials and selectively in subordinated financials. But the rally has argued for improving slightly the position in the capital structure.
High yield is predominantly based on the fact we think we are in a positive part of the economic cycle.
That is conducive to lower default rates and although yields have come down significantly, we still think they overcompensate for default rates, which are going to come in under 5% this year.
We have reduced our exposure to emerging market sovereign debt, but still see value in the credits, because of the economic growth in those regions.
Bryn, talk us through some of the thinking behind your positioning on the Ethical Bond.
BJ: We have been overweight financials, overweight insurers and similarly to what Mike was saying, we are actually playing the Basel III and Solvency 2 regulations at the moment.
The new rules will mean some of the bank capital out there at the moment, which is being used for regulatory purposes as core Tier one capital, will no longer qualify for regulatory capital. So, effectively, banks and insurance companies will have bonds outstanding that are absolutely no use in a capital structure and because they are quite expensive for them, they have higher yields generally than senior and some of the other debt, it just becomes expensive outstanding debt.
These new rules have thrown up a huge opportunity and we have been actively trying to find which bonds we feel will no longer be able to be used as regulatory capital.
In fact we have already benefited from that, and we bought HypoVereinsbank 7.76% 36 call 34s on this view. Unicredito have actually gone out and tendered for that bond and we have got the cash for that. We have loads of other little ideas which we plan in that theme.
The other point as well about tier one is all the time a bank is paying its equity dividend, you have to have your coupon fulfilled. Through the credit crisis, a classic example was ANZ Bank, which is one of our top 10 holdings. The Bank was still paying its equity dividend all through the credit crisis. And we felt that this bond got treated as badly, if not worse, than any other Tier one debt and the yields were extortionately high, which was very attractive.
So we are continuing to try and find value. The easy money, the beta has gone, but there are still pockets of value out there and understanding the covenants behind the bond can really be quite important.
Similarly on the insurance side, the Solvency rules there could have an impact and we also feel there could be some opportunities although they are potentially harder to find.
Finally the other issue about all this is the fact if banks and financial companies are forced to hold more capital, as a debt holder, that is going to make us a lot happier. It is the equity holders who are complaining about the fact these businesses are unable to generate the excess returns to support an ever growing equity price. So we think this is fairly positive for the sector.
From S&P’s perspective, what trends have you noticed in terms of the way the sector is being rated? Has it moved more quickly, have spreads changed significantly?
JM: Tier one is the lowest ranking form of debt in the capital structure. It is loss absorbing and coupons are deferrable, but investors are compensated with a higher yield. In Q1 2009, tier one was pricing in Armageddon and the sector was seen somewhat as a binary bet.
A lot of managers felt this was not their area of expertise. It is very opaque and it is hard to value this stuff because we do not know what the regulatory environment is going to be. Some guys just had it in their portfolio and could not shift it and obviously the worst thing from a performance perspective was to get rid of it this time last year, because it has rallied really strongly.
I think Bryn has covered most of the areas but in a capital raising environment, one of balance sheet repair, that is good for bond holders, but not so good for equity holders, in an increased regulatory environment. So a lot of people still have banks, while more risk-averse fund managers have utilities. They might be a bit richer but in the event of a double dip, you have got more certainty of the cashflows, and there is more transparency in the underlying business.
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