We live today, in a somewhat surreal world where, as Tim Bond, the author of the Barclays Capital Equity Gilt Study points out, £800bn (€1.2trn) of final salary UK pension schemes are trying to buy £41bn of long dated index-linked gilts, which he likens to an elephant trying to squeeze into a mini!
With real yields on long dated index-linked bonds driven down to less than 0.5%, it is not surprising that serious questions are being asked about misallocations of capital, and the justification of current spreads on corporate bonds. The spillover into a booming demand for conventional bonds has driven down long-term bond yields to levels which look suspiciously like a bubble, and has had the perverse effect of increasing the present value of liabilities and hence pension fund deficits despite booming equity markets, thereby exacerbating the very problem that a stricter liability driven focus was intended to alleviate.
While corporate bond spreads are at historical lows, and many would dispute whether they represent adequate compensation for credit risk and offer a liquidity premium, desperation for yield ensures that spreads may remain tight for some time. But as Andrew Sutherland and Craig McDonald of Standard Life Investments (SLI) point out: “If interest rates or government yields rise significantly then people won’t need credit for that extra yield they require.”
In addition to deciding whether current levels of spread are offering sufficient compensation for the risks, bond managers have had to cope with the downgrading of US auto firms from investment grade to high yield and the impact of private equity on the marketplace, with little protection for bondholders in the event of a highly leveraged acquisition leading to the downgrading of outstanding bonds. Their scope for manoeuvre has been made somewhat easier by the growing acceptance of the use of credit derivatives in the management of corporate bond portfolios.
Are investors being compensated for risk at such low spreads? Kevin Corrigan of Fischer Francis Trees & Watts sees that “risk premia in many assets are low and in corporate bonds is unsustainable” while SLI’s Sutherland has the view that “there is still value there in the short term, but this is pretty much as good as it is going to get”.

Jean-Francois Boulier, at Credit Agricole Asset Management (CAAM), points out that dividend yields on equities start looking attractive at these levels. “As a bond investor, I look at the earnings stream and look at the premium – when I look at the liquidity premium and take away the default spread and compare that with the equity dividend stream, bond prices look high.”
Pimco’s Robert Mead makes the point very strongly that while overall spread levels may look reasonably stable as reflected by credit indices, there has actually been a bifurcation taking place in the marketplace, with spreads on banks tightening and other sectors widening significantly. The telecoms sector, for example, is now looking attractive again. “If you take a 10-year BBB bond and hold it for its whole life, the chance that it will default is 4%. So on the basis that the average recovery rate is 50%, you have a 2% loss of principal over 10 years.
In a diversified portfolio, if you get an extra 20bps on the rest of the portfolio, you would breakeven. On that basis, 10-year BBB telecom paper offering 75-85bps over government bonds looks attractive even after taking account of other risks such as liquidity, spread volatility and rating changes.” He goes on to add that “10-year BBB banking paper is also offering 60bps and historically has had much lower default rates” and as a result, banking debt along with emerging market corporate debt are two areas that Pimco are favouring.

The global economy is fairly strong, and while Mead sees corporate leverage increasing at the margins, it is not a leading indicator of defaults. McDonald opines that “corporate profitability is at very strong levels, the level of earnings growth will fall but it will probably remain positive. The level of liquidity in the system means that there is sufficient liquidity to bail companies out which get into trouble. So in the short term the environment remains very supportive.” However, he adds that “longer term there will be a time when the economy turns”.
The huge growth of private equity leveraged buy-out transactions in Europe is having a significant effect on the debt markets, not just through the increased supply of
high yield debt and secured loans.
As Sutherland points out, “shareholders are selling out to private equity firms who are replacing
the equity with debt. When that happens it is invariably negative for existing bond holders, and increasingly these are BBB and A rated companies. This time around though there is a wall of money, the sheer scale of some of these investments is different.”
Boulier also expands on this theme: “The private equity firms have many more bullets than in the past; they can buy companies much larger, €10-20bn even €30bn. Investment banks are craving fees and with merger finance and everything else, everyone gets part of the cake in an LBO.”

For the shareholder this can bring benefits, as Sutherland points out. “The threat of LBOs encourages senior management to act in a more shareholder friendly manner. A couple of years ago CEOs were focused on repairing balance sheets and that was good for credit. Now, though, they are focusing on growth in shareholder value which, while not necessarily bad for bond holders, does make some credits vulnerable as quite often it will involve leverage”.
The threat is less in the sterling market where a big percentage of the sterling index is in financials, “which are very sensitive to credit ratings and so less likely to become overly shareholder friendly”, according to Sutherland, who goes on to add: “Compare that to Europe and the US where there is a much greater proportion of industrial BBBs and these are more likely to leverage up and go non investment grade. Certainly you saw a lot of that last year in the US and in Europe you are beginning to see it this year.”
The real problem is for investment grade “because these are the companies which will leverage up into high yield. If you are a high yield investor you are starting afresh. In the long term there are obviously a lot of highly indebted companies in high yield, but in the short term the economy is good, interest rates are low, things are fine.”
Managers need to be very aware of which sectors and companies are most at risk, like Portugal Telecom, “which has a good chance of being taken private, and bond spreads there have already blown out”, according to McDonald. Bond managers need to be particularly aware of the details of the covenant protection available to them. A change of control covenant for example, can be beneficial since, as Pimco’s Mead points out,
“it can lead to bonds trading below par having to be repaid at face value”.
Conversely, in the absence of such a covenant, “the bond may become subordinated to other debt, and in any case, will be part of a more leveraged capital structure”. The event risk can also be dependent on the maturity of the bond. In a private equity transaction, Mead finds that “banks do not like short-dated liabilities so bonds that are less than three to four years maturity are very well protected as they are likely to be refinanced into longer-term debt”.
CAAM, according to Boulier, has developed “its own radar system to detect which sector or companies may be likely to have risks”. FTTW’s Corrigan sees these risks as more idiosyncratic than systematic though and feels that “it is easy to overstate the risks. Some industries are more exposed to private equity bidders eg, those with strong cashflows that are not cyclical and not highly regulated are more interesting for private equity firms.” His view is that “for many private equity investors, the lead times are long, but the IRRs and multiples have been getting lower and the number of dealmakers in private equity firms is limited so it is easy to overstate their impact. Spreads will drift wider but not by a large amount.”
The private equity-led growth in the issuance of secured loans, traditionally dominated by commercial banks, has led to some fund managers such as Henderson Global Investors managing portfolios of them for institutional investors. As they point out, the European market is estimated to represent over $300bn (€252bn), which is more than three times the capitalisation of the European high yield market. As these are floating rate, and high yield, they may not be seen as suitable for any cashflow matching applications, although the extra yield may be tempting when combined with interest rate swaps.

The increased use of credit derivatives by mainstream fixed interest fund managers is a trend that is transforming the management of corporate bond portfolios. The introduction of the iTraxx European indices of credit default swaps gives the ability to access a diversified portfolio of European credits in a low cost liquid format and is widely used by investment banks as a proxy hedge against senior tranches of CDO portfolios.
Boulier for example, explains that “we use the derivative markets more and more. Last year was the first year of real use of credit default swaps in many strategies and we also used tranches of iTraxx”. Corrigan uses CDS extensively, particularly in their absolute return targeted portfolios where “they are 80% of what we do in our total return portfolios. These typically have Libor  benchmarks and have return targets ranging from Libor + 1.5% to Libor + 4.5%.  We allocate the cash to cover margin and invest the rest in Libor based instruments. The alpha is generated on top of that through derivative exposures.”
There are, however, still some issues that managers such as SLI are concerned with: “We are starting to use credit default swaps in some of the life assured and annuity funds but we haven’t started using them in a wide range of client funds yet. As an industry we are concerned about the accounting procedures and actual systems which have grown up behind CDS. Its development has been very ad hoc, we would like to see more robust systems and valuation processes before we commit client money. In this environment we do not feel we are really missing out because CDS are most powerful in their ability to short names, and that’s profitable in a bad credit environment which we obviously aren’t in. We know quite a few people who have shorted names and the carry cost of shorting has outweighed any benefits, there hasn’t been enough volatility.”

The fundamental difficulty that any corporate bond manager has to face in a long only portfolio is that the risk-return trade-off is highly skewed, so that it is far more important to avoid losers than to find winners.
Use of credit derivatives has changed the opportunity set available to corporate bond managers, enabling them to go short giving a symmetric risk profile for the credit-based hedge funds. However, long-only managers are still faced with the issue of beating a benchmark index, which, while useful for performance comparisons, would not represent an optimal portfolio. As a result, managers need to be comfortable with deviating substantially from the benchmark and eliminating stocks irrespective of index weighting if they have a negative outlook.
As Boulier points out: “What happened last year to General Motors and Ford was very bad. The downgrades by S&P were at the end of March, but the bonds were kept in most indices for another two to three months.”
The danger for managers and ultimately for institutional investors, is the perception that ‘risk control’ means ensuring that deviations from index weightings are kept low, entailing holding bonds that the managers would rather be short of than long, given an opportunity. Capitalisation weighted fixed income indices suffer from that fact that a fundamental difference between equities and debt indices is that the amount of an issuer’s debt represented in a bond index is not very sensitive to the market’s pricing of its debt.
The credit spread forms only a small part of a bond’s yield except for high yield or distressed debt portfolios. As a result, we have the perverse result that the weaker an entity becomes financially through the issuance of more debt, the more an index will weight that entity, even though its attractiveness is reduced. In contrast, unsuccessful companies with decreasing equity prices will see their weightings automatically decrease in a capitalisation weighted equity index.
Fixed interest investment processes need to focus on controlling exposure to stocks with a high chance of default given the asymmetric risk/return profile. FFTW for example, grade companies in three ways. ‘Stable/core’, where the credit profile is stable and/or improving over a 12-month period; ‘negative/tactical’ where there is some quantifiable risk of ratings transition but is likely to be limited; and ‘negative/short’, where the risks of a significant ratings transition are material and/or unquantifiable. As Corrigan explains: “If we look at autos and compare BMW and Ford, we may decide BMW is a stable/core and so we could invest in it for all our portfolios, while if Ford is negative/short under no circumstances would we invest in it or deal in it except by shorting and that is a valuation call that portfolio managers can take.”
Bond managers that are part of multi-asset fund management groups often try and leverage the research of their equity colleagues and may even attend meetings with company management on a joint basis. Specialist bond managers argue however, that equity research is only valuable if it is based on detailed cashflow modelling. They would rather rely on a purely credit-focused approach often combined with a top-down macro view of economies and relative attractiveness of different segments of the bond markets.
The views of rating agencies are important in that the parameters for investment for many institutional investors are determined by ratings. However, Corrigan saw them as “being reactive in the last cycle. Now they are being pre-emptive with an increased frequency of rating changes. Moody’s are trying to flag an uptick in default rates but 2005 showed that their projected timing left something to be desired.” While clearly, “at the individual credit level, they are important”, he goes on to add that “at the macro level, research analysts and investment banks tend to be better”.
Is capital being misallocated as a result of pension funds’ willingness to invest for the long term at real yields of 0.5% or less, and where does that leave the attractiveness of credit may be a debate that will continue for a number of years? What is clear is that if long dated bond yields persist at levels of around 4% or less, then gaining an extra 30bps in investment grade bonds will be seen as a significant increase in return – even if on a personal level, few individuals would want to lock away investments for 30 or more years at a fixed rate of 4.3% or less!

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