Making bond mandates more flexible

Should European investors be investing in the US bond markets? Increasingly, the answer is that probably they are already, even if the benchmark is local, whether a European bond index or a set of liabilities. This is the “global alpha-local beta” paradigm that is sweeping the European institutional bond markets, and which inevitably will lead to an increased focus on the US bond markets for European investors.

As Stephen Holt of Principal Global Investors (PGI) explains: “To my mind we are entering the third stage of the way fixed income has developed in Europe…You go back 10 years and fixed income was a poor cousin of equities; there was a general belief in Europe for example, that all bonds were governments and there wasn’t the interest in credit, largely because the credit markets in Europe were small. The second stage was a recognition that credit was actually quite exciting, another dimension to taking risk, so you saw a move into mandates with composite benchmarks involving both government bonds and investment grade credit, perhaps with limited flexibility to invest off benchmark,” says Holt. “Now with the growth of LDI and a simultaneous realisation that bonds need to work harder - aiming for 75bp outperformance and delivering 30 really isn’t going to cut it - we’re reaching the third stage and I expect the limits on flexibility to be completely removed.”

In future, he continues, we will see managers investing totally outside their benchmarks, using derivatives and swaps to port the alpha they generate back to a sterling or euro bond benchmark.

“The big domestic European bond managers have gradually repositioned for the second stage, but aren’t really ready for the final move …That will require much greater depth of credit expertise, particularly in US markets, which have a much wider range of opportunities. In the third stage, managers with scale and expertise to access a global universe of opportunities, and US credit in particular, will have a big advantage over those yet to make this commitment,” Holt concludes.

State Street Global Advisors (SSGA) goes so far as to divide its fixed income processes into alpha and beta generators with the alpha generation undertaken by a global team where geographic regions become less relevant, according to Elizabeth Para, who explains that while the majority of European investors want domestic beta, 90% of high yield issuance is in the US. “Leaving it out it would be missing out on a huge opportunity,” she says. “Clients are increasingly showing interest in absolute return strategies, but also a greater willingness to consider alpha from different regions other than the benchmark. For example, for a euro government bond market index we would most likely have the physical portfolio of European government bonds, but then overlay with interest rate and currency swaps, and credit default swaps on individual credits, with most of the opportunities in the US. More than two thirds of credit issuance is in the US, with a lot more depth and diversity.”

As one can imagine, the global alpha domestic beta approach is playing to the strengths of the US fund management houses, who have decades of experience of credit in particular, as well as expertise in the intricacies of the major specialist markets in the US such as mortgages, other asset backed securities (ABS) and niche areas such as the US preferred or hybrid security marketplace. SSGA for example, have a global team covering ABS and MBS, according to Para, and they look at euro and sterling issues as well as dollar issues. She says that at present most of the alpha is in the US marketplace, where spreads are wider.

However, the diversity of the US market does raise challenges for even the largest US fixed income managers. One approach is to adopt a manager of managers approach, building up a portfolio of specialist fund managers within the different sub-sectors of the US bond markets.

A variation on this theme is the route taken by PGI, who have acquired two specialist US bond managers to provide diversification to their own in-house capabilities: Post Advisory Group which specialises in US high yield securities, and Spectrum Asset Management, which is one of the largest managers of US preferred securities. While the managers are completely autonomous, products such as PGI’s Global Strategic Income fund which has a “global alpha” philosophy, seek to benefit from the diversification produced through combining the capabilities of their three US based fixed income groups together with the resources of PGI’s European and Australian offices.

A number of fixed income managers are going down the route of offering such Libor plus strategies in Europe. This reflects a response to both the focus on LDI and absolute returns, and the desire to achieve diversification by accessing a global universe of stocks, which for a European investor invariably entails having a major allocation to the US debt markets.

 

The US bond markets are roughly half of the global debt market, and the last few years have seen major changes in the relative size of the very distinct sectors within it. As Payden & Rygel’s Jim Sarni explains: “There has been a dramatic decrease in the relative size of the US government portion, while in the corporate bond market, the supply is declining because the amount of cash being generated by corporate America, combined with the lack of capital expenditure means that they don’t need the money. The sector that is growing rapidly is the structured finance - the ABS, MBS and so on.”

As well as the major segments outlined, the US market also has some specialist bond markets, which can be utilised in strategies designed for foreign investors. Preferred securities for example, are the highest yielding investment grade securities within capital markets. The market is about $340bn (€253bn), and consists of two basic varieties: $25 par preferreds and $1,000 par or capital securities. They are senior to common stock, but subordinate to bank debt and traditional corporate bonds. As Stone Harbor’s Torchia says: “We think of them as bonds, they act like bonds and they are very bond-like technically.”

Spectrum’s Bernie Sussman adds: “If you look at the $25 par sector, the overwhelming majority is still owned directly by individuals and it is very much a retail market which makes it unique in the world of fixed income…As a fixed income market it’s very user friendly, the minimum investment size is very low, listing is on the NYSE, many of the names are very well known.” In contrast “the capital securities market is very much an offshoot of the corporate bond market, so has the same types of players on both the sell side and the buy side - institutional pension funds, insurance companies and hedge funds are active.”

 

With corporate bond spreads still near historical lows and bond yields looking to have more upward potential than downwards, it is not surprising that managers are somewhat apprehensive. Moreover, investors are clearly wary with regard to inflation, and as Stone Harbor’s Torchia comments: “I think the Fed probably feels the same way, that we are on a bit of an edge as far as inflation is concerned. While they can probably live with inflation at current levels I don’t think they are going to be willing to tolerate a higher rate of inflation. We are talking about 2.5% core CPI. I think that’s right on the borderline.

“If we see a drift higher over the next few months then I would suspect the Fed would tighten even against signs of weakness in the economy. I should say that our base case view is no interest rate changes in 2007, but clearly that is predicated on inflation not getting worse. As far as the yield curve is concerned our view is that we are probably stuck in a range here, I don’t anticipate 10 year rates moving above 5% anytime soon on a sustained basis, for the next year at least.”

Given this, it is not surprising that Torchia says he is “a little more cautious relative to where we were at the start of the year”.

He explains that he is “cautious towards the high yield sector, most specifically the high yield bond sector. While the sector has performed well so far this year, spreads relative to where they have been, are tight.”

He goes on to make the point that “We could be drawing nearer to the end of the good credit cycle that we have been in since the end of 2002 and as a result we have reduced allocation to that sector. It may be a bit early but we are looking down the road over the course of the next 6-12 months and we think there is a possibility of widening in the high yield market.”

In the ABS marketplace, Torchia takes the view that yield spreads in credit card securities are not particularly attractive. “Our position as far as credit card backed securities is actually pretty small, he says.” Payden & Rygel’s Sarni concurs expressing the view that “in general, MBS is an area that we are constructive on. Commercial mortgage-backed securities (CMBS) in particular, have a lot of corporate bond-like behaviour. They are fixed rate with a geographic spread set of commercial and industrial properties around the US.”

With an increased emphasis on absolute return type mandates, Torchia makes the point that “in these Libor orientated portfolios there is a fairly wide opportunity set in floating rate securities. So, a lot of the securities that we would buy in the ABS sector are naturally floating rate as opposed to having to be hedged.”

He goes on to add: “I would also look at bank loans as well as bonds within the high yield sector, and here I am talking about the leveraged loan market. We consider this to be a fairly important sector particularly in the libor plus/absolute return assignments because the loans are almost exclusively floating rate and in our minds, they make ideal assets for absolute return strategies.”

 

The US sub-prime mortgage market has clearly hit the headlines but what is reassuring is that there has been little contagion in the rest of the marketplace. Aberdeen’s Dan Taylor points out that “With few exceptions, nearly all of the riskiest [BBB and BBB-] tranches of sub prime mortgage deals (home equity ABS) issued in recent years have been sold into collateralised debt obligation structures (specifically mezzanine ABS CDOs). The danger as Aberdeen sees it, is that “these structures seem doomed to fail, because the very nature of the CDO creates a degree of capital flow into a sector that dwarfs previous historical experience on which the structure is based.”

Going forward, Taylor sees that the most likely future course is for the rating agencies to put off recognition of the severity of the issue until they absolutely must act. “That will be when the lower rated BBB/BBB- tranches of specific sub prime mortgage deals are undeniably going to begin taking near-term principal write downs.

“A cascade of downgrades across the industry will follow, which will then pass through to the mezzanine ABS CDOs that hold these securities. Ultimately, the lower rated [A, BBB, BBB-, BB] tranches of these mezzanine ABS CDO structures may be worthless, and some of the AAA classes will see significant downgrades, perhaps even principal loss.

“The bottom line is that there is enormous leverage to the unfolding sub prime mortgage debacle in these mezzanine ABS CDOs. That’s the bad news. The good news is that the cross-holding nature of this scheme may have actually inadvertently contained the bulk of the associated risk therein.”

Payden & Rygel’s Robin Creswell holds the view that it is too soon to confidently assess the effect on the broader marketplace. “But sub-prime lending, which accounts for 15% of the total MBS issuance, is potentially an important part of the underlying tapestry of the financial markets and won’t go away,” he says, “There will, however, be an acceleration in the standardisation of documentation, procedures and so on, which will lead to a healthier sub-prime market at the end of it.”

As Stone Harbor’s Torchia advises: “I would say that investors who are not part of this market should monitor market developments, don’t jump in now because there are still some issues that need to be sorted out. But at some point a little bit later in 2007 some of the new securities that are going to be issued will carry yield spreads a bit wider than they have been over the last couple of years to entice investors back into the sector. I think the underlying credit quality in those loans will actually be very good.”

On a wider front, Torchia points out: “The other thing to keep in mind is that we have been in a fairly virtuous credit cycle since Q4 2002. Six months from now we will be five years into that cycle and historically if you look at credit cycles, they can start to turn after four, five or six years. Combine that with the fact that you have had somewhat more subdued US economic growth, it pays to be a bit wary of credit market developments because we could start to see some deterioration in overall credit quality.”

It is the absolute return approach that is likely to be most significant for European investors who clearly have no real benefit in using a US dollar benchmark. But for Stone Harbor’s Torchia “the differences aren’t as significant as some might imagine. We are typically using the same sort of overall strategy and investment process whether we are managing against a fixed benchmark or a Libor benchmark.

“In the case of the Libor benchmark we are eliminating the interest rate component from the bonds bought. We look at the full range of asset types including fixed rate bonds as well as floating rate. To the extent that we are buying fixed rate bonds it becomes necessary to hedge out interest rate risk.

“We look at both exchange-traded futures and interest rate swaps. We use futures more frequently, believing that the higher incremental return compensates for the increased basis risk, and use the full range of two, five, 10 and 30 year Treasury bond futures contracts.”

While the US market is always going to be a key component of a global alpha-local beta approach to bond investment, the weighting to the US markets can change dramatically. “Although the US is 50% of the global weighting, Europe is now the biggest issuer of bonds, having overtaken the US in 2003, and in the long term, there will be an increasing trend for Asian issuance in local currencies” according to Payden & Rygel’s Sarni.

He adds that, like any manager with a global alpha strategy, “we are agnostic on what is the capitalisation weighting of a country’s bond market. We are more interested in where is the value. For example, if we look at a Libor plus mandate that we have for a UK institution, two years ago, it was more than 70% in US bonds whilst today, it is more than 85% in sterling bonds.”

European bond investors will increasingly see a shift towards absolute return orientated mandates with a Libor plus benchmark and no geographic restrictions on the investment universe. As a result, they will need increasingly to be aware of the opportunities, but also some of the pitfalls in the US debt markets.