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Where now for bond markets?
What are the wider implications for credit in the light of this summer’s liquidity crisis? IAN ROBINSON, ASIP, explains how the market has changed in recent weeks and where there are still opportunities.
By IAN ROBINSON, ASIP
or the three or so years preceding the liquidity crunch which gripped markets this summer, declining volatility created an appetite for riskier structures and a push for higher returns in a low-return environment. In bond markets this manifested itself as higher leverage, subordination or stratification, reduced credit quality, credit rating arbitrage or indeed any combination that was required to meet investors’ ravenous appetites.Leverage was on the rise but not just in the conventional manner of shifting corporate balance sheets towards debt. As any private equity investor will tell you, leverage is the panacea that heals the prospect of low
returns, but the abundance of easy money led to an environment in which financial engineers were encouraged to build leverage upon leverage – in other words, investors were borrowing to fund their portfolios of leveraged structures issued by financial companies that had themselves resorted to leverage to please the shareholders.
Subordinated bonds have also been very popular, offering investors a premium for sacrificing their privileged place in the queue should the issuer run into trouble. Generally the investor can expect the performance of the subordinated bond to sit somewhere between senior bonds and equity. Recent innovations include corporate hybrids and non-step banking paper. In both cases, the investor suffers subordination and reduced certainty of when their principal will be returned. This used to be one of the main attractions of bond investment and a core feature of asset/liability matching.
The intention of all this innovation may be to lower the overall cost of capital by appealing to different segments of investors. However classic financial theory tells us that the total returns of an enterprise, including interest payments, equity returns and tax, are not dependent on the financing but merely that they get divided in different ways. Unfortunately, for the man at HM Revenue and Customs this innovation has a tendency to transfer wealth from the state, so perhaps offering the bond investor an extra sweetener to partake in this ritual.
Prior to this summer’s liquidity crisis, a virtuous circle had developed of further declines in volatility and risk premiums and a seemingly never-ending supply of cheap credit papering over any cracks. Ultimately this led to a gaping hole in the form of losses on US mortgages and the cycle came to an abrupt end.
Arguably the recent low-return environment, demand for and supply of ever riskier products and structures and the ensuing liquidity problems shared similarities with previous episodes in financial market history. These include the junk bond debacle of the eighties and the flight to quality in 1997/98 that led to widespread hedge fund losses, most infamously the collapse of US hedge fund Long Term Capital Management that threatened to bring global financial markets to their knees.
HOUSE OF CARDS
Now, as then, the house of cards built on excessive levels of lending had to fall down eventually and the rising defaults in the US sub-prime housing loan market provided the trigger. Recognition of the depth of the problems forced a broader reassessment of credit risk resulting in serious nervousness among investors.The first victims of this liquidity crunch were those institutions that required access to funding immediately. Most prominent among these were structured investment vehicles, or SIVs, and bank conduits, which used cheap, short-term debt to buy longer-term, higher-return securities. The maturity mismatch of these investment vehicles required regular access to the capital markets and, more specifically, shortterm asset-backed commercial paper in order to function normally. When access to this funding dried up, both bank conduits and SIVs started to encounter serious problems.
The restricted access to credit also led to the problems at Northern Rock, whose business model relied on funding from the securitisation markets, and highly leveraged investors such as some hedge funds were not spared either.
For much of the summer the great uncertainty as to how far risks had spread within the financial system and exactly where the losses resided paralysed corporate bond investment. But as greater transparency has returned to the markets and risk premiums have increased, opportunities for return are beginning to emerge.
OPPORTUNITIES
These opportunities can be found in two broad areas. The first are those emanating from the supply and demand imbalances, either as the market seeks ways of transferring assets from one set of investors to another or as a result of a reduced pool of participants.
One fall-out from the liquidity crisis is the abundance of asset-backed securities, the price of which was initially reduced indiscriminately in the fight to find homes among investors. Indeed many of the aforementioned SIVs and conduits are being forced to sell their assets to stay afloat and the extent of the problem can be evidenced by recent talk of creating a super SIV, a billion fund backed by three major US banks, designed to prevent SIVs from selling at distressed prices. Investors that are capable of warehousing these securities can take advantage of the situation to buy top-tier asset-backed securities at much more attractive spreads to Libor.One of the temporary homes for many of these assets is the banking sector which has also been a prolific issuer of debt. Over the past few years, significant amounts of this issuance has been in floating rate form to be bought by those funds that have also been buyers of asset-backed securities. These funds may now be net sellers of banking paper at a time when the banks need to increase their liquidity. While the obvious answer may be to turn to equity markets it appears that the favoured route to raise capital is through fixed-rate issuance. Certainly numerous banks have tapped the markets at spreads that were just unimaginable a few months ago.
The supply and demand imbalance has also affected the arbitrage between physical and synthetic instruments. One example is the negative basis trade, the name given to credit trading in which the trader/investor buys a bond as well as a credit default swap (CDS) on the same entity, essentially removing the potential loss if the issuer of the bond defaults. When the CDS spread is less than the bond spread, the trader can make a small but relatively risk-free return. Until J
uly of this year there were few examples of these and often the differential was a handful of basis points. Now that t he number of potential arbitrageurs has fallen, albeit temporarily, many negative basis trades are offering investors a return of about 25 basis points per annum.It will be of no surprise to readers that a dislocation has also occurred in other money market rates but this has
extended down the maturity curve to Sterling swap rates. The gap between five-year gilts and swap rates has risen from 0.4% to 0.65% – a level not seen since the turn of the century. For longer maturities the impact was temporary and has now reverted to pre-crisis levels.
OUTLOOK
The second swathe of opportunities is based on the investor’s own outlook for the market and on differentiating
between issuers or structures. Before the recent problems, the incremental reward for taking on extra credit risk was minute and the op portunity cost for making an incorrect decision was usually also low. Decompression has altered the risk/reward balance giving investors a window of opportunity to be handsomely rewarded for backing
survivors. Essentially, the winners will be those investors who do their homework and get their stock selection right.
The big gains on any of these trades will only materialise if and when market pricing moves some distance towards those pre-crisis levels. However, it may be a considerable time until the impact of recent events on the real economy is known. The US housing market remains in decline and the higher price and reduced availability of credit is likely to dampen growth and pressurise consumer and corporate balance sheets. There are some counterbalancing bright spots – lower interest rates being the most encouraging – but in the meantime mark to market volatility could be severe in potentially thin and fear driven markets. Any investors unable to ride that volatility could find themselves the subject of the next morning’s headlines.
Please be aware that these are the manager's own views and not necessarily those of F&C Investments. They do not constitute financial advice.