Euro corporate bonds: pessimism breeds opportunity

Paul Read, co-head of fixed income at Invesco Perpetual describes the development of the European corporate bond market and analyses the reasons for the enormous spread widening in the last few months.

In recent years, the euro area bond market has grown to become the world's second largest fixed income market after the US. Between the end of 1996 and the end of 2007, its market value increased from USD 85 bn to USD 1.6 tn. One of the most important catalysts for growth was the introduction of the euro in 1999. As a result, the previously small, fragmented bond markets denominated in a multitude of national currencies became part of a larger, more unified market denominated in one single currency.

Within this market, the high-yield sector, which did not exist in any meaningful sense in themid-1990s, now accounts for USD 110 bn, almost 7%of the total market volume. In its early form, the euro area high-yield market was dominated by telecom operators that raised funds to finance the purchase of 3G licenses. However, over the past few years the high-yield market has become far more broad based.

Thus we have been witnessing an extremely positive development - but all these superlatives did not make the euro corporate bond markets immune to the fallout from the sub prime crisis.

Loose monetary policy...

Hindsight is easier than foresight. Today we know that the problems in credit markets that have manifested since last summer can be traced back to the easing of interest rates by the US Federal Reserve and other central banks in the aftermath of the bursting tech bubble and 9/11. Abundant liquidity contributed to a general easing of credit conditions, with credit becoming more easily available and on cheaper terms. Coupled with rising house prices, the asset backing for much of the increased lending improved, and defaults on mortgage credit fell to low levels. These conditions encouraged yet more funds to be made available. This in turn prompted more buyers into the market for homes, pushing up home prices further.

The seeds for a reversal were sown in the rise in US interest rates from 2004 onwards that raised the cost of mortgage borrowing. Partly because this reduced the affordability of mortgages and partly due to an oversupply of new homes, the pace of house price inflation slowed and then turned negative. In these circumstances, banks became less willing to make credit available. With lower house prices and tighter credit conditions, mortgage quality deteriorated as defaults on mortgage loans began to rise, causing banks to tighten credit further.

...and financial innovations

However, the new banking business model, known as ‘originate, package and distribute', also played a role. Loans were packaged into new securities before being distributed to new investors. There would typically be different tranches of such securities, with each having a different credit rating. The originator of the loan was left with little or no interest in ensuring the continued soundness of the borrower.

Crisis

From mid-2007 onwards, there was increased skepticism among investors about the underlying value of such instruments. Many of the products at the centre of the problems, such as CDOs (Collateralised Debt Obligations) and other SIVs (Special Investment Vehicles) were, as we now know, not adequately understood. In turn, markets did not sufficiently appreciate the risks involved, with many of the loans used in the construction of these products originating from sub prime mortgages.

During the sub prime crisis, banks were forced to take these loans back onto their balance sheets and write down assets. This put a constraint on the balance sheets of the banks, which, as a result, had to seek external capital and curtail lending. Interbank-lending rates soared and this, in turn, prompted forced selling as funds had to meet margin calls, driving down valuations even further and putting additional over European government bonds from June 2003 to July 2007. At present, these spreads are around 300 bps.

Since last autumn, write downs from European banks have exceeded USD 204 bn, compared to

USD 184.3 bn from US banks. Nonetheless, these institutions have also begun rebuilding their balance sheets and strengthening capital ratios. Since March, however, they have also been more active in raising capital to strengthen their balance sheets. The relative ease with which institutions have been able to do so is encouraging, as their success in capital raising has eased concerns about their credit risk. Of course, the process is not yet complete, and continued deleveraging by banks and other financial institutions will continue to weigh on market technicals for some time.

Lower indebtedness

While it is right, given the headwinds economic growth is facing, to be cautious about euro area growth prospects for 2008, one factor which we consider will lend support to growth is that euro area consumers generally have lower levels of debt than their US and UK counterparts. Moreover, that debt tends to be at long-term fixed rates of interest rather than short-term variable rates, meaning that European consumers are less sensitive to fluctuations in short term interest rates than their UK and US counterparts. Euro area companies - and their bonds - are set to profit from this.

Debt also remains less excessive at the corporate level in Europe than in the past. Companies have repaired balance sheets that were excessively indebted six or seven years ago, mainly due to telecoms overpaying for 3G licenses.

Defaults to rise, but expectations look excessive

In recent years, euro corporate bond default rates have been significantly below their long-term averages, suppressed by a strong global economy and abundant liquidity. With an economic slowdown in developed economies now underway, and a much poorer liquidity environment, companies that had taken on significant leverage are likely to come under increasing pressure, causing the default rate to rise. Moodys' most pessimistic forecast suggests the default rate in Europe could increase to almost 8% in the next twelvemonths. According to data from Deutsche Bank, the average five-year cumulative default rate for European investment-grade bonds was 0.8%, while the worst was 2.4%. At current spreads, 15% of the euro investment-grade market would have to default before an investor in investment-grade credit underperformed government bonds over the next five years.

In the European high-yield segment, about one fifth of all bonds defaulted on average within a five-year period. In the worst cohort, almost a third of the bonds defaulted. At current spreads, over 40% of the market would have to default for an investor in European high-yields to under perform government bonds over the next five years.

The unwinding of leverage has left spreads implying an overly negative outlook. We believe that credit spreads more than compensate for the increased risk of default.

More choice - again

Supply is improving as well. New issue markets, which were effectively shut for three months, have been strong recently. In the US market, there has been as much new issuance this year as there was in the whole of last year. By May, non-bank investment grade bond issuance in Europe also hit a record high for the year to date. Following the demise of many highly leveraged investors, who had been major participants in new issue markets in the first half of 2007, there was uncertainty about where demand for such new issues would come from - but the market absorbed the new issues without major difficulty.

Outlook

The post Bear Stearns euphoria appears to be behind us and concerns remain surrounding the short-term outlook. The iTraxx Crossover index (an index of 50 mostly high-yield corporate bonds, which is seen as a barometer of investor appetite for riskier credit) has widened by 130bps since mid-May.

Looking ahead, it seems inevitable that economic conditions will remain challenging for some time, which will present a headwind for credit and indeed all risk markets in the coming months. Although we expect defaults to increase, the default risk being priced in by credit markets is far worse than that which has historically occurred. Furthermore, the general unwinding of leverage and the lower risk appetite of investors has moved spreads to levels that more than compensate for the increased risk of default. However, the rebuilding of confidence will be a time-consuming process.

The risks involved in credit market investing have clearly increased over the past year. However, for those investors who are prepared to look beyond the current problems, we consider value to be compelling, both on a relative basis (against government bonds) and, increasingly, on an absolute basis.