Legend has it that a Nobel Prize winning economist was standing by a bank of elevators on the ground floor of a well known university. Several elevators passed on the way down to the basement. Someone asked, “Why does everybody in the basement want to go up right now”? The economist responded, “You’re confusing supply with demand”. With record levels of new credit issuance in 2009, we consider both the composition of credit supply and the new sources of demand.
New sources of demand
In order to isolate the supply side of the equation, let’s take a peek at the demand side. Who’s buying credit? Traditional credit investors (credit dedicated funds) have certainly put more cash to work year-to-date through the purchase of new issues. This traditional demand has also been boosted by the arrival of new sources of demand:
- Government bond investors: finding record wide levels of credit premia in investment-grade credit relative to sovereign debt
- Equity investors: finding risk premia levels in credit comparable to equity risk premia but with less than one-third the volatility of equities
- Liability-driven investors: finding long-dated fixed coupon assets, across multiple sectors and currencies, to match long-dated liabilities
- Unconstrained credit investors: finding a wide array of cheap high quality assets that have been mispriced due to the credit crunch
So, what are credit investors buying?
Shifting composition of credit markets
Many credit investors have been hurt by exposure to financials over the past year. Whether they were overweight or underweight relative to their benchmark didn’t matter, because most European and Sterling credit benchmarks hold between 30% and 50% allocations in financials. These are made up of banking issues, insurance issues, and specialty finance company issues such as GE Capital. What is surprising to many investors is how much benchmark exposure to financials has declined over time, notwithstanding the slow increase witnessed over the credit cycle boom now unwinding (see chart 1). This shift in mix away from financials is likely to continue its longer-term trend as we witness a dramatic change in the composition of total new issuance.
Non-financial supply abundant
The first five months of 2009 have brought a flurry of new-issue supply that has contributed to the trend away from the dominance of financials. Banks have largely been unable to issue unsecured paper free from government guarantees, which means that issuance of the industrial and utility sector has taken the lead in changing the mix of credit benchmarks (see chart 2). During the first quarter, we witnessed the largest corporate bond deal in history as Roche placed U.S.$16 billion of new debt across six tranches in three currencies. We have also seen a wave of large utility debt supply brought to market from issuers such as E.On, Gaz de France Suez, National Grid, Vattenfall and Iberdrola. In many cases, these new issues have come to market with significant new-issue premia.
This shift away from financials is a welcome trend for many of the clients with whom we speak. Investors are looking for diversified exposure to credit right now, with less focus on replicating the broad sector distribution of credit indices. There is a certain intellectual justification for this: those issuers that have borrowed the most money will be the largest constituents in a bond index, so it may not make sense to allocate a large portion of a portfolio to these companies.
At PIMCO, we have been building diversified credit portfolios for clients to capture these broad opportunities in credit, whether it be investment-grade non-financials, senior secured loans, convertibles, asset-backed securities or even bank debt. The credit market is changing as new issuance and debt retirement trends unfold, but these more opportunistic credit portfolios may be positioned to capture the best risk-adjusted returns irrespective of benchmark weightings.
This new supply strongly supports the idea that issuers have embraced the elevated spread levels, with gusto. In short, issuers believe that credit risk premia have shifted to a higher level and it won’t be temporary. On the other hand, the absolute level of yields has been capped by very low government bond rates. By absorbing record new issuance, investors have shown more confidence in credit markets than they did the latter half of 2008.
Locating the credit opportunities
So how is PIMCO linking all of these new issue developments to its credit strategy? For traditional investment-grade credit portfolios, we continue to favor sectors such as senior financials, utilities, telecoms, food and other non-cyclical credits. Banks, for example, will continue to delever and will most likely end up being more regulated and utility-like. This means that the supply of bank capital securities is unlikely to spring back to previous levels. Banks will try to move either higher up the capital structure (into senior funding or using deposits) or further down (“true” loss absorbing equity-like instruments).
In more opportunistic credit portfolios, we prefer investment-grade, emerging market corporate debt and high quality asset-backed securities (ABS) over unsecured high-yield bonds. Overall, valuations in investment grade are somewhat less compelling than they were two to three months ago but remain cheap compared to historical levels.
Across all these opportunities, we still anticipate so-called negative-basis opportunities where we can benefit from buying protection on individual issuers through credit default swaps (CDS) while simultaneously buying the equivalent cash bond. A “negative basis” is where the spread for the CDS is lower than the spread on the bond, allowing investors to create yield without adding default risk to the portfolio. While the level of negative basis has narrowed recently, there are still opportunities to be found.
Watch both supply and demand
The extreme valuations witnessed after the Lehman default have faded over the last few months. This largely reflects the view that we have moved away from a global financial meltdown to an environment of generally higher risk premia. Credit spreads have not yet reached the levels where they traded prior to the Lehman default. In our view, credit may not be as cheap as it was earlier this year, but spreads still offer significant value. Given the volatility versus equities, we think that credit offers the opportunity for better risk-adjusted returns.
Hence, the key to strategy is avoiding the losers, as we have entered the next phase of the credit cycle which is demonstrated by:
- Rising idiosyncratic risks (finding weakest links in the credit chain)
- Rating agencies cranking up the downgrades (even AAA sovereigns are at risk)
- Increasing amounts of debt restructuring
All of these themes speak to the notion that so-called tail risks abound. Tail risks describe very rare risk events that can cause very high losses for portfolios when they do occur. At this tender stage of the credit cycle, deeper analysis is required of each issuer and each individual security, even if investors seem to absorb the new supply without concerns. In this environment, investors have eagerly picked up the new issues brought to market. Could it be, though, that investors have rushed into the new issues too quickly? In the scramble to participate in so many new deals, has the level of scrutiny fallen? We certainly think that more due diligence for each new issue is required. It will give you something to think about the next time you wait for an elevator.
Luke Spajic
Executive Vice President