|Simon Surtees, co-manager of Gartmore's corporate bond fund, gives his thoughts on last year's corporate credit market and details what he expects to see in 2006|
2005 was the year that the European corporate bond market finally seemed to wake up to idiosyncratic risk, as several large corporate issuers were stalked by private equity firms and suffered erosion in credit pricing.
The long feared downgrade of Ford and General Motors to junk status came and went with only a relatively short period of market turbulence in the second quarter.
The sky didn't fall in, although the year is ending with scepticism among some that the world's largest automaker can avoid bankruptcy in 2006 or beyond.
What structures did you favour in 2005 and why?
Summer 2005 saw the emergence of the corporate hybrid security market, with Vattenfall's eye-catching Eu1bn benchmark.
Other European corporates followed in its wake, creating a Eu6bn-plus market for these subordinated deals. A number of investment banks reorganised their trading desks to provide dedicated coverage of this nascent asset class.
What made you money and what didn't and why?
Our funds were positioned to take advantage of GM and Ford's fall from grace and we have used the latest bout of weakness to pick up extremely high yielding, short dated paper from GMAC and Ford Credit, which we intend to hold to maturity.
We remain of the view that GM will seek to divest a majority stake in its financing arm, although headline risk has provided a rollercoaster ride on medium dated GMAC exposure.
We benefited from taking aggressive positions in some of the initial hybrid corporate securities issued this summer, taking profit ahead of our expectation that autumn would see a veritable flood of issuance in this new asset class, which could have pressured secondary spreads.
The expected flood of new issuance failed to materialise but we do believe that the asset class will become an established part of the European corporate bond market as companies address balance sheet issues, including pension scheme deficits.
Your expectations for 2006?
We are not expecting significant tightening in credit spreads.
There will of course be individual credit stories where spreads tighten sharply, although in many instances this is likely to be from a position where they had already blown out on rating downgrade fears, poor operating performance and event risk fears.
We believe 2006 will see continuing M&A as the European credit cycle evolves and that on balance corporate spreads will track sideways or widen.
However, moving to underweight credit forfeits carry and would fail to compensate for what is likely to be only modest spread widening, as the market will remain supported by strong technical factors.
The credit curve, in terms of both rating quality and credit duration, is too flat and will steepen, although the timing and catalyst for this shift remain evasive.
We will continue to express a credit barbell on our funds, managing duration through higher quality paper and taking credit risk at the shorter end of the curve in higher yielding securities where there is an attractive payback for our research effort.
|Tjomme Dijkma, head of investment grade euro and dollar credits at F&C Asset Management in Amsterdam, gives his outlook for 2006 and reviews 2005|
The search for yield will gain momentum in 2006. Too many investors are seeking higher spreads and higher government yields, but yields are low and will stay low — at least in Europe.
We expect this to result in issuance from corporates and financials at new levels of subordination. The gap between tier one and pure equity may be almost erased, producing even more equity-like hybrid capital instruments than we saw in 2005.
Brokerage paper will do well, as its spread over senior bank debt is too wide. And, as pension funds and insurance companies look at their duration mismatch and take steps to rebalance portfolios, they will realise that their portfolio yield is too low and will look for yield in the credit market. Long dated technology, media and telecoms (TMT) bonds and subordinated financials will profit from that.
2005 has generally been an average year for European fixed income and, on a currency hedged basis, a poor year for US dollar fixed income.
Due to the enormous flattening of yield curves, government indices have produced higher returns but, corrected for longer duration and excess 30 year exposure, returns on credit were quite similar to those on government debt, especially in euros.
We have been overweight the long end of the curve in all portfolios (euro, global and dollar), which has been the main driver for our performance, together with the underweight of dollar paper in the global portfolios. But long dated TMT issues and tier one non-step-up banking issues have been negative for performance.
Avoiding LBO targets has been the name of the game for the non-financial sectors. TeleDanmark, Degussa and Rentokil have moved wider on facts and rumours, and recently KPN, VNU and Wolters Kluwer have been suggesed as LBO targets.
We have been successful in avoiding names that widened because of LBO rumours but the only way to really avoid LBOs is to sell all corporate exposure, except in France, where President Chirac will block selling to leveraged money to save jobs.
In 2006 we will have to see change of control clauses in new corporate issues.
In 2005 we made money by being overweight emerging market debt. The US dollar and global portfolios outperformed by being overweight Russian bank debt — for example Bank of Moscow, Vneshtorgbank and Sberbank, Kazakh banks such as KKB, TuranAlem and Japanese banks like Resona and Sumitomo. Some of the 2005 issues for Russian banks tightened more than 100bp relative to Treasuries.
In Euroland, tier one issues for Banca Popolare di Lodi and Eureko have been the winners in terms of spread compression.
Short dated subordinated debt has also performed strongly. Changes in European tax regulations helped bonds issued before 2001, as coupons are tax-free and some of these bonds (often subordinated bank debt) traded through swaps.
For financials, we favour non-step-up tier one bonds at current levels. 2006 will bring more non-step or even more equity-like hybrid capital but current levels are very attractive. Barclays, for example, has a non-step issue with a 10 year fixed coupon trading at mid-swaps plus 130bp. And this is well rated and has no LBO risk.
All the retail targeted CMS perpetuals have fallen sharply and retail has a lot of money on those instruments. But at current levels even the CMS trades are looking very attractive and we expect institutions to buy into this sector next year.
|Claus Tofte Nielsen, senior portfolio manager, Norges Bank Investment Management, assesses what 2005's developments in covered bonds mean for the market|
What impressed you most in the covered bond market in 2005?
Spanish borrowers were the most innovative, opening up the long end of the market. I would like to see covered bond issuers taking advantage of the whole curve.
Investor interest in the long end is, however, not that deep, so issuers have to be very careful if they do not want to pay up. They have to be opportunistic.
Were you pleased to see new issuers coming to the market?
They were often interesting, but sometimes too expensive so I did not always participate.
This year we had an issuer's market. ABN Amro, for example, did not really pay up to launch its first covered bond. It issued as if it had been in the market the whole time. Investor interest was huge this year and issuers could come to market at almost any spread.
I hope it will be different next year. I expect supply to grow again, as we have new names coming into the market. Also I expect swap spread widening, so just buying covered bonds against governments and making the positive carry is not a clear-cut strategy.
You were disappointed in the way that the market initially reacted to reports that Allgemeine HypothekenBank Rheinboden might be
liquidated. Has the situation improved since then?
The spread on AHBR paper has come in approximately 10bp, but in comparison to triple-A mortgage backed ABS it is still trading wider in the short end, and at the same level in 10 years.
You still don't have a liquid market. I think the market is uncertain about the commitment Lone Star [which has bought AHBR] has to the covered bond market.
What this story tells you is that you cannot only look at the cover pool, you have to look at the underlying bank because of the headline risk. You will probably still get your money back on the covered bond, but you could end up with some very illiquid bonds. The risk is that these would have a substantially wider spread than their peers.
Let's imagine that a bank in Spain, the UK or Ireland had the same problem as AHBR. In Germany Eurohypo put in a bid for its cover pool and there were a lot of potential other candidates out there. But if a bank in another country had similar problems would you have the same support? In some cases you probably would, but not always.
Will there be more differentiation between names then?
Yes. A lot of investors bought any covered bonds without looking at the name, so AHBR paper was only trading at a very small pick-up to rock-solid names. You have also seen the Bawag story and some widening there, and there was even talk about a downgrade for Depfa.
And then you have Basel II, where risk weightings in the future will depend on the senior rating. It will take years before it has full effect, but some influence is expected already next year.
The bottom line is that you cannot only look at the cover pool, you also have to look at the legislation and the headline risk on the issuing entity and the mother company.
Are you looking forward to the Italian covered bond market opening up in 2006?
They have to make the legislation extremely strong. A 10% risk weighting will certainly help.
They will have to come with something that is without any doubt rock-solid triple-A and totally independent of how the rating on the Italian government will develop. Otherwise they will have to pay up.