The development of a credit culture among European fund managers took a long time to get underway. The advent of the euro has made its momentum unstoppable.
Institutional investors are ready and willing to make the jump away from currency and convergence plays and enhance their returns from a new source - credit.
But they still see a market in its infancy, where liquidity and diversity are lacking and a great supply/demand imbalance has driven credit spreads into over-tight levels.
Graham Field asked a number of leading European fund managers to detail their experiences of the new euro credit markets.
The arrival of the euro has exposed a fault line within the European fund management community. On one side are the internationally-oriented investment managers, which have embraced the opportunities created directly and indirectly by the euro.
On the other are the relatively timid nationally based fund managers, which have still to begin diversifying outside their home markets.
"It will be a gradual process for continental European fund managers to move away from a model of investing in domestic or neighbouring markets," says Robert Thomas, director of fixed income at Henderson Investors in London.
What we have seen so far is "the tip of the iceberg" according to Liz Ward, senior fixed income research analyst at consultants Frank Russell. "It is difficult to get a really clear handle on the asset allocation shifts that have occurred. But our feeling is that in the real heart of euroland the change has been slower than people had hoped."
Those who have embraced the change have done so enthusiastically. Wouter Weijand, head of European fixed income at ABN Amro in Amsterdam, is puzzled by the fact that he still receives invitations to speak at European regional bond conferences.
Weijand will be speaking in Milan in September, but he has chosen to examine a pan-European theme, whereas he is "surprised that there is still a lot of interest in the regional Spanish or Italian or Finnish markets whereas these may become almost extinct in five or 10 years' time."
Others share his reaction. Jeremy Richards, the director responsible for fixed income investment strategy at the UK's Prudential Portfolio Managers (PPM), says: "I have been surprised how little differential there has been between euroland members in terms of the spread that individual bonds trade at. There's a small premium for Italy but not the size you'd expect if Italian investors had switched to German-issued euros."
Weijand believes that familiarity keeps some investors trapped in their domestic market. "We see that French investors are bidding up French names, that Spanish investors tend to overbid for Spanish names and that Germans pay more for German names," he says.
Over the long term, this situation is likely to change. The change will come with greater transparency in the market and a greater reliance on ratings and credit quality, as opposed to familiarity of name, to judge credits.
"Some investors tend to think that they know a credit and treat it as, for instance, a double-A," says Weijand.
"But once these names are rated they may find out that it is actually a single-A. Ratings will mean that comparisons between names will be just like comparisons between the prices of German or Spanish products in euros."
The reality is that larger investors are leading the way into euroland's new opportunities while the smaller, domestic investors need more time and energy to take the initiative.
Major players, such as Edith Siermann, head of European fixed income at Robeco in Rotterdam, have been able to take the euro in their stride.
"Our clients were already preparing to move cross-border before the arrival of the euro and asking for presentations on that. It's been quite a logical step," says Siermann.
There is also a distinction between the behaviour of public and private investors. Andreas Johannsen of DWS, the mutual fund subsidiary of Deutsche Bank in Frankfurt, says: "Private investors still want to buy in their home market, even though it's all one thing from a currency point of view."
Gerhard Aigner, chief investment officer of Raiffeisen KAG - the second largest Austrian fund manager - explains a typical reaction from a European asset management group that has moved gradually but which acknowledges the need to diversify.
A change from a purely Austrian to a European benchmark meant that Aigner has had to increase slightly the duration of the holdings in his portfolio to match those in the rest of euroland.
"The Austrian market, along with the Italian, had the lowest duration of the euroland markets, so we had to increase," he says.
That meant selling a small proportion - around 10%-15% of Raiffeisen's Austrian bond portfolio - and buying longer maturities of other issues.
The scale of Aigner's buying was limited for two reasons. One was a desire not to destabilise the market through large, sudden movements. The other was that the Austrian market continues to offer attractive yields relative to Germany or France, and Aigner could see no reason to sell four year Austrian bonds to buy four year German bonds. Such a move would have meant giving up 15bp-20bp.
While Raiffeisen KAG is moving increasingly into holdings of Spanish, Portuguese and Belgian bonds, Aigner is insistent that any change only happens "where we see relative value". He adds: "We're constantly monitoring spread sheets to look for relative value. We're pricing relative to the swap curve and the government benchmark yield curve."
Aigner sees the proportion of non-Austrian holdings in the Raiffeisen portfolio rising to between 30% and 50% over the next few years. But it will be a slow process as, for instance, he will hold two or three year Austrian bonds through to maturity and only invest outside Austria as new money and maturing principal money becomes available.
The biggest debate among fund managers turns on the extent of opportunity and diversity available to them as they expand investments into euroland. Ward at Frank Russell is certain that "there is liquidity for managers who are exploiting opportunities on corporate bonds and structured bonds".
She says: "The opportunity set is attractive and clients are keen to buy, though they are waiting for issuance to pick up, liquidity to improve and benchmarks to become more efficient and offer longer track records".
Fund managers such as Ulrich Frolich, senior portfolio manager with Danske Capital Management in Copenhagen, are, for instance, "thinking about" the asset backed securities market. Frolich has no exposure yet, chiefly because he has not yet done the necessary research to understand the risk and structure of the 10 year credit card issues seen in Europe.
Several investors are satisfied with the quality of credit research available. "I've seen a lot of it and Goldman Sachs has done some very good analysis," is the view of one German asset manager.
Weijand at ABN Amro believes the larger, internationally oriented houses are clearly winning out over the smaller, domestic institutions.
But Siermann at Robeco has one gripe. "Although there are a few houses that have done good research, what we're still missing is a global approach to credits," she says. "What we see is very much regional research with no comparisons between, say, a Ford issue in euros and one in dollars."
As investors weigh up the range of opportunities, there is still some scope for playing the convergence game. "Greece is an investment opportunity," according to Nader Purschaker, head of fixed income at Metzler Investment in Frankfurt. But, he stresses: "There's no free lunch. No pattern will ever be the same."
On a similar theme, Richards at PPM says: "Eastern European convergence plays are not unattractive. But there's not a lot of juice in them compared with the old Italian convergence play and they are not big markets."
Purschaker talks in general terms of horizontal or vertical diversification as offering the prospect of spread advantages and low correlation to Treasuries.
Others see the convergence game as played out. This has left them scratching their heads in the search for opportunities.
"Last year was a free lunch," says Gunter Philip, fixed income fund manager with Allfonds International Asset Management, part of the Bayerische Hypo-Vereinsbank group in Munich. "You absolutely have to work harder for pick up this year."
That reasoning leads Philip inexorably towards credits. "Everyone is looking for pick up and that means you must go to higher risk and look for diversification," he says. "But that's the big problem in euroland - there is no diversification except the corporate bond market and asset backed securities market."
Most investment managers are now focused on the credit market as the best means of diversification. Weijand of ABN Amro says: "The main change to the market has been the development of the credit perspective and allocation and the change to benchmarks."
Investors such as Aigner at Raiffeissen welcome the openings that the new euro market provides. "There are not many Austrian corporate bonds and Austrian bank bonds are quite rich," he says. "So we are very happy to have new opportunities in Pfandbriefe and bank and corporate bonds."
Credit is the key to diversification, according to Frolich at Danske Capital Management. "Before the euro, a Danish investor with holdings in Italy, France and Germany had quite a well-diversified portfolio," he explains.
"But with 11 currencies going into one, total risk has been much less. So, from a portfolio risk perspective, taking credit into the portfolio has been important. The low interest rates of the last year or two have also meant that the percentage of credit in portfolios has increased."
The problem that Frolich and many other fund managers point to is a disequilibrium of supply and demand for credits.
"The euro credit market is not an effective universe," says Frolich, "because demand has been greater than supply and there are tight spreads, especially among the lower credits. US corporates are more attractive from a credit perspective."
An unprecedented proportion of new issue volumes in the first five months of 1999 came in the corporate and utilities sector. Some investors were not unduly surprised.
"It is fair to say that a lot of new issues have come along," says Johannsen at DWS. "It's difficult to say if it was much more or much less than we originally expected, but it's been within the range of expectations."
Credits are also interesting to the large index-based fund managers such as Barclays Global Investors (BGI). For these investors, the combination of a high proportion of government debt in both the Salomon Smith Barney EuroBIG and Lehman Euro-Aggregate indices, and the convergence between sovereigns in the core and periphery of euroland, has made index tracking relatively easy.
However, says Partha Dasgupta, head of index fixed income investments at BGI, the arrival of large scale corporate issuance is beginning to change the landscape. "When a market is growing - even if it is still embryonic - we do have to participate as sectors grow," he says.
Dasgupta says that index funds will need to be "more careful in their selection as they will need sufficient diversification in their portfolios to avoid elements of specific risk which can lead to tracking errors. Given the volume of issuance, we are in a position to pick and choose to some extent on the basis of liquidity."
This search for sector exposure is propelling the index funds towards the new issue market for several reasons. One is the fear of creating a market impact if they go into the secondary market for large exposures. Another is a lack of liquidity in some parts of the secondary market - particularly in issues below Eu2bn in size.
Some investors are hesitant for the moment because of relative value considerations. "In our assessment, corporate credits in Europe are not yet correctly priced, although we believe that we will move into them in the future," says Thomas at Henderson Investors.
Unattractive pricing has meant that Thomas has bought "the odd name, but our corporate holdings have tended to be concentrated elsewhere, especially in the US dollar market."
International developments have, nevertheless, worked to underpin demand - at least until the last few weeks. "We changed the domestic weights of our portfolio to go into the corporate bond market," says Philip at Allfonds.
"After the big blow-out with the Asian crisis, there was a euphoria in euroland at the start of the year. It's been a goldrush, like the German Neuer Markt."
Weijand says that memories of the Asian crisis are being put to one side. "There has been a greater readiness to take on credits after the disastrous experience of 1998," he says. " Investors in the Netherlands were heavily under-invested in credits and emerging markets."
Credit appetites consequently survived last year relatively unscathed.
More recent market conditions have been less favourable. "All the issues which came in the last few weeks have been too tight," says Philip. "We saw a widening and the market going to a defensive position while we wait for developments in the equity market and with the possibility of a rate hike in the US."
Johannsen at DWS adds: "The better known credits have been more expensive, but people were hungry for yield, at least early on. That phenomenon has gone away to some extent."
Richards at PPM - who runs UK-based multi-currency funds - has largely avoided euro credits to date because of the limited total yield which new issues offer relative to government bonds.
Government bonds trade much closer to Libor in euroland and, says Richards, "we are not desperately keen on buying European corporates because spreads aren't that wide." But Richards concedes: "We would find the whole thing more interesting if total yields were bigger."
Nevertheless, credits appeal to Allfonds' Philip as having the edge over duration plays. "You don't win or lose anything by making decisions on duration. The only pick-up this year has been in the corporate bond markets. The first ones in have made big profits, but those who came in during the last couple of weeks have had big losses on their portfolios."
ABN Amro has set up a euro credits fund that has pulled in around Dfl 500m (about Eu220m). The fund, says Weijand, is "an important message to clients that it is not easy to get exposure to credits by being invested in five names. You need a diversified credit portfolio to manage credit risk sufficiently across sectors, durations and implied ratings."
Weijand wants to see at least 100 names and possibly between 150 and 200 to develop a really good credit portfolio. Until that critical mass builds up, his strategy will be to get exposure to other names that are not available in Europe and then to swap out of currencies. He did that with a triple-B dollar issue from the Republic of Qatar issue at 379bp over Treasuries that he swapped into euros at 320bp over.
Others, such as Richards, regret the lack of a diversified pool of potential investments to date. "A lot of the issuance has been at the top end of the quality spectrum and there has not been much at the lower end of investment grade. Nor has there been much sign of disintermediation of the banks with small and medium-sized companies issuing."
Nevertheless, strong demand has meant that finding liquidity in credits can be difficult. "You do find it in new issues, although from what I know of the US conditions are more or less the same there and secondary trading is limited," says Siermann of Robeco.
Richards at PPM believes the euro has helped deliver "chunkier" corporate issues than would have been possible in any single one of the 11 predecessor currencies.
Weijand sees liquidity improving but still finds that it can come and go. "What we see is bull market liquidity," he says. "If there's a bear market or some sort of nervousness, liquidity will drain away. Although issues are getting bigger and market-making is wider, liquidity still needs to be proved in a bear market."
Dasgupta at BGI agrees to a certain extent. He finds that on larger issues with bigger names market-makers are willing to take bullish inventory positions and may be prepared to go short to quote a price. But inventory positions for some of the less liquid issues have become quite defensive.
Equally, the choice of sectors has left investors somewhat underwhelmed. Siermann has changed her approach to go into the credit market, particularly in search of non-financial issuers.
"There's tobacco, autos and telecoms but that's it," she says. "There is more than there used to be, but we would like to see more diversity - such as utilities - so that you have a broader market.".
Weijand feels that "the sectors we most like don't have issues because the companies in them don't need the money. We probably will get more electricity issues, but we would like to see media and pharmaceuticals issues that are non-cyclical," he says.
The heavy rush of tobacco and telecoms companies is beginning to provoke investor fatigue - although, as Weijand says, "you can now plot a complete curve in tobacco."
The number of issues in the tobacco sector - which has welcomed many of the biggest names such as BAT, Gallaher and Philip Morris - works to the advantage of the big investors like BGI. "The wide variety means that we can be selective," says Dasgupta.
Opinions are divided on the usefulness of a sector rotation strategy. "As a domestic fixed income investor, sector rotation is the most strongly increasing in importance," says Aigner at Raiffeisen KAG. Relatively speaking, Pfandbriefe are not attractive for Aigner at current market levels.
Overall, Siermann recognises that "sector rotation is the case in the US and I expect it will happen here as well. It's not our approach as we like to diversify across sectors without actively playing them and rotating," she says.
Dasgupta is hesitant about applying sector rotation strategies at this stage. "We do studies of the relative value of sectors, but it is still very early days in this market," he says.
"To some extent we don't yet have the histories to allow us to do it in detail. As the market evolves we will develop the quantitative tools to allow us to take a bet between credit ratings and between sectors."
For Purschaker at Metzler Investment, the choice between sectors is complicated by a split between high yield and investment grade credits. "The bulk of investment grade credits are financials, while we estimate that 70% of high yield is in media and telecoms," he says. Any choice about switching sectors becomes, therefore, a choice between grades of credits.
Purschaker sees the "immense" growth in European high yield issuance - it has quadrupled since 1997 - as a sign that the structure of rating distribution in Europe will eventually become more like that in the US, where it is more evenly split between investment and non-investment grade credits.
High yield debt is already on the agenda for some investors, but often through a specialised vehicle. As Weijand points out, the important sea change in the market is the move into credits. High yield will be the icing on the cake.
"Given the concentration of investors in domestic government bonds, it's a huge move if they put a significant proportion into investment grade credits. Non-investment grade is for the more experienced and bigger investors, it's not mainstream yet," he says.
Philip at Allfonds strikes a correspondingly cautious note. "Triple-B is our investment limit," he says. "Our clients say that's enough for them. They've got enough risk in international markets and don't need another risk in the credit markets."
High yield is certainly on the radar screen for European investors. "Today there is no strong preference for triple-A government versus triple-A financial issues: it is simply a relative value play if there is a spread pick-up for holding one or the other," says Ward at Frank Russell. "We are moving towards a situation in which the issue will be more that of investment grade or non-investment grade."
Henderson Investments and Raiffeisen KAG are among those fund managers developing high yield funds. Aigner launched a public mutual fund for high yield credits in May and it drew in around Asch120m (Eu9m) in its first three weeks.
But the paucity of supply has meant that Aigner's definition of high yield has had to be expanded to find suitable investments. The fund invests in the US as well as the European market (hedging exposure back into euros) and also goes up to single-A grade credits.
But other fund managers take a more sceptical view of the offerings so far. "There's been some high yield debt, but it has ranged from the expensive and poorly structured to the reasonably priced and poorly structured," says Richards at PPM.
His objection to the structuring rests on the fact that a lot of European high yield debt has come in the form of structurally subordinated bonds issued by holding companies or through subsidiaries. "That puts you in a weak position relative to the banks and pretty much rock bottom of the list of creditors. This fact is not being properly priced into the bonds," he concludes.
For most investors working against the indices, high yield is likely to play only a relatively small role in their portfolios for the time being. The biggest change as far as indices are concerned has, in most cases, been the migration from national to European-wide benchmarks.
Weijand at ABN Amro comments: "A lot of clients followed our suggestion of moving to a European benchmark from a domestic one. We use the Salomon Smith Barney Emu government index for most clients."
Aigner at Raiffeisen KAG has, similarly, moved from purely Austrian indices to the JP Morgan Emu benchmark.
Some observers believe the story of a battle of indices has been overdone. "A lot of people have been trying to create the story of a big index war going on with the providers locked in a struggle with one another," says Paul Grice, fund manager at Lombard Odier, "and there may be some truth in that.
"But the idea that fund managers are revising benchmarks because of the euro isn't the case at the moment."
Grice sees clients and consultants - rather than fund managers - as the crucial players in the choice of indices. "Clients go to consultants who find the correct balance of asset classes to meet liabilities over the long term," he says. "They choose the benchmarks between them and those are still the same."
While there may have been some moves from national to European benchmarks, the net result has been that JP Morgan and Salomon Smith Barney have retained their grip, despite the challenge from Lehman and the development of its Euro-Aggregate index.
Weijand says: "We have used Salomon since the 1970s and that index is the most consistent and longstanding series available.
"There is no reason to change and it is also difficult to explain to clients that you've changed your benchmark."
Ward at consultants Frank Russell sees two major problems with switching to the broader Lehman Euro-Aggregate index with its 7,000 components. Firstly and quite simply, she says, "Lehman does not have the brand name recognition in Europe that JP Morgan and Salomon Smith Barney enjoy."
Secondly, she says, "there is a feeling among a lot of portfolio managers - which is shared by clients - that the broad benchmark isn't yet investible. There are too many securities in there that are highly illiquid and do not have reliable bid/offer spreads."
That does not present too many problems for BGI's Dasgupta. "For the Euro-Aggregate, we could still track it quite accurately with holdings of 80 or 90 securities," he says.
The reason lies in the fact that even the composition of the Euro-Aggregate is still around 60% government bonds. By using jumbo Pfandbriefe it is possible to substitute for some of the less liquid Pfandbriefe in the Lehman index.
Only as corporate issuance picks up will the tracking of indices become more of an issue for BGI.
"We've seen the Salomon EuroBIG expand from 800 issues to 856 as corporate issuance has grown," he says. "If we annualise the issuance we saw in the first quarter of the year, then it will start to have an impact on the composition of the index," says Dasgupta.
Ward sees other advantages in sticking to a government-only benchmark such as the JP Morgan Emu bond index. "Consultants and clients are still uncertain about the new opportunity sets," she says.
"They want to have exposure to them - but on a tactical basis rather than as a strategic allocation."
Large bets outside a government-only benchmark also make it an inherently easier target to beat than an index that combines government and non-government issues.
Frolich of Danske Capital Management says: "A lot of asset managers in Europe still use a government benchmark even if they have 30% or 50% of total assets in credits."
Ward does, nevertheless, see some evidence of a move to a "midway point," with some clients now looking at the Salomon Smith Barney product in a euroland context because they want a provider who will be able to offer a representative broad market benchmark in the future.