Challenging Markets Call for Innovative Strategies
The pace at which global corporate bond markets are changing makes it hard for fixed-income investors to keep track. Not only have credit returns shown swings from dramatically bad (2001 and 2002) to amazingly good (2003) but also the need for new instruments is growing day by day. The further we see spreads continuing their tightening trend, the further the desire for new instruments and new strategies is spurred.
How can active managers add value in such a challenging environment and, more importantly, is the corporate bond market still attractive for investors with spreads as low as they are?
Do Corporate Bonds Offer Added Value From an Historical Perspective?
What added value may corporate bonds be expected to offer in the long run? The table (below) shows the return and risk of investment-grade credits, equities and government bonds measured over the last 20 years.
During this period, corporate bonds have generated higher returns than government bonds, at a slightly higher risk. The fact that investors make higher returns on corporate bonds is not that surprising, as they are rewarded for the higher default risk involved in this asset class. However, the fact that the risk of a diversified credit portfolio is only marginally higher than that of a government bond portfolio may not be that obvious. If we would correct for differences in durations and yield curve effects between the two markets, we would even end up with a lower risk for corporate bonds. This lower risk is the result of the negative correlation between government bond returns and credit returns. After all, interest rates typically decline in a below-trend economic environment.
This means there is a higher risk of rising credit spreads and thus negative credit returns. Conversely, strong economic growth will lead to rising interest rates combined with declining spreads. This explains the desirable diversification between government and corporate bonds. Because of this, corporate bonds boast the highest Sharpe ratio (return over cash per unit of risk).
Is There Still Added Value at Current Levels?
There is little doubt among investors that credits offer value in the long run. However, a lot of investors are less optimistic about prospects in the somewhat shorter term as spreads are near historical lows. Investment-grade credits showed a record outperformance versus government bonds of more than 5 per cent in 2003! On top of that, 2004 again proved to be an excellent year for credit investors so far. Until the end of November, corporate bonds outperformed government bonds by more than 2 per cent.
Still, return is not the only dimension as we have to look at risk as well. One striking aspect of the corporate bond market is the difference between risk in quiet markets (e.g. 1993–1997) and that in volatile periods (e.g. 2001–2003). For portfolios with similar positions, the risk (measured by the tracking error or volatility) can easily be three or four times higher in volatile periods than in quiet periods. This is illustrated in the graph (below) of the average market spread for US corporate bonds over government bonds as well as the average tracking error of similar investment-grade credit portfolios through time.2 The graph shows that the active risk (or tracking error) of a well-diversified corporate bond portfolio was close to 1 per cent when spreads were at their highs. This means that such periods offer great opportunities for an active manager to prove his credit selection skills by outperforming the benchmark by a wide margin. However, the graph also shows that, as spreads decline, the tracking error does so as well. This makes it harder to achieve the same outperformance. If spreads continue their declining path or remain stable at around current levels – as we saw in the mid-1990s – tracking errors are likely to decline even further. The risk-return perspective is therefore still reasonable. However, it does make us wonder how active managers can still add value in an environment of low and stable spreads.
How Can Active Managers Still Add Value?
The combination of lower returns and lower risks definitely means that active managers will have a more difficult time adding value. Credit investors will therefore have to prove their innovative skills to adapt to the new market circumstances. Those who will succeed in benefiting from new developments are the ones that will survive in this highly competitive industry. Some of the developments that will offer interesting opportunities are:
• An Increasing Demand for Credit Default Swaps (CDS)
A credit default swap is an instrument that enables the default risk of a company to be traded separately from the actual loan to that company. This means that an investor can buy (sell) default risk and earn (pay) a premium in return, without actually lending his money to that company. This instrument used to be the domain of banks and insurance companies. However, synthetic CDOs and hedge funds entering this arena, as well as an increasing focus within banks on the diversification of credit risks, has caused enormous growth in the CDS market.
Nowadays we see that more and more real-money investors are preparing to enter the market as well. CDSs allow them to enter markets they could not reach before (because, for example, issuers did not issue in the desired currency), to include both leverage and short positions in their portfolio and to make use of different risk premiums required by different investors;
• A Growing Demand for Index Products
Apart from derivatives on single names, derivative products on indices are showing increasing liquidity. The merger between Trac-x and Iboxx products into ITraxx particularly boosted this market. This opens the way for investors to play asset allocation towards corporates or certain sectors in this market in a cheap and effective way.
As a result a new performance driver can be added.
• An Increasing Interest in Credit Hedge Funds
Lower returns will push up the demand for hedge funds with a strong focus on credits. Not only are they able to leverage returns towards an attractive level for clients but they are also able to short, which allows them to profit in an environment of rising spreads.
Adding new instruments and strategies sounds simple but one has to beware of the pitfalls as well. First of all there is the need for accurate pricing, back-office handling and trading know-how. The rapid developments in standard documentation, widely accepted identifiers of reference entities, independent price sources and electronic trading platforms are definitely helping the market to reach a mature status. Apart from these technical aspects, the usage of new strategies also requires a different mind-set of investors. That is, it takes different skills for an investor to look for opportunities to profit from deteriorating credits or to turn a bear market into a positive performance driver.
Conclusion
Corporate bonds have historically shown attractive returns. Given the low spread environment we expect both lower returns and risks in the coming period. As a result, active managers are faced with the challenge of how to add value in this low risk and return environment.
The changing environment is arousing interest in new instruments such as CDSs, index derivatives, tranched CDOs and credit hedge funds. The manager who will succeed in incorporating these new instruments and strategies in his portfolios will be tomorrow’s survivor in this business.
ERIK VAN LEEUWEN
ROBECO
1 We use the MSCI US Index for equities and the Lehman US Treasury
and US corporate indices for bonds.
2 The risk in this graph is calculated with Robeco’s Credit Risk model.
The model is described in the ROCK note The New Risk Model for Highyield
Corporate Bonds.
Entry Filed under: Bond Market, Securities