UK credit investors seem to have become more relaxed about risk in recent months, but they may have to prepare for market volatility
UK Corporate bonds have had a very good run recently. Corporate bond spreads have fallen again, implying that investors are becoming more relaxed about corporate risk but is that really the case?
It certainly looks like it considering the enthusiastic take-up of new debt issuance. Issuance has been strong and issuer credit quality has reduced.
During the second half of 1998, AAA sovereign and supranational issuance was 60% of total eurosterling issuance, and that has fallen sharply to just 12% in the three months to July 2001.
Investors do now seem keener to take on more risk ' in particular, many of the holders of AAA bonds are switching into the lower rated, higher yielding bonds that are now being issued.
On the demand side, despite the continued series of mergers and amalgamations in the financial sector, the type and variety of new institutional buyers of corporate bonds has increased.
Demographics, FRS17 and the revisions proposed to the minimum funding requirement (MFR) have persuaded pension funds to increase their exposure to bonds, generally at the expense of equities ' this has been a growing feature of the last 12 to 18 months or so.
We have also seen recent moves by some UK Life Assurers to increase bond content as well, motivated not by market views but rather by concerns about solvency. Some have moved billions. Finally, there has been reported buying of long-dated eurosterling from EU pension funds, which cannot obtain the yield and duration domestically that is available in the UK.
While pension funds may be seen as significant long-term holders, it remains to be seen what the reactions of their advisers and trustees will be should spreads widen sharply at any time.
Similarly, while it may make sense, for life company solvency reasons, to switch equities into bonds right now, this may be partially reversed if equities regain their poise.
We have had a large number of relatively spread-insensitive buyers new to the credit markets keen to increase weightings in fixed interest at a time when government debt is in short supply. This has forced investors to buy corporate bonds and increase their risk profile and has been behind a large part of the recent reduction in UK credit spreads.
One consequence of this can be seen in the changing relationship between UK corporate bond spreads and equity market levels since 1998.
Spreads rose sharply in mid-1998 in conjunction with the Russian/LTCM crisis, and then fell gradually over the balance of the year as Central Banks adopted a very supportive stance. Spreads gradually rose again in 1999 as supply of stock resumed and worries grew about the effects on credit ratings of corporate leveraging and share buybacks. Spreads peaked at very high levels in mid-2000, since when they have fallen steadily.
How do these moves correlate with equity markets? In 1998, the post-Russian crisis fall in spreads was accompanied by a recovery in equity markets. The 1999/2000 rise in spreads was accompanied by a sideways move in equity markets as they benefited from the factors that affected corporate bonds adversely ' greater leveraging of balance sheets. Since then however, the most recent fall in spreads from summer 2000 has been accompanied by a fall in equity markets.
At the same time as the world has been getting more gloomy about equities, UK institutions have been buying corporate debt heavily.
Looking forward, the credit markets may be much more closely aligned with the equity markets than previously and new levels of volatility could be on the horizon when they recover.
Over and above this change in supply/demand dynamic (see chart 1), there are a number of factors that are beginning to look much more worrying. Evidence of hard times is coming about through higher default rates, particularly in the US.
While we have seen technology issues defaulting, there have also been some old economy corporate defaults. High default rates are usually good news for high yield stocks in the sense that weak credits are weeded out by default, leaving the stronger credits to benefit from the easier credit positions.
However, this is not necessarily good news for investment grade as large defaults will ultimately feed through to the banking system and could reduce the availability of credit to all corporates.
Sterling credit markets are predominately investment grade. If the government bond markets are right and we are heading for recession, the likelihood of significant problems arising in the financial system will be increased.
One area currently experiencing very real worries about default is emerging market debt. Argentina has already hit problems because of the strength of the dollar, exacerbating the economic problems it already faces.
Hints at a move to a partial float of the currency, plus difficulties in enforcing stringent fiscal cuts, have led the country to the brink of bankruptcy. 1998 could be revisited should this happen ' then the ongoing consequences of sovereign default were huge, as global investment banks cut back their commitment to risk following losses registered in Russian sovereign debt.
In spread terms, the UK market has outperformed its international peers (see chart 2). Dollar credit spreads have remained high to encourage inflows of capital to support the currency when the trade deficit has been exploding. Previously, when the US government was issuing substantial amounts of debt, Treasury yields would have taken the strain.
In the 12 months to end May, non-residents snapped up $245.8bn of US corporate bonds and sold $67.5bn US Treasuries. Should the dollar fall, it may support Argentina, but it could also provoke a flood of capital out of the greenback which would cause a sharp hike in corporate spreads.
A rising spread environment and potential flight to quality would negate the beneficial effect of a weak dollar for emerging markets.
Another worrying factor for UK Corporate spreads is the fundamental paradox that, while markets are getting increasingly excited about the prospects for lower interest rates as growth expectations are revised down, no apparent concession is being made for this in the UK credit markets (see chart 3).
Some spreads, particularly the better quality spreads and swap rates, have already fallen a long way. In analysing swap spreads, we use a model that uses interest rate expectations, yield curve slope and gilt supply as parameters.
While swaps don't look too far out of line compared to the model at the moment, we see very little downside in the short term. In the longer term, we see swaps coming down as gilt funding resumes, as it always does.
Further immediate outperformance of the long end of the gilt curve, or significant corporate interest to take advantage of these very low swap rates, could push swaps higher.
Recession, default and risk ' not three words you would associate with a rally in corporate bond spreads. The market has performed well, but you may need to get ready for some volatility.
Corporate bond investors should prepare for volatility.
Fears of default are currently lurking around emerging market debt.
In spread terms, the UK corporate bond market has outperformed its peers.
To promote 'long-term investment'
Switching 'hard and expensive'
Smaller funds still packing a punch
To drive progress