By Dylan Emery The European credit markets are set to take a nosedive in quality, threatening...
By Dylan Emery
The European credit markets are set to take a nosedive in quality, threatening to seriously disrupt the risk profile of corporate bond investors, according to Credit Suisse Asset Management (CSAM).
Benchmarking will ensure that fund managers will follow suit with their portfolios even though they should be looking for lower-risk alternatives like emerging European government debt.
Ratings agencies have been gradually lowering the credit ratings of both new and existing issues for several years now but the investment banks have continued to puff every new issue, dulling many investors' senses to the creeping danger of credit migration.
Now things are coming to a head, said Emmanuele Ravano, head of fixed income for CSAM.
He expects a flood of issues to drop from A to BBB during the coming year and fund managers following their benchmarks will be forced to follow suit.
"So far, this migration of credit has gone unnoticed,"said Ravano. "Now the change has become much more dramatic Ã it totally modifies the risk profile."
According to Lehman's figures, the European bond market was 2% BBB and 22% A in 1999.
Last year, the BBBs accounted for 9% of the market, while As rose to 36%. CSAM estimates the BBB market is set to grow by another 5-10% within one year.
The volatility of excess returns in the longer term seven to 10-year A and BBB bonds is almost twice as high in Europe than in the US.
This shows a rating inconsistency between the two markets, Ravano said, adding CSAM has looked at two scenarios.
If there is 'moderate migration', four issues will be downgraded: E22m of debt. But in a 'severe migration' scenario, then 48 issues will be downgraded, the majority of which will be telecoms.
Another potential danger is the tendency for companies to securitise the debt. This distance between the original bond and the instrument the investor buys can effectively increase the risk.
Ravano said: "The issue could be BBB but you are so subordinated that your actual rating might be significantly lower."
Because of the dominance of benchmarking, investors are pressured into owning new issues.
But if investors were to move away from the traditional benchmarks and become more active investors, issuers would have to be less complacent.
Ravano said: "But if people stopped buying BBBs, it would put a lot of pressure on companies to notice debtholders. They would have to look at debt holders as they have done with shareholders."
Ravano offers some solutions to this problem. Firstly, investors have to stop benchmarking so slavishly, he said.
Then they have to find substitutes for lower grade corporate debt, for example eastern European government debt.
Ravano said: "People are concentrating on corporate debt only. But last year Slovakia was paying 3% above a BBB in euro terms."
He pointed out that emerging European countries could not afford to completely default on a debt and, unlike companies, always had recourse to taxation.
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