The corporate bond market is an increasingly important vehicle for asset allocation. However, the volatility seen in the market over the last 18 months has hurt many investors. Asset managers who have adapted their investment style to respond to this increased volatility are now well positioned to take advantage of the improving credit conditions expected over the coming year
Opportunities for generating returns from government bonds have been greatly reduced in recent years.
Falling inflation has driven government bond yields lower across markets, reducing the medium-term expected returns from government bonds as an asset class. At the same time, the closer cyclical alignment of major economies has led to greater correlation between regional market returns and a convergence in interest rates.
Together, these factors mean fewer opportunities to add value through country selection. Investors are therefore seeking alternative asset classes and benchmarks, motivated by the desire to add value and diversify exposure. One option is to use the corporate securities ' or 'credit' ' markets.
Over the medium term, investment-grade corporate securities can simultaneously add value while reducing volatility in a portfolio. They offer a higher yield to investors to compensate for their greater credit risk but they also act as a natural diversifier to government bonds because credit markets and governments tend to outperform at different stages of the economic cycle.
This is supported by fundamental economics. Corporate credit tends to improve perform well within an expanding business cycle (when a rising interest rate environment would typically lead to poor returns on government bonds) and deteriorate when the cycle contracts.
Many investors have embraced this argument over the past three years and shifted assets into investment-grade corporate bonds to enhance the expected long-run term risk-return profile of their funds.
Of course, good long-term investment strategies can go very wrong over short periods of time, and few of these investors were prepared for the severe underperformance and high volatility of that corporate credit has suffered over the last 18 months.
As would be expected in an environment of slowing global growth and weakening equity markets, credit spreads widened in aggregate across the board. What was not expected was the degree of dispersion of performance among issuers within rating bands and sector groups.
Market participants became far more selective in the issuers they owned, punishing companies with weak management, poor transparency, and a large refinancing need.
Spreads for these issuers rose relative to companies that were perceived to be safer. Higher borrowing costs for the weakest, most highly leveraged issuers caused a further deterioration in market perception, which fuelled spread dispersion. This dynamic is one reason why investment-grade corporate bonds exhibit an asymmetric risk profile. The chart below left illustrates the average spread differential of single A-rated issuers in comparison to higher and lower rated credits over the last five years.
Essentially, the typical shape of the credit curve means that the potential for outperformance of an improving corporate credit is significantly less than the underperformance associated with a deteriorating credit profile. This is particularly true for ''fallen angels'' ' issuers whose ratings falls below BBB-investment-grade.
For credit managers, there is more money to be saved by avoiding the worst performers than there is to be made by overweighting the best performers. This is exemplified by the huge losses sustained in portfolios holding bonds issued by Enron, WorldCom and, TXU Europe, and Marconi. This is further illustrated in the chart below right showing the performance exhibited by the Top 20 best and Worst 20 worst performers in the Lehman Global Aggregate Index over the year to October 2002.
In times of high market uncertainty, the underperformance of corporate bonds can be immense and widespread.
The Russian debt crisis in 1998, the slowdown in the US in early 2000 and the issues with corporate governance seen over the last 18 months have all caused significant underperformance of by corporate bonds.
In early 2002 there were close to 100 issues with a dollar price below 80% of par.
So event risk is inherent in corporate bond markets and can be a powerful driver of negative returns.
How are investors managing these higher risks? To remain at the forefront of developments in the credit markets, it is essential to dedicate considerable resources to quality credit research. As a result, given the heightened impact of issuer-specific risk, more than ever credit analysts need to focus on 'avoiding the losers' and staying ahead of any ratings downgrades ' particularly those to sub-investment grade.
To manage security-specific risk more effectively in downcycles, it is also important for fixed income managers to have in place both tight limits on issuer concentrations and firm stop-loss policies for deteriorating credits.
Increasingly, fund managers are increasingly using derivatives to manage risk, increase effective liquidity, and to create diversified corporate risk more readily with ease.
Derivatives contracts and structured notes linked to single credits or to credit indices can provide investors with a fully tailored credit exposure, allowing them to add value by overweighting names they like, while underweighting names they want to avoid.
Recently issued notes linked to the returns of the iBoxx and JECI indices have been well received by the market. To date, these structures have been most prevalent in the more mature US and continental European credit markets. However we can expect them to be used more in the UK.
Corporate bond funds that have carried out these enhancements are in an ideal position to benefit from the more positive credit market environment we expect to see in 2003.
Managers increasingly using derivatives to manage risk.
Investors are seeking alternative asset classes.
There is more to be saved by avoiding the worst performers than by overweighting the best performers.
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