The combination of America’s subprime crisis and a raft of undigested new issuance hit the corporate bond market hard, then banks exacerbated the problem by issuing more debt.
It is rare that bonds are the centre of attention, but fixed interest markets have created much excitement over the past quarter. They have been the cause and victim of much of the turmoil from the subprime debacle. How has the fallout shifted the landscape in global bond markets? And are fund managers starting to find select opportunities after the rout?
Before May, the corporate bond market was enjoying a happier time. Risk appetite was at historical highs, while spreads over government bonds were at historical lows. Default rates were low, and corporate balance sheets and earnings were in good shape. The global economy had enjoyed a period of unprecedented growth. High yield – which is more sensitive to the performance of underlying companies and less to interest rates – performed particularly well. Government bonds, depressed by rising interest rates, stayed out of favour.
The situation saw an exact reversal in May. Investors offloaded risk and headed for quality. Government bonds did well, while corporate bonds fell on a sliding scale, according to their relative riskiness. High yield was hit particularly hard. Two things were to blame: the subprime blow-up in America and a slew of undigested new issuance. This explosive combination conspired to generate the volatility in bond markets.
John Patullo, manager of the £730m Henderson Preference & Bond fund, says: “People got used to an environment where risk was rewarded. Central bankers had supported that through low interest rates and inflation. Eventually, low interest rates led to excessive speculation in the system. There were risky loan structures and then the subprime issuance. Another problem was these structures were held by leveraged institutions. When the market turned, hedge funds had to unwind the leverage they had used to buy into leveraged positions.”
The subprime problems have created broad risk aversion and, as no-one knows where the subprime risk is, banks no longer trust each other. This is why the Federal Reserve and Bank of England have stepped in to lower the overnight lending rate and bring stability and liquidity back to the system.
Yet excessive issuance has been an equally significant problem, although it has not grabbed as many headlines. Nick Hayes, bond fund manager at New Star, says: “Private equity groups were going to the large banks, who were underwriting their deals and lending them money. These loans were then packaged up and sold on in the high yield market. Everyone was buying high yield, and as a consequence yields were getting lower. Covenants were weak. Eventually, buyers began to realise there were billions in issuance still to come and decided to wait for the best deals. There was a buyers’ strike.”
Predictably, the ensuing rout has hit banks hardest. Stephen Snowden, manager of the Old Mutual Corporate Bond Fund, says: “The banks have had patchy transparency in terms of what they’re holding. When markets are fragile, they shoot first and ask questions later.” He adds that there was a knock-on effect when banks could not offload their leveraged loans: they had to keep the risk on their balance sheets and therefore had to raise more capital by issuing more bonds, creating an even bigger overhang of new issuance. As Snowden says: “You couldn’t paint a more grim scenario for the banks.”
The only defence in the markets has been to hold plenty of government bonds. In corporate bonds, quality has been key: higher-rated credits have fallen less hard. Everything tends to correlate more strongly in a bear run, so there have been no safe sectors. Snowden points out industrial corporate bonds have done less badly, but have still been hit.
Credit markets are now in an anomalous position. Government bonds look expensive, but the turmoil may turn the interest rate cycle in their favour. Default rates remain low and corporate earnings robust. Yet corporate bonds look cheaper than they have been for some time. Is the downturn likely to spill out into the main economy in the next quarter?
Christian Kassar, a fund manager at BDO Stoy Hayward, says: “Credit is going to be tighter and it will be harder for companies to borrow. The problems could filter down to the consumer because banks may tighten standards. If that materialises things may start to slow down.”
Bryn Jones, manager of the Rathbone Ethical Bond fund, agrees the problems need a reasonably quick resolution or growth will slow: “Generally, confidence needs to return to the market. Cash rates need to come back down and banks need to have confidence in each other. The trouble is inflationary pressure is still high.” He adds the biggest problem would be a default.
Henderson’s Patullo is more optimistic. He says central banks will step in to support the banking system and the global economy is generally in good shape; the recent rout may yet prove advantageous for bonds markets in the longer term. He adds: “This has led to a valuation shakeout. We are looking to add risk selectively over the next few months. Spreads are compensating investors far better for the risk they are taking.” Snowden agrees, saying it will be a long time before people reinvest in some of the more aggressive debt structures that have been created during this period. There will be less leverage and covenants will be stronger.
Snowden also says there are some bargains around: “By the end of the year, now will prove to have been a cheap entrance point for corporate bonds. The credit market is pricing a much worse scenario than the equity market and I think it will adjust.” However, both Patullo and Snowden argue there will be another few weeks of volatility while the market digests new issuance and adjusts.
A clearer picture will emerge towards the end of the month as American banks admit to their subprime exposure in trading and results statements. As Hayes points out, there are signs of confidence returning, with new deals from GE and Deutsche Bank. The next quarter should show whether this is going to be a “Wall Street” or “main street” phenomenon – that is, the extent to which the real economy will be affected.