Market panics throw up opportunities as, in the aftermath of this crisis, attractive valuations tempt investors to take a punt. The fixed income sector is where managers can trawl for value.
History tells us the best long-term investment opportunities are often created in the aftermath of a crisis. Just as the later stages of a bull market sends valuations to stratospheric levels, the reverse is true during the later stages of a bear market, creating opportunities for patient investors.
This bear market started in the fixed income sector, which is where we are seeing valuation anomalies. During the first half of 2007, the credit markets were showing signs of a bubble, which should have been seen as a warning.
Fixed income volatility had declined to almost nothing, credit spreads had narrowed to all-time low levels in most markets, and in securitisation the level of issuance seemed to be on a stable, if exponential growth path.
Innovation in structured products reached dizzying heights. Not only was there huge growth in issuance volume, there was an impossible array of innovations in the market for securitisations. The traditional set of collateralised structures underwent iterations and upgrades unprecedented in the history of fixed income markets.
The innovations were not confined to cash-settled instruments, either. With the help of the credit derivative market, almost any conceivable exposure could be created, hedged or traded.
Asset managers were not the only ones to extend their focus to securitisation-style markets. Investment and commercial banks globally were eager to use the synthetic technology of the credit markets to hedge exposures, trade views or engage in balance sheet reconfigurations. Of course, the hedge fund industry was at the forefront of the use of new ideas.
It is no coincidence that the collapse of two Bear Stearns hedge funds may be regarded as the first dominos to fall. The procession has continued unabated in some sectors. The demise of the Bear funds was a mix of too much leverage in an asset that suddenly started showing unexpected drops in value. The well-known unwinding follows: margin calls from brokers, forced selling to meet the calls and a rapid end to a fund with a previously unblemished track record.
The degree of dislocation, however, should give those with time and liquidity on their side excellent opportunities. As with all previous market panics, in this cycle there has been indiscriminate selling with no differentiation between good and bad credits based on fundamentals.
The graph shows how spreads have changed for some of the main fixed interest asset classes. In a typical credit spread widening environment, there is a hierarchy across the credit spectrum, with lower quality credits such as high yield and emerging market debt widening more in relative terms, compared with higher quality credits.
This has not been the case in this cycle. The chart shows that, with the exception of emerging markets, credit spreads have widened out, but investment grade and capital securities (deeply subordinate fixed-income securities, typically issued by banks, that qualify as regulatory capital and are recognised as quasi-equity by the ratingagencies) are at all-time highs and, we argue, offer value.
Our view is that capital securities, which have historically traded tighter than investment grade debt, appear attractive. While this is not surprising given the root of the credit crisis has been in the banking sector, the current level of spread should be sufficient to compensate for a 28% default rate over the next five years. While it is likely that more banks will fail in the coming months, we do not see almost one third of the banking sector going bust.
The actions of the Federal Reserve and other central banks have done much to sta
bilise the financial system – as those banks that are seen as too large to fail will be acquired or nationalised – and the high level of defaults being priced into the market is unrealistic.
The high level of yield in the capital securities market provides a sizeable cushion should spreads widen further. The table shows indicative total return and excess return (alpha) over Libor (the London Inter-Bank Offered Rate) for a range of scenarios.
Our expectations are for returns over 10% a year for several years in a row. Even if we are early and spreads continue to widen, at current levels, there is good downside protection. For example, over a 12-month period even a further 100 basis points increase in tier one spreads could result in a positive 3.3% return.
The crunch is likely to present patient investors with good opportunities. Often, the area of the market at the epicentre of the crisis is where valuation anomalies first appear, and in this cycle it is fixed income. For managers with expertise at assessing relative value across a broad spectrum of fixed income sub-sectors, the market environment offers rich pickings.