European Central Bank president Mario Draghi’s decision to just sit there rather than do anything over the summer has given the credit rally of 2012 a boost. The masterly inaction of Draghi and his fellow central bankers (prior to the launch of outright monetary transactions) has cemented the establishment of corporate credit as the asset class of choice for investors looking for relative safety combined with a pick-up over Bunds and treasuries.
The credit boom is serving the real-money investment community well, but many supposedly smart-money hedge funds and investment banks are missing out on the party.
The performance of investment-grade credit this year is impressive in terms of returns, business volumes and the ability to recover from market setbacks.
The iBoxx index of European corporate bonds has tightened by 140 basis points since January, with returns for the year close to 9%. A wave of corporate bond issuance in the first quarter seemed to have been slowed by market jitters in April and May, but the flow of debt sales resumed quickly and there was surprisingly substantial activity in the traditionally fallow period of August, with a new volume record set for the month.
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Global corporate debt issuance of more than $120 billion was above twice the August average recorded by Dealogic, helped by heavy US issuance of investment-grade and high-yield bonds. So what could possibly go wrong? The answer is not nearly as much as could easily go wrong in other asset classes.
The corporate bond sector does not just have a far superior Sharpe ratio to equities; but it has also greatly outpaced the better-quality government bond markets recently in terms of risk-adjusted performance.
And while yields in the Bund and treasury markets could fall even further if the euro crisis flares up again, this is bringing its own complications for investors by forcing real yields below zero in shorter maturities. Corporate issuers have set new records for low yields on bond issues this year, but there is no immediate prospect of investors paying IBM to look after their cash.
This should be good news for investment banks and hedge funds. However, beyond a decent flow of debt capital markets’ fee income, banks are struggling to monetize the establishment of corporate credit as the asset class of choice. And many hedge funds have over-complicated their credit-investment strategies this year and squandered the returns on offer from dull but worthy corporate exposure.
The struggles of big funds, such as Paulson, and even more consistent performers, such as Brevan Howard and Bridgewater, have drawn attention. However, the main credit specialist funds – which tend to have assets under management in the middle of the $1 billion to $10 billion range – have also been substantially underperforming benchmark corporate bond and default swap indices.
The thrashing of JPMorgan’s London whale in the default swap index markets provided windfall profits for some funds, as well as plenty of entertainment. However, hedge funds were understandably cautious about running positions that were too exposed to the vagaries of JPMorgan’s risk-management decisions, and losses of close to $6 billion by the firm’s chief investment office were not enough to give a substantial boost to many credit funds.
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BlueMountain Capital, which is one of the biggest credit-fund groups, at around $10 billion, managed to deliver more than 10% of first-half growth in its main fund, helped by gains from the JPMorgan trade unwinds. However, this slight outperformance of core investment-grade credit was an exception. Other credit funds that benefited from the JPMorgan fiasco nevertheless struggled to record any net gains for the year by August. One complication for banks and hedge funds has been the failure of the credit derivatives market to keep pace with the rally in cash corporate bonds. This presents a contrast to the trend four years ago when Lehman collapsed and corporate bonds yields soared as secondary liquidity disappeared, while default swaps remained relatively liquid and constrained, creating enormous basis losses for bank dealers and hedge funds.
However, a move in the opposite direction can also catch out funds and dealers that try to profit from basis trading or credit volatility.
Banks face the additional complication this year of trying to manage down their inventory holdings of corporate bonds to demonstrate they are not quietly running exposure that would fall foul of incoming Volcker Rule restrictions on proprietary dealing.
In a year when some well-timed management of corporate credit inventory would have provided a bottom-line boost, many dealers have instead passed up potential income and suffered intermittent basis losses on related derivatives hedges. Bond against default swap shifts have not created the losses on hedges that were a serious blow to some of the biggest fixed-income dealers last year, but basis moves have combined with falling demand for structured credit solutions to deliver anaemic results for banks.
This leaves credit sales and trading as a business line in continuing decline, in terms of revenue for investment banks. Credit fell from 21% of total fixed-income revenues at the top-10 dealers in the first half of 2011 to 17% of a similarly sized revenue pot during the first half of 2012, according to analysis by Coalition.
Dealers might well be able to avoid a repeat of the credit-hedging losses that contributed to a poor second half for fixed-income revenues by banks last year in the wake of market disruption in August and September. However, the flow of new corporate bond issues is likely to slow after a back-to-school flurry in September, if only due to seasonal trends and a reduction in the number of borrowers that have not yet filled their boots with cheap debt.
And many real-money investors will be tempted to cash in some of their gains for the year in corporate credit, which is likely to arrest the pace of spread tightening.
Any increase in volatility could boost returns for some of the credit hedge funds that have missed out on the corporate debt party, but investment banks are unlikely to be able to turn their year in credit around. That will leave rates trading as the only fixed-income sector to deliver meaningful revenue growth for banks this year – just as Libor-related fines start to spread from Barclays to other leading dealers and eat into net income.
It isn’t hard to take a glass-half-empty view of investment banking prospects when a year of relative market stability and investor demand for core products fails to deliver for dealers.
