With falling differentiation in returns, limited liquidity and a forecast of flat European investment grade non-financial corporate bond issuance for 2012 – after only totalling €163 billion in 2011, down from €166 billion in 2010 – many managers believe this lack of supply will force corporate bond funds to increase their allocation to synthetic exposures this year.
Life isn’t easy as a corporate bond fund manager these days.
The credit market has become increasingly homogenous from a performance perspective. Therefore, BAML Global Research European credit strategist Barnaby Martin suggests it no longer makes sense to analyse it with a bottom-up approach.
A further challenge for the bond market is acclimatising to structurally lower levels of liquidity: supply is limited because of the sovereign debt crisis, as well as broker-dealers running historically low levels of inventory due to regulatory concerns and risk aversion.
In contrast, CDS indices provide exposure to diversified credit risk cheaply and in size. Consequently, Martin argues that bond funds should expand their mandates to allow portfolio managers to trade more frequently in synthetic names.
He views this move as part of a wider shift in approach to credit markets that are experiencing extreme volatility and mean reversion.
“What drives credit now are external forces rather than the fundamentals of a given company," says Martin. "Bond portfolio managers therefore have to adapt to be able to capture small, specific trading opportunities. They need to become ‘sovereign experts’ to some extent and re-examine which benchmarks their portfolios should be measured against.”
Such a shift in approach requires portfolio managers to be proactive and operate within a short-term timeframe. In addition, they will need to become savvier about how external news flow drives credit.
European corporate bond portfolio managers are to an extent using CDS as a proxy for physical assets, but not necessarily executing in a large size, according to Henderson Global Investors credit portfolio manager Chris Bullock.
“CDS indices are seeing more flow from long-only funds, although they are mostly being used as an overlay or add-on rather than as a direct substitution for physical bond securities,” says Bullock.
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| "What drives credit now are external forces rather than the fundamentals of a given company. Bond portfolio managers therefore have to adapt to be able to capture small, specific trading opportunities" - Barnaby Martin, BAML |
Index strategies
CDS index strategies vary according to fund constructs.
Some corporate bond funds use CDS to replicate their positions, by selling protection to earn carry. In this case, portfolio managers would hold the exposure as they would a bond.
But other funds use CDS to express views and thus enhance value.
“CDS are cheaper to trade around news flow and in size than bonds," says Bullock. "But there are drawbacks. CDS liquidity is concentrated around the five-year tenor, which for example limits the extent to which a seller of CDS would benefit from spread compression versus longer-duration bonds.”
Typical trades in the new environment will be tactical and strategic, notes Martin.
“Strategic trades exploit the positive basis between cash and CDS; tactical trades use CDS indices to go long and cover when the market tightens, and go short when it widens – allowing portfolio managers to take a short-term view on direction," says Martin. "There will be plenty of volatility and opportunities to trade the market tighter and wider in the coming months.”
Long-only funds usually have a cap on the amount of cash they can hold, however, with most needing at least an 80% allocation to their core asset. Benjamin Jacquard, head of credit trading at BNP Paribas, says that conceptually it would be possible for some funds to change their mandates to allow increased exposure to CDS. But most retail funds have clear constraints on synthetic exposures, so they would need a large proportion of holders to agree to the change, while others simply have prohibitively conservative leverage limits.
“Investment houses tend to be either comfortable with CDS or not," adds Bullock. "If they are the latter, they would need a considerable shift in mindset and to invest resources before they entered the market. It’s not a case of simply making a quick decision to start trading CDS: there are legal hoops to jump through first in terms of signing ISDA documentation and establishing the infrastructure to price, trade and settle the instruments.”
While synthetic buckets in fund mandates will have to increase to facilitate this new environment, it won’t be a case of ditching cash entirely in favour of CDS, according to Martin. But whether end investors will be comfortable with the new paradigm is a function of their own risk appetite.
“Some investors may be averse to derivatives exposure in their portfolios," says Martin. "But ultimately they’ll have to take on board that although the CDS market has its quirks, it offers better liquidity than cash. Participants that are committed to credit will need to adapt accordingly.”
Jacquard doesn’t see the substitution of cash bonds with CDS by corporate bond funds becoming a trend, however. “It could work for some funds, but not in an extensive way,” he says. “It makes sense for market participants that are already able to trade CDS to use the instruments as a partial replacement. Other alternatives could be to participate in private placements or progressively ramp up risk to compensate for the limited supply.”
Portfolio managers can also look outside of the European universe to dollar or sterling corporate bonds to diversify. But typically there are caps on allocation to non-base currency assets as well.
Capacity
Against the backdrop of limited primary issuance and little secondary liquidity, capacity becomes an important consideration, according to Bullock.
“If a fund grows too large, in an over-the-counter market like credit, there is real risk that it will end up with a disappointing track record," says Bullock. "If it maintains a more sustainable size, it can take more advantage of opportunities in the secondary market because there aren’t many funds actively trading. If a fund trades in €1 million to €2 million size, there’s liquidity, but there isn’t much liquidity for trades over €4 million to €5 million. Consequently, if a fund’s AUM is in the multi-billion euro range, the inability to source large allocations is problematic. Investors may want to focus on smaller-sized funds, otherwise they may as well simply buy the index.”
Indeed, the emphasis in the European corporate bond market in 2011 was on getting the overall allocation right.
“Last year was characterised mainly by buy-and-hold activity,” says Bullock. “There was a large band of funds that essentially performed in line with the index, with a smaller tail in outperformers compared to recent years. Funds tended to stick to their positions, making occasional macro adjustments.”
European investment-grade corporate bond volume is expected to remain flat or increase slightly, unless the European sovereign debt crisis deteriorates markedly. Autos will likely dominate issuance – Renault, Peugeot and BMW have tapped the market – as well as telcos and utilities, because they have short-dated maturity profiles. Heavy issuance from French corporates is also anticipated.
Looking ahead, a number of unknowns remain for the market. “While the redemption calendar suggests slightly lower issuance levels, a pick-up in corporate M&A may drive issuance up but is not our base case,” Bullock says. “Equally, if banks step away from corporate lending, that may facilitate issuance. The latter is likely to only happen gradually, however.”
Jacquard suggests it’s a bit early in the year to begin predicting the full consequences of low primary corporate bond issuance.
“The tone of the market can reverse quickly," he concludes. "We could see a pick-up in supply after only a bit of positive news about the economic environment. Many corporates will need refinancing this year and they will come to the market on an opportunistic basis.”