ECM Asset Management’s Jens Vanbrabant believes Europe’s credit markets require particular attention
Jens Vanbrabant, portfolio manager at ECM Asset Management, says that investors need to adjust their exposure to European credit markets because of the way they have been affected by the financial crisis in the region.
During the last six years the financial crisis has caused upheaval for governments, financial institutions and households across the world. What is perhaps less well understood is to what extent it has affected Europe’s credit markets.
In this note we will review how the size and composition of Europe’s investment grade bond markets have changed with reference to two indices – the Merrill Lynch ER00 and ER40, which track the performance of EUR denominated investment grade corporate debt and EUR denominated BBB rated corporate debt respectively.
The table below lists key characteristics of our indices for three dates chosen to reflect the start of the century, the start of the debt crisis and today.
|Number of issues||1,733||1,280||1,150||731||290||67|
|Amount outstanding (Euro)||1,399,824||921,097||445,144||548,581||200,633||27,789|
|Asset swap spread||111||27||28||173||47||92|
|Yield to maturity||1.8||4.6||5.6||2.3||4.7||6.2|
|Average cash price||109.7||100.2||98.1||108.5||100.1||97.8|
Source: Bank of America Merrill Lynch
Firstly, we note the explosive growth of the bond universe. Since 2000, the ER00 has more than tripled in size to €1.4trn. Between 2000 and 2007, this growth was a consequence of a number of factors such as the recent creation of the single currency, the maturing of young credit markets and the build-up of the debt bubble. From 2007 onwards, the continued growth was largely explained by banks’ efforts to control the size of their balance sheets by pushing companies into the public bond markets.
The lower average rating of the indices is also worth a comment. The ER00 is now rated four notches lower than 13 years ago as the share of the index rated AAA dropped from more than a quarter to zero. Before the start of the debt crisis, the deterioration in average rating quality was mostly attributable to active decisions by management teams to gear up balance sheets in the hope of improving shareholder returns, but since 2007 the lower ratings have been predominantly passively incurred in the sense that they resulted from more difficult trading conditions taking their toll on corporate financial metrics.
Thirdly, the moves in opposite directions of credit spreads and yields have been quite pronounced. Whereas the spread on the ER00 quadrupled to 111bps, the yield was cut by more than two thirds to 1.8% in a reflection of the zero interest rate policy implemented by central banks globally. What this means is that a much larger share of the returns available from investing in the credit markets now arise from spreads as opposed to interest rate yields, suggesting that it makes sense to invest on a duration hedged basis. The interest rate cuts also led to the average cash price rising to 109.7 for the ER00 versus par only six years ago.
Dramatic shifts indeed. What are the lessons for the prudent investor?
During the first five years of the century, the BBB space was the sweet spot for investing in credit markets not only because absolute spread levels were attractive (e.g. 92bps for ER40 in 2000 vs. just 28bps for ER00) but also because from a relative point of view the amount of spread that was available in excess of what was required to protect the investor from expected defaults was most attractive in the BBB bucket. Although these arguments still hold today, they are offset by a number of other factors.
Firstly, the table shows that the spread argument for focusing on BBB credit is less compelling than in the past. With a current asset swap spread of 111bps, the broad investment grade market which has an average rating of A- now offers investors the opportunity to achieve returns similar to those that were available in the BBB segment of the market in the early years of the century (as a point of reference the ER40 asset swap spread in 2000 was 92bps).
Secondly, whereas the exposure of the ER00 to the five peripheral European countries was broadly unchanged from 2007 to 2013 at 14.5%, that of the ER40 increased by almost 70% from 21.5% to 36.5%. The graph shows how the weight of Italy and Spain in particular has increased since 2007:
Source: ECM Research, Bank of America Merrill Lynch
Anecdotally it is worth pointing out that at the end of 2003, the ER40 contained just one Spanish bond (Endesa 4.2% 2009 ISIN ES0230670210) and following an upgrade to the single A rating category, it disappeared from the index in 2004 hence the ER40 had no exposure to Spanish risk at the end of 2004! So as the BBB universe has become the habitat of credits from fiscally stretched countries, it is fair to say that the index has lost an element of diversification.
It seems like the credit crisis has moved the goalposts for credit investors. From a risk adjusted point of view, unlike before the start of the financial crisis the higher ex ante returns available from investing in the BBB universe are now outweighed by the concentration risk to Spain and Italy. Investors are better off focusing on the investment grade corporate debt market as a whole as opposed to just its BBB sub segment because it is more diversified and stable in terms of its country breakdown.
ECM funds are not benchmarked to specific indices but use them to set volatility guidelines. Our focus on Multi Asset Class Credit (MACC) investing allows us to access the most compelling opportunities across the credit spectrum. This focus on sourcing best ideas means that we avoid the trap of being benchmarked to an index such as the ER40 at a sub optimal point in time. ECM will continue to invest in Italy, Spain, Portugal, Greece and Ireland but the timing and size of the investment will be decided by our investment process, not a pre-determined index weight.