Dr. Jochen Felsenheimer
Managing Director
XAIA Investment
Too good to be true?
2012 was a tremendous year for the European HY market. The iTraxx Crossover started the year at 750 bps, while closing at 480 bps. This translates into return figures close to 10% – and was certainly a strong reversal from the spread-widening trend witnessed in 2011. However, the general trend was driven by the European debt crisis rather than by micro fundamental developments. The HY market benefited significantly from a low yield environment and increased risk appetite of investors. Yield hunters have been scouring the markets to purchase anything offering a decent yield, especially as the safe haven characteristics of sovereign debt were questioned. Too good to be true? Perhaps not, but certainly too good to continue in 2013!
Top Story: The end of the European debt crisis?
Following two years of numerous unsuccessful attempts to resolve the European debt problem, there were two major events in 2012 which triggered a turning point – at least temporarily. First, the Greek PSI in March removed Greece from the headlines and provided a potential template to trigger a lasting debt reduction in Europe, although European authorities were not explicit in regards to whether this was meant to be a one-time event. The overall positive reaction of the markets was primarily driven by the perception that Europe was finally undertaking a legitimate effort to combat the crisis after all the pseudo-initiatives in 2010 and 2011 (first & second Greek bailout and the establishment of the European bailout mechanism, which did not immediately help).
High Yield, Financials & Sovereigns: Moving hand in hand through 2012
The Greek PSI was probably not the smartest solution – but it reflected the willingness of all major institutions to implement measures in order to resolve the prevalent situation. The decisive point was the fact that European politicians emphasized that the Greek PSI was a one-time event. Given the high refinancing requirements of European countries over the next decade, in combination with the declared target to reduce the interdependencies between sovereigns and banks within the Eurozone, foreign investors were urgently needed to provide sovereign funding. Foreign investors, however, demand a stable legal environment, one that minimizes the risk that governments could easily restructure their bonds, thereby ignoring the basic rights of investors. This was precisely what occurred during the Greek PSI, while Cyprus is currently the next candidate for a potential restructuring, as recommended by the IMF. It is extremely important for the European debt market in general, that European authorities are able to enforce a bailout package without any bond restructuring. Otherwise, it is our opinion that outside investors will not be willing to provide government funding in Europe (especially in peripheral countries) at the relatively low yields urgently needed by the usual suspects (Portugal, Spain, Italy).
The second big event that transpired in 2012 was Draghi’s announcement that the ECB is willing to buy sovereign bonds to restore “normal” risk premiums, i.e. lower refinancing costs for Eurozone members in the primary market. “Never fight the ECB” was the logical reaction by investors, who immediately increased their risk appetite. This was reflected in a strong decline in risk premiums, not only in the peripheral sovereign space, but also in the equity and credit markets. High Yield bonds benefited greatly from investors rolling down the credit quality curve to generate a return sufficient to match their liabilities (pension funds and insurance companies) or to attain their target returns (umbrella funds et al.). Hence, it is primarily real money being invested in the High Yield markets, which is also reflected in the fact that the amount of HY-risk in Exchange Traded Funds for the first time exceeded the amount invested in HY index swaps, such as the iTraxx Crossover or the CDX HY indices. Moving forward into 2013, we believe that there are two major questions for High Yield investors which need to be answered: i) will the low yield environment persist, and ii) how do High Yield markets behave in a low yield environment.
Question 1: Will the low yield environment persist?
This question is closely linked to our introduction, i.e. whether we have already seen the peak in the European debt crisis. Actually, the current status of the Eurozone looks rather comfortable in comparison to the situation a year ago. Ireland appears to be out of the woods already, while Portugal has exceeded the requirements set by the EU in order to continue to have access to European bailout money. The refinancing costs for Spain and Italy declined sharply and both countries have been able to tap the market to fulfill their current funding needs. The establishment of the ESM, in combination with the ECB’s announcement to retain rates low and liquidity high, signal a further relaxation of the crisis, which should also trigger further spread tightening in the peripheral space. However, this situation is not driven by a bright fundamental trend but rather by “artificially” supportive technicals, i.e. the current liquidity overhang provided by the ECB. That said, it will be important that the positive effect from the monetary side translates into a positive trend in
the real economy, otherwise, a Japan-like scenario seems the most likely outcome. This is precisely what we think. Comparing the cause of the European debt problem and the measures established to fight the crisis, Japan provides the best template for what might happen in Europe over the next couple of years. The lessons which can be learned from history (pls. see Reinhart et al (2012): Public debt overhangs, J. of Economic Perspectives, Vol. 26, # 3) show that Europe might enter in a long lasting period of low growth and low yields. Consequently, we could argue that persistently low yields will provide further support for risky assets, especially high yield bonds. There are however more effects which must be considered!
Question 2: How do High Yield Markets behave in a low yield environment?
Assuming the Eurozone will enter into a Japan scenario, low yields will have several different effects, and will definitely not be a catalyst for a quick return to fundamental prosperity. At a first glance, the effect of low yields on High Yield markets looks supportive as i) it technically triggers a reallocation into risky assets, and ii) a continuous liquidity overhang argues for low default rates. Unfortunately, there is also the other side of the coin, as can be seen in Japan, which has been in crisis mode for nearly 17 years! Besides negative effects on the equity market (which could trigger adverse spillover effects into credits), the biggest problem is the stability of the financial sector. This is a similarity between Japan and the Eurozone. The former was forced to directly support financial institutions, which is stringently the case in Europe. The risk of persistently low interest rates for financial markets is not on the “corporate” side, but rather on the financial side of the economy. Asset-liability-driven accounts, like pension funds and insurance companies, will experience increasing stress the longer (the formerly known as) risk-free rates remain at current levels, as these institutions will not be able to match the liability side of their balance sheets, given that asset returns remain subdued. As these institutions are currently major holders of high yield debt, any crisis in the European insurance sector will consequently lead to a sell-off of risky assets. Even without assuming that the next “black swan event” will hit the markets in 2013, the risk resulting from asset-liability managers arises from the fact that insurance companies will be forced to lift hidden reserves to fulfill their financial liabilities. This can only be accomplished by selling “good” performing assets like corporate debt, including high yield bonds.
In summary, we do not believe that the low yield environment will end in 2013, nor do we opine that the effects from persistently low yields have only positive effects for high yield credits. We acknowledge that there exist major differences between Japan and the Eurozone, as the latter is a currency union. Thus, there are additional effects in Europe, which primarily result in a higher heterogeneity regarding the aforementioned potential outcome of a low yield environment for European High Yield markets. Funding needs of high yield companies in different countries will not be satisfied to the same extent, as peripheral high yield companies will have a disadvantage in accessing capital markets and also in securing bank financing. Single-name picking rather than buying into beta seems to be the right strategy in such an environment. In addition, there is another risk factor for High Yield markets arising from the on-going fight against the debt crisis: the potential effect on growth patterns in Europe.
Credit fundamentals: Growth, where art thou?
Again, the effect of the debt crisis on the real economy is closely linked to monetary policy. First of all, we do not believe in financial repression in Europe. This is simply due to the fact that money is much more flexible than was the case some decades ago, when the US solved their debt problem by financial repression after World War II. On the back of integrated capital markets, capital is always at risk of “flight” in the case government taxes it indirectly. This thesis is strongly supported by the increasing importance of Asia as the new global hotspot for investments. Singapore recently overtook Switzerland in terms of assets under management. We also do not believe in inflationary pressure in the real economy. Obviously, we do have inflation in Europe, however the expansive monetary policy of the ECB is triggering asset price inflation rather than inflation in goods markets. Bailout money will primarily be used to support banks’ activities to fund their balance sheets and will only be transferred into the real economy to a small extent. If the inflationary pressure remains subdued, the ECB will be able to stick to its current policy, though this policy does not have positive growth effects. European monetary authorities are currently facing a kind of liquidity trap, which also means that the ECB is simply not able to push economic growth. If we assume that the low yield environment persists, the logical consequence is that this will be accompanied by a low growth environment. The basic problem in Europe, however, is getting even worse by the lax monetary policy of the ECB, as it supports the close link between the real economy and the financial system.
The threat for economic growth is the size of the financial industry
In addition, the risk is that the European debt crisis will become a European growth crisis. This is again linked to the heterogeneity of the economic structure and the diverging economic trends among EU member states. Setting interest rates for the whole of the Eurozone simply means that no single member country acts under the “optimal” interest rate from an individual perspective. The fact that own currency devaluation from the viewpoint of a member country is not a potential policy measure, and interest rates are fixed, fiscal policy remains the sole alternative to support economic growth. As the dominating countries (led by Germany) in Europe argue that debt reduction rather than fiscal spending is the appropriate solution to the debt crisis, peripheral countries will be unable to increase government spending as a growth initiative. Moreover, with an average unemployment rate of 11.7% (as of October 2012) in the Eurozone, and with some countries even approaching more than 25% (Spain and Greece), there are striking arguments against any positive impetus from the consumer’s front. If government spending declines, driving exports via currency devaluation remains impossible, and consumption growth stays subdued, the key important question is: where should growth come from?
To make a long story short: European financial markets will most likely start to expect subdued growth patterns in Europe in the foreseeable future. And the focus will shift to the major driver of global economic growth during the next couple of years: Asia. This again supports the view that there will be a diverging spread trend within the European High Yield universe. While those companies with presence in the booming regions will benefit, those with a European focus will most likely suffer. In general, the dominating effects in the short term will remain monetary impetus, while the major impact on spread valuation in the long term is economic growth. This is clearly an argument against a positive trend in risky asset classes when monetary actions eventually fade away. There is however an interesting spillover effect on High Yield markets in a situation of low yields and low growth; companies which are unable to enforce higher prices for their products will start to increase leverage if “easy money” is available to support profit generation. This would clearly be an argument for a weakening of credit protection ratios, especially for cyclical companies. In this respect, there is an additional potential threat from the perspective of bond investors: the return of shareholder value policies at the expense of bondholders!
Equity vs Debt: Are equities the better choice?
One major argument for buying equity instead of debt is the relation between the dividend yield and credit spreads. There are already many protagonists who proclaim a switch out of bonds into equities given the extremely low performance potential of government bonds and following last year’s rally of credits. But, could this also be a potential risk factor for high yield bonds?
Equity vs. Debt: Who is leading whom?
First of all, the performances of high yield credits and equities have been closely linked in 2012. This was not only driven by the liquidity overhang which supported all risky asset classes, but also by the current stage of the debt-equity cycle. We have not seen companies increase leverage on average, while the earnings situation also argued against a micro-fundamental driven sell-off of equities. In such a situation, equities and credits generally move hand in hand with regard to value. Referring to the ideas mentioned above, we would clearly argue for a continuation of this pattern – but probably with a changing leading sign! Although increasing leverage might be a potential loophole for some companies, we do not think that this trend will be established in general. Credits and equities will remain impacted by the same fundamental drivers. A further deteriorating growth trend and the rising systemic risk for financial institutions on the back of the low yield environment, will trigger both, lower equity valuations and wider spread levels.
There is another factor which, in our view, argues against the rotation from high yield bonds into equities. One major outcome of the financial crisis since 2007 is the political pressure to impose stronger regulatory rules on both markets and market participants. Put simply, it is becoming increasingly difficult for many accounts to keep a high level of exposure in equities. Selling bonds to buy equity is therefore not an alternative for many institutional investors, especially out of the asset-liability segment (insurance companies/ pension funds). Solvency II and Basel III will finally trigger financial institutions to behave with a greater degree of risk aversion, forcing them to keep higher liquidity and equity ratios, while lowering their risk positions. This brings us to our last point, which we believe will play a comparable role as credit fundamentals in the trend of financial markets: regulatory challenges.
Regulatory challenges: A potential Damocles’ Sword
After introducing the short-selling ban on European sovereign risk in November 2012, the establishment of EMIR (European Market Infrastructure Regulation) will be the next step towards more regulated markets. Under EMIR, all OTC-derivatives (including HY CDS) transactions will be transferred to clearing houses. The introduction of EMIR was initially planned for January 2013, which was a rather ambitious target and could not be implemented in time. In December, the ESMA announced that the introduction will be postponed to the end of 2013. Although this will not have a direct impact on the cash High Yield market at first glance, it illustrates the willingness of regulatory bodies to reduce systemic risks by restricting free market forces.
Moreover, the introduction of a European Financial Transaction Tax (FTT) is planned for the beginning of 2014. The tax will cover the whole corporate space within Europe, including cash bonds and also derivatives. The current draft recommends a 10 bps tax rate for cash bonds and a 1 bp tax rate for derivatives, which have to be paid per trade (and not per round turn). Consequently, the FTT will trigger a noticeable increase in trading costs, especially against the background of the current low yield environment. It is hard to say what the impact on high yield credits in Europe will be, as the FTT will apply to almost all asset classes to the same extent (the gross tax rate is the same). At a first glance, the tax will be designed in a way to avoid any re-allocation effects among asset classes. Nevertheless, there will definitely be an effect on the relative valuation of credit derivatives versus cash instruments, benefiting the former at the expense of the latter. And there will be an indirect reallocation effect, as the tax rate of 20 bps (per round turn) will have an indirect impact on the relative valuation on different assets (low yielding assets suffer relatively more than higher yielding assets). This could even be seen as a relative advantage of high yield bonds compared to safe havens and higher rated credits.
In any case, we do think that the impact from regulatory changes will have a more prominent role in analyzing (at least) relative value opportunities in 2013 and beyond. Hereby, there are two dimensions of effects deriving from a stricter regulatory environment. One dimension applies to the financial instrument itself, the other dimension applies to the specific status of the investor. We view the latter as the more important effect, because a changing investment behavior of specific market participants will have an impact on their asset allocation process.
Conclusion: Not too good to be true, but too good to last
Aggregating all the aforementioned arguments, there are rising threats for the European High Yield universe, stemming from the on-going low yield environment, from deteriorating growth patterns, and from potential reallocation shifts driven by regulatory changes. In the short-term, the supportive effect from the oversupply of liquidity will continue to dominate High Yield markets, however, we believe that moving into the second half of 2013, the deteriorating fundamental environment will prevent spreads from tightening further. Investors jumping on the high yield train should probably take the next stop to descend the train or, at least, to implement a more cautious stance towards European high yield assets.
It is obvious that the current situation in Europe argues for single name picking rather than buying into a broad market, as there are increasing signs that market segments will diverge, driven by largely different fundamental trends within the European High Yield markets. This is primarily due to geographical aspects (core Europe versus periphery), sectors (cyclical versus non-cyclical) and market positioning (growth regions like Asia versus stagnating regions like Europe).
We expect significantly more volatility on the derivatives side compared to cash bonds, as the majority of the latter are still in the hands of real money accounts while there is a rising number of cross asset players using index swaps, like the iTraxx XO, as an instrument to implement short term trading strategies. This will trigger some anomalies between CDS and bond markets, while the average basis in the European High Yield segment should stay slightly positive at least in H1 2013.
Generating returns in 2013 will undoubtedly be more difficult than was the case in 2012, and thus we would like to close with a cautious quote: “When a thing is funny, search it carefully for a hidden truth” (G.B. Shaw).