Introduction
Shahzada Omar Saeed has an MBA in financial management and is head of the high-yield team at Swisscanto Asset Management, where he is responsible for overseeing investments of US$1 billion. He is lead manager for the Swisscanto (CH) Institutional Bond Fund—Global High Yield I and the Swisscanto (LU) Bond Invest Short Duration Global High Yield fund. Under his leadership, Swisscanto has experienced exponential growth of greater than 300%, along with achieving top-quartile ranking for its flagship institutional bond fund. Before Swisscanto, Saeed worked for Western Asset in London, where he was responsible for co-managing some €750 million of high-yield and leveraged-loan portfolios. Prior to that he held a similar position with F&C Asset Management.
The collateralized loan obligations (CLO) market was a major source of funding in the European capital markets for companies looking to raise debt. What is likely to happen to this market through 2012?
There is no doubt that demand for CLOs is diminishing. Until 2008 they made up about two-thirds of the European leveraged-loan market. However, after the crash of 2008 and the collapse of collateralized debt obligations (CDO) or structured debt in general, demand for CLOs has virtually disappeared. A CLO is a bundle, or pool, of corporate loans made by a bank or a group of banks. Like CDOs, which were backed by mortgage securities and which are now regarded as a major toxic element in the crash, a CLO is a structured investment vehicle. It is divided into tranches of increasing risk and increasing reward. The most senior tranche of a CLO pays a modest rate on the debt, and investors holding the senior tranche are paid off first on the maturity of the CLO. The investors holding the next tranche are paid a higher premium and are paid off after the senior investors, assuming that there is sufficient money remaining in the CLO. The same for the next tranche, and so on.
Investors holding the tranche with the highest premium are the last to be paid, so their money is the most at risk. However, a significant proportion of leveraged loans within the CLO would have to default and pay very little in the pound, euro, or dollar before this class of investor took serious capital losses. For this reason, the higher-risk layers of CLOs were seen as attractive by institutional investors across Europe until the 2008 crash. However, CLOs are, by their nature, structured investment vehicles, and these vehicles are to a very large extent no longer viewed as feasible options by European investors.
Another point is that CLOs are inherently leveraged vehicles. Prior to 2008 leverage multiples were very aggressive (10–15 times) and the cost of financing this leverage was very low (Libor + 20 bps). This low cost was because the bulk of the CLO tranches were rated AA and above. With diminished demand for structured debt, leverage multiples drastically reduced to three to six times and cost of financing moved significantly higher compared to the past (Libor + 300 bps). As a result, the only survival option for the remaining vehicles is if spreads for leveraged loans remain significantly wider on a sustainable basis. Hence, European CLO markets are likely to shrink by some 75% as a consequence.
The troubles of the CLO markets play very well for the high-yield corporate bond market in Europe, which is now growing as companies look to renew debt that used to be serviced by CLOs. However, the general lack of appetite for CLOs in Europe, which makes them nearly impossible to roll over as new CLOs, creates a further problem. The maturity profile of most of the CLOs that are still running has a maturity date that is around the same time as the loans themselves become due. The banks cannot sell the CLOs on since there is very little duration left, so they are going to have to find the money to pay out to the investors on the maturity of the CLO and then hope that corporate borrowers can meet their debt at maturity or the CLO investors could lose significantly. With the diminished appetite in the market, it is clear that when current CLOs reach their maturity that will effectively be the end of the CLO market in Europe for the foreseeable future.
What does the diminished appetite of the CLO market mean for investors in high-yield corporate bonds?
Inevitably, the proportion of leveraged loans to high-yield corporate bonds is increasingly switching in favor of bonds. Given that a significant maturity wall of leveraged loans is due over the next two years, in the face of this demand for credit high-yield bond investors have been able to secure better terms for themselves than has historically been possible.
To put some color on this, since the Lehman Brothers crisis in September 2008, 50% of all new debt issuance has been as secured high-yield bonds, which means that the bond is backed by assets of one sort of another, be they security against property, cash flows, or whatever. The historic position was that secured high-yield bonds were a rarity. Intuitively, bond investors securing better terms should have a lower premium, but, to the contrary, bond coupons have actually moved slightly higher. Before the move from CLO to bonds began, the coupon averaged 7.25%. Today the average coupon is 7.4–7.5%, so not only do the bonds come with securities that guarantee that a high percentage of the capital will be recovered in the event of a default, but the investor gets a good coupon rate as well. What this means is that if you make four years of coupons and you get a 70% recovery on a default in the fifth year, you have, from an economic standpoint, lost nothing on that particular bond and your portfolio of bond holdings is not damaged. The 70% return on capital in a default is the history of the index for defaults, so that is not an unreasonable assumption. For me, in an era of low returns, this makes the return from investing in high-yield corporate bonds very attractive.
To what extent are you seeing pension funds switching their investment strategies to take advantage of corporate bonds as an asset class?
The big surprise of 2011 and the early part of 2012 is that pension funds are not yet beating their way into this to any really noticeable extent. My estimation is that, on average, 2% of their funds are allocated in this asset class. However, I foresee issuance in Europe remaining above average levels for a few years ahead, despite the fact that the issuance over the last two years has been quite high relative to the recent past. At the same time, companies that are new to the bond market in Europe are having to pay a new issuance premium of 100 to 150 bps on top of what is already a decently high coupon, plus offering security for the bond. This is a very attractive rate of return and represents a fundamentally positive shift for investors in the bond market. In my opinion, investment managers really have to capture this trend if they want performance in their portfolios, considering the low interest rate and low-inflation environment.
How do you see the new capital requirements on banks affecting the corporate debt market?
There is no doubt that companies whose debt is rated as single B and below by the ratings agencies are going to be pushed away from the banks and toward the bond markets. This will be an inevitable effect of the new capital requirements under Basel III. In the past, before Basel III, $2 of CCC-rated debt meant that a bank had to apportion $2 of equity to cover that risk. Basel III demands that they apportion $9 of equity for every $2 that they lend to a CCC-rated company. This means that for a bank the cost of having CCC leveraged loans on the balance sheet is astronomically high. This is why you are seeing governments setting up mechanisms to guarantee loans to small to medium-sized enterprises. Without this, lending to a vital sector of the economy would simply dry up.
However, this issue is mitigated as, for borrowers of this type, loans are usually well secured against assets, so banks can be expected to continue to support this vital part of the economy because such loans are already well collateralized. Where the real squeeze is going to be felt is in the middle bit. Corporates with turnovers of US$200 million and more, but outside the big-company bracket, will find that debt is now significantly more expensive—which, of course, is good for high-yield bond investors. However, there is now a necessity for companies in the US$200 million and above bracket to put in place the fiscal discipline internally that will enable them to bear the higher cost of debt. For a few years they have been enjoying ultra-low rates that were not reflective of their actual credit standing, and that position has now changed for the foreseeable future.
The transition is going to be difficult for some. We have seen instances of companies preparing to approach the bond market and then backing out when they discover the coupon expectations of potential investors. If they are unable to tap the bond markets, they are going to have to try to restructure their existing debt by agreement with their banks, or else default outright.
The amount of high-yield corporate debt that has to be rolled over in Europe through 2012 and 2013 amounts to €5 billion. This is not of itself an issue for the global high-yield asset class. But the real drama will start in the second half of 2013 through to 2015, when the debt that requires rolling over will amount to some €76 billion. I do not see the market being able to self-finance that level of debt. So new money is going to have to be found. That new money will come from the bond markets, and to a lesser extent from hedge funds and private equity houses. However, corporates are going to have to offer attractive premiums to tap these sources. My feeling then is that despite the fact that coupons are already very attractive, they are going to go still higher through to 2015.
How is the low growth and deleveraging scenario expected to affect bond markets in developed countries?
The volatility experienced in the last four to five months of 2011 had a severe impact on growth expectations. We forecast a mild recession in Europe for 2012 and attach a 95% probability to such a scenario materializing. The inevitable and obvious result of a recession in Europe will be an increase in default levels, which we expect to rise to between 5% and 7% from their current historic lows. The default level in global high yield we expect to be less, at around 4%, though the market currently anticipates defaults of no more than 3%. However, the price of high-yield corporate bonds is such that you are currently being compensated for at least twice as many defaults as we expect in Europe. So if the question is whether or not the high-yield asset class offers protection against volatility and defaults, in my view the answer to that question is absolutely yes. However, what it does not offer protection against is an Armageddon scenario where Europe breaks apart ungracefully. Cumulative default levels would rise to around 45–50%, a level similar to the Great Depression in the 1930s. In such a case all risk asset classes, including high-yield bonds, will suffer heavy losses.
There are things to watch for, of course, particularly in financial-sector bonds. Some bank bonds pay 14%, but they tend to be what are known as “COCO” bonds, or contingent convertible bonds. They are straight bonds with a high coupon, but there is an agreement in the bond that if the capital ratio of the bank concerned falls below a certain level, the bond will be converted into equity. Suddenly, instead of holding a bond that puts you ahead of the equity-holders in the event of a default, you are left as just another equity-holder and all the protection of the bond goes out the window. If that happens, 14% will not look at all like an attractive recompense. These bonds, however, are worth considering as a way of adding extra performance to a high net worth individual’s portfolio. So far there have been about five or six COCO bond issuances in Europe, but the market for these bonds is expected to grow to some half a trillion euros over the next five to six years as European banks refinance themselves. Any stressed bank will be interested in this, but you have to consider the investment case very carefully.
There is no doubt that this is an exceptional period for any fund manager in the high-yield corporate bond space. We are going through a multiyear period of high volatility and massive deleveraging by both the finance sector and governments, which is very painful for economies. The geopolitical risk is huge, too. If you look back at history, it is very clear that periods of massive deleveraging and high volatility have tended to coincide with major wars, so political risk is extremely high. To prevent a major accident in the market, the European Central Bank (ECB) and Europe’s political leaders have so far built a liquidity “trauma center.” Soon they will have to convert this into a full-blown “liquidity hospital,” and it is highly unlikely that we will see this happening in a “single-shot, big bazooka” move such as was being spoken of toward the close of 2011. The politicians have been tested by the markets again and again, and each time they have balked at coming up with a two trillion euro-type rescue package. So support will come in a variety of different forms instead.
On a positive note, we have seen political changes in Greece, Italy, Spain, Ireland, and Portugal that are clearly stepping-stones toward tighter fiscal union. We saw action by six major central banks at the end of 2011 to reduce interest rates for interbank lending. We saw the ECB confirming that it would be the lender of last resort for banks. And in addition there has been the recent very successful LTRO (long-term repo operation) program, which was viewed very positively by the market. All of this has helped to keep the interbank market functioning—and more will be needed to keep it functioning. The “liquidity hospital” that Europe is going to have to set up to prevent a total liquidity freeze will need to provide each and every type of therapy that is required in the months and years ahead.
Peripheral Eurozone countries have realized that they have to swallow their austerity medicine. We saw Ireland leading the way. The Irish have realized that they have to take hits on pensions and on property, and they are delivering admirably. Ireland continues to have a higher premium on its debt than core countries, but there is no run on Irish sovereign debt because they have shown that they have the resilience and the maturity to deal with these matters. Portugal and Spain are now also working very hard to implement austerity. Italy, too, is coming into line. Governments in peripheral countries now realize that whereas in the past you could fund a 100% debt to GDP ratio at 4%, those days are gone. As a result of this level of realization by politicians, I put the chances of a major implosion of the Eurozone at only 5%.
Although it will not be a smooth ride going forward, investors will find that high yield really is a good hedge against both inflation and volatility. If you are getting 9% plus your capital back, that is a level of return that is unmatched by most other investment options. At the same time, investor appetite for the high-yield market will keep funds flowing to corporates, which has to be a very good thing for the global economy at a time when bank credit is drying up.
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