Low Yields Rising Risks The New Fixed Income Environment It s High Time to Understand the Fundamentals!

Transcription

1 Low Yields Rising Risks The New Fixed Income Environment It s High Time to Understand the Fundamentals! Ralph Geiger August 2014

2 Content 1 2 What Worries Investors? Investment Considerations 3 Summary August

3 1 A Global View Is Necessary There are positive and negative news Positive news In most countries economic growth is picking up Negative news Many valuations have become expensive and interest rates might have seen the lows Risks Fed, China s growth especially real estate prices Source: Credit Suisse,/IDC, Wirtschaftswoche, CEIC, Nomura As of August

4 1 Fed Fund Futures in 2014 and Yellen s Remarks Fed Fund Futures, yield in % Yellen in March Federal Open Market Committee (FOMC) Meeting: Something on the order of around six months (after tapering) Yellen two weeks later: The scars from the Great Recession remain and reaching our goals will take time Yellen a month later: There may be more slack in labor markets than indicated by the unemployment rate 9 July: Fed officials agreed to end their bond-buying program in October no word about a rate hike FOMC press conference of Janet Yellen, Picture source: Wikimedia, Public Domain Source: Bloomberg, Datastream, Credit Suisse/IDC As of August

5 1 Is Tapering Changing the Yield Environment? Federal Reserve officials predicted their target interest rate will be 1% at the end of 2015 and 2.25% a year later Right now there are two general camps: some Fed officials want the first hike to occur by the summer of 2015 while others seem to favor the first move closer to the end of the year USA: Interest rate curve changes FOMC voting members see higher short rates Sources: Bloomberg, Datastream, Credit Suisse/IDC As of Sources: Bloomberg, Datastream, Credit Suisse/IDC As of August

6 1 Bonds Have Reacted, but Are Anchored by Short Rates The Fed said that it would continue to hold short-term rates near 0% during On the unemployment side they started to introduce the phrase participation rate (as the 6.5% unemployment rate had been broken). Furthermore, the Fed promised not to sell bonds 10-year government bond yields (2 10Y) G7 yields vs. G3 business confidence % Jan 84 Jan 88 Jan 92 Jan 96 Jan 00 Jan 04 Jan 08 Jan 12 US EMU Switzerland UK Japan Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: eview, Credit Suisse/IDC As of August

7 1 Worldwide Gross Government Debt as % of GDP (IMF Estimates) Total debt for OECD countries was at 74.2% of total OECD GDP in 2007 and has grown to 112.5% in 2014 (estimate) Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Datastream, Credit Suisse/IDC As of August

8 1 But Governments Have to Reduce Debt! Different ways to reduce the debt burden (all possibilities have already been tested) Growth Debt reduction through economic growth, income is higher than expenditures Privatization program Reducing the role of the state via privatization/deregulation/liberalization (does not work when companies are nationalized) Austerity (real saving) A balanced government budget, requires savings everywhere; will not find a majority (i.e. France, Italy) Inflation As soon as yields fall below inflation, real debt reduction starts an elegant way to reduce debt Haircut Leads to a partial or full reduction of debt; the most radical way to restructure debt (Greece, Argentina) Financial repressions Affected by two factors: interest rates are kept artificially low and an artificial demand is created (i.e. forced loan in Italy since December 2012) August

9 1 Surges in Government Debts and Their Resolution Historically Inflation is most effective in liquidating government debts, when interest rates are not able to respond to the rise in inflation and in inflation expectations Sources: National Bureau of Economic Research, Reinhart Sbrancia As of March 2011 August

10 Content 1 2 What Worries Investors? Investment Considerations 3 Summary August

11 2 Investment Considerations The difficulty: Finding a balance between performance, risk and diversification 1 Performance To achieve a reasonable fixed income return at a time when duration is unattractive since yields may rise again (economic recovery) and credit spreads are tight 2 Risk Tapering has started and many credits are mispriced. Risk/return relationships should be analyzed carefully. The focus should lie on understanding the sources of risk inherent in the different asset categories. 3 Diversification Diversifying traditional bond investments has become more important than ever before The question which investment should deliver what in a portfolio has become even more important August

12 2 Risk Is That a Rational Investment Strategy? The race for yield or how Greece received cheap money Facts Memory Issue size: EUR 3bn five years. The order book was in excess of 20bn. Yield 4.95% (Rating: S&P: B-/Moody s: Caa3). Investors: 33% hedge funds, 14% banks, 4% pension funds and insurers. Two years ago Greece had a debt restructuring, private investors took a haircut of EUR 100bn. The last issue was 2010 (five years for EUR 20bn), a few months later the first bailout started and the IMF, ECB and European Commission had to support Greece with EUR 240bn. Reality Government debt rose to 174% of GDP (higher than before the haircut) and liabilities increased from EUR 307bn to EUR 330bn. Question: Do we speak here of practically guaranteed ECB bonds Draghi Put a kind of community Eurobonds? Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Credit Suisse, Bloomberg, Die Welt As of April 2014 August

13 2 Some Investment Ideas What Should You Look Out for? A few key elements you might like in your portfolio 1. The global development Where is growth and wealth? Are there still investment possibilities? 2. Corporates or governments? Sometimes it s worthwhile looking a little deeper into the subject 3. Security or higher yield? Look for an asymmetrical risk profile leave the upside open but limit the downside 4. Safeguard your money At 0% the risk/return relationship is slightly skewed August

14 2 Current Global Default Rate (and Forecast) The default rate stands at 2.3%, below the 4.5% historical average, according to Standard & Poor s. Historically low yields, while investors are desperately looking for yields, have allowed companies to delay defaults as they have been able to easily refinance their debt (especially during the last five years). Even as leverage and signs of credit deterioration build up in the system, nobody predicts a rise in defaults! Sources: Bloomberg, Credit Suisse/IDC As of Source: Natixis As of August

15 2 Credit Spreads Narrowed Considerably When the credit spread is greater than the additional risk, it makes sense to buy corporate bonds Although interest rates in general are low, credit spreads still offer value and have room to tighten Credit spreads to benchmark Euro Credit spreads to benchmark US Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Bloomberg, Credit Suisse/IDC As of August

16 Return 2 Credit Exposure versus Duration Risk A bond has two kinds of risk: interest rate risk and credit risk. These are two distinct types of risk that can have a very different impact on various asset classes within the bond market. Credit curve Traditional corporate bond Government curve Corporate short Duration Credit: Yes Duration: No Time Laufzeit Span While some areas are more sensitive to interest rates, others, such as lower quality bonds, are more sensitive to credit risk. Understanding this difference is critical to achieving effective diversification. For illustrative purposes only. Source: Credit Suisse August

17 2 Maximum Drawdown of the Different Rating Segments 0% -15% -30% -45% AAA AA A BBB BB B CCC & lower Rating Bucket Maximum Drawdown Period August 2010 April 2011 AAA AA A BBB BB B CCC and lower -3.95% -3.12% -3.56% -6.14% % % % August 2010 April 2011 August 2011 November 2011 August 2011 November 2011 May 2011 October 2011 May 2011 October 2011 May 2011 October 2011 Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Credit Suisse, BofA Merrill Lynch Indices, Bloomberg Data: June 2010 June 2013 August

18 2 Credit Spreads in Euros High Yield Outperformed Investment Grade It is important to understand how fixed income diversification opportunities have changed in today s low yield environment Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Datastream, Credit Suisse/IDC As of August

19 2 A Dangerous Development High yield payment in kind (PIK) bonds issues rose last year from USD 6.5bn to USD 16.5bn. About 30% of the issuers of such bonds before the financial crisis of 2008 have disappeared. New loans with Covenant light New issues with PIK clauses Cov-lite: loan agreements Loan agreements that do not contain the usual protective covenants for the benefit of the lending party. Today more than 50% of loans have easier terms. PIK = Pay-in-Kind bond Pay-in-kind securities are financial instruments that pay investors in the form of additional securities rather than cash coupons. Usually the issuer has the option to choose. Sources: S&P Capital IQ, Credit Suisse, Deutsche Bank August

20 2 Investors Take More and More Risk Bonds with the lowest possible credit ratings have soared in popularity with investors. The yield on CCC rated bonds (in USD) fell from 20% in 2009 to 7.75% at the end of October (S&P: risk of default >50%). In bonds with a volume of USD 380mn defaulted (with Prokon in 2014 we think the figure will be much higher). Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Die Welt, Bloomberg August

21 2 Rising Risks You Have to Understand Them Many mini bonds (Mittelstandsanleihen) showed volatilities that were far away from normal bond behavior Price changes of the Bond M Index Air Berlin: Equity price changes. Today company has negative equity of EUR 53.1mn. Bond 8.25% 2018 yield at 6.8%. Scope Rating CCC- (Total debt: EUR 1.1bn). Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Boerse Stuttgart, Bloomberg As of August

22 2 But Do Investors Use the Same Investment Approach? Credit spreads of high yield and emerging market bonds versus US Treasuries The yields on the two indices are roughly equal the first time that this has happened since April High yield no longer enjoys a yield advantage. Interestingly, investors prefer high yield companies over emerging markets. Many high yield companies could refinance their debt at very favorable terms, while emerging market spreads widened, even with a higher rating. Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Datastream, Credit Suisse/IDC As of August

23 General government fiscal balance (% GDP) 2 Fiscal Prudence Platform for Further Economic Growth Fiscal balance and gross government debt to GDP (%) in Japan -8 India UK US -6 Malaysia Czech Republic Latin America Indonesia Mexico Taiwan Emerging Asia China Russia Turkey Brazil EMEA Chile South Africa Thailand Switzerland Korea Poland Hungary Eurozone Consolidated gross government debt (% GDP) Emerging markets have become increasingly prudent when managing their domestic economies. Burdensome government debt, large fiscal deficits and overexposed current accounts plagued many markets in the past, but today the developed rather than the emerging world faces these issues. Sources: Credit Suisse PLUS Research and Analytics, Thomson Reuters Datastream Professional, Consensus Economics, European Commission, IMF, national statistical offices August

24 2 Valuations Are at Attractive Levels After underperforming massively during 2013 following Bernanke s Taper Talk, emerging market bonds have regained their footing. Using the Barclays indexes, high yield outperformed emerging markets by 7.6% until Since then, high yield has underperformed by 2.0%. Emerging Markets IG Corporates versus US IG Corporates Emerging market region spread performance Oct 09 Apr 10 Oct 10 Apr 11 Oct 11 Apr 12 Oct 12 Apr 13 Oct 13 Apr Composite Africa Asia Europe Latin America Middle East EM vs US IG Spread Differential, bps Average Source: J.P. Morgan Indices As of Sources: J.P. Morgan Indices, Credit Suisse As of Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: S&P Capital IQ, Credit Suisse, Deutsche Bank August

25 Correlation to intererst rates 2 Reduce Interest Rate Sensitivity and Return Volatility 100% Government Bonds Reduce correlation to interest rates Avoid excessive return volatility 80% Investment Grade Corporate Bonds 60% European High Yield 40% 20% Convertible Bonds1 Aktien 0% 0% 5% 10% 15% 20% 25% Risk 1 Correlation to interest rates of convertible bonds depends heavily on the considered time period; correlation within the last 3 years 17% and within the last 10 years 57%. Historical performance indications and financial market scenarios are no guarantee for current or future performance. Sources: Credit Suisse, BofA Merrill Lynch Indices, Bloomberg Data: June 2010 June 2013 August

26 2 Structure of a Convertible Bond Bond A convertible is a bond that can be exchanged into shares at a specified conversion ratio (typically at any time) Nominal value of bond Prospectus Convertible At maturity the investor receives (but not both) Stocks Option A convertible bond is a combination of a corporate bond and a call option on a stock Convertible Bond Corporate Bond + Embedded Call Stock Option Source: Credit Suisse August

27 2 Convertible Bonds Convertible bonds have an asymmetric risk/return profile. Equity like upside potential and limited risk of losses thanks to the supporting bond floor. Convertible bonds have the potential to rise in price if the company s stock performs well. If the stock does poorly, convertible bonds have a safety net since they have a specific maturity date at which time investors will receive their principal. For illustrative purposes only. Source: Credit Suisse August

28 Convertible bond price 2 Hidden Equities in the Bond Market The bond floor of the convertible typically protects a large portion of the investment Distressed Bond-like Balanced Equity-like Convertible bond price Investment premium Parity Conversion premium Bond floor Share price For illustrative purposes only. Source: Credit Suisse August

29 2 Historical Asset Class Performance Convertibles with Higher Returns and Lower Volatility than Equities Global Broad Market Corporate Index MSCI World UBS Convertible Global Global Sovereign Broad Market Plus Index Category Return p.a. Volatility Sharpe Ratio Global Equities 4.4% 14.9% 0.08 Global Convertibles 7.8% 11.0% 0.41 Global Government Bonds 5.5% 2.9% 0.79 Global Corporate Bonds 6.2% 3.9% 0.75 Returns hedged in USD, Data: MSCI World (TR) vs. UBS Global Convertibles Index vs. ML Global Broad Corporate vs. ML Gl. Sov. Broad Historical performance indications and financial market scenarios are not reliable indicators of current or future performance. Sources: Credit Suisse, Bloomberg As of August

30 2 Inflation A Brief Summary of the Recent History Average annual inflation rate Switzerland (2.61%) and Germany (2.72%) are the only countries that have achieved an average inflation rate below 3% Sources: Credit Suisse, OECD August

31 Nominal rate Interest rates Nominal bonds react to movements in nominal interest rates independently from the source of the change, i.e. real rates or breakeven inflation Real bonds (ILBs) react only to changes in real interest rates and are immune (protected) against changes in inflation expectations Real rate Breakeven inflation Risk premium Expected inflation 2 Safeguard Your Money! Nominal yield curve Real yield curve For illustrative purposes only. Source: Credit Suisse August

32 Content 1 2 What Worries Investors? Investment Considerations 3 Summary August

33 3 Summary Which risk do you prefer? Credit risk or duration risk? Have an unbiased view of the markets! What are fundamentals telling you? Bonds with equity elements do exist and look interesting in the current environment Although inflation is not a problem at the moment, consider investment alternatives should inflation reappear Remember Separate the different drivers Duration Credit spreads Decide upon What is your investment horizon? Are you prepared to take risks? Can you live through volatility? Take your decision based upon fundamentals. Balance the risk: governments versus corporates. The combination of different performance drivers will make the difference Source: Credit Suisse August

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