In today’s credit markets, it is essential to have a defined roadmap, in which you can establish where you are in the economic cycle, how much risk you want to take and what you want to invest in, said David Hawa, Client Portfolio Manager of the Robeco Financial Institutions Bonds strategy, during the “2018 Kick-off Master class Seminar” that the asset management company of Dutch origin held in Palm Beach.
Fundamentals
In order to prepare its roadmap, Robeco analyzes the credit markets from three different perspectives, taking into account the fundamental, valuation, and technical factors.
Beginning with fundamentals, the 10-year US Treasury bond ended the year at 2.43%, the same performance level as it began the year. There was no volatility in the US sovereign bond market, nor was there any for German or Japanese bonds.
About inflation, in the United States the only component in the US with price growth is Owner Equivalent Rent. A trend that they hope will be reversed as inflation begins to gain relevance. Meanwhile, in Europe, all the components of the European GDP are growing, which, according to Robeco, is very positive because it means that loan default levels are decreasing.
“With the European Central Bank’s official rate at levels of -0.4% and the German two-year bond also in negative territory, investors have to pay to be holders of these bonds. When GDP growth was in deflation and there was no growth in Europe, it could be argued that these levels were going to be maintained, but with growth at between 2 and 2.5%, it’s logical to believe that normalization of interest rates in Europe is close, even without inflation. That’s why we believe that interest rates will increase. Comparing the German bond and the 2-year Treasury bond, the spread between the two has widened since the Federal Reserve began its cycle of increases. Sooner or later Draghi and his team will also have to begin to raise rates, let’s not forget that quantitative easing measures were launched in Europe due to the fear of deflation and now we have passed that phase. The fact that rates are going to start rising is good news for the income statements of European insurers and banks, whose margins are suffering in an environment of negative interest rates.”
In the case of the United States, if the level of unemployment continues to decline, inflation will be seen in wages: “If inflation returns in wages, the Fed could be pressured to accelerate the rate of interest rate hikes, something we particularly take into account as a potential risk. “
Valuations
In general terms, the aggregate of credit market valuations is much lower than its average. The behavior of European investment-grade corporate debt -excluding financials- was better than that of US corporate debt with BBB rating -also excluding financials-. That is why Robeco is committed to European credit as, with lower levels of leverage, it’s more attractive than US credit, especially now that the volatility seen in 2016 has disappeared.
“Taking into account the valuations presented by the different levels of subordination of the financial debt, some of the issues of contingent convertible bonds, the so-called CoCo’s, offer an adequate spread for their level of risk.
This type of debt supports a higher level of risk: if the Tier 1 capital level of the financial institution’s balance falls below the minimum pre-established by the issue, the bond is automatically converted into shares. But, some issues of these CoCo’s also reward the risk incurred with attractive spreads. It takes a very high level of experience in both transactional analysis and credit analysis to enter this market,” said Hawa.
According to Robeco, the valuations of European financial debt have greater attractiveness than European investment-grade corporate bonds. Specifically, subordinated debt issued by insurance companies offers a spread of 200 basis points, and Tier 2 bank debt a spread close to 120 to 130 basis points, as compared to less than 100 basis points offered by European investment-grade fixed income when excluding the finance sector.
“The CSPP (Corporate Sector Purchase Program), the quantitative easing program established by the European Central Bank, can buy corporate bonds, but cannot buy bonds from financial institutions. Having earmarked public money to help financial institutions after the 2008 crisis, there was a popular clamor for the ECB’s money not to be reinvested back into banks. Therefore, there is a gap between the valuations of investment-grade European corporate bonds and European debt issued by financial institutions.”
Technical Factors
Central Banks’ monetary stimulus programs, which for years have been injecting a lot of liquidity into the market, are being phased out. The Fed has been working on that for some time, Bernanke was the first president who indicated his intention to withdraw the quantitative easing program in 2013. With the arrival of economic growth in Europe, Draghi should also initiate the rate hike, something that Robeco does not expect to happen until 2019.
“Another interesting issue for US investors is that, given the asymmetry created between the Fed’s rate hike and the ECB, the cost of hedging for non-US investors has increased due to the existing spreads between short-term rates in Europe and the US. Many of the Asian investors who bought US corporate bonds are now looking for greater exposure to corporate debt and European financial debt because of the high price of hedging costs. Another point in favor of the Robeco Financial Institutions Bonds strategy.”
The Assett Classes Invested in
Most issuers in which the strategy invests have an investment grade rating. However, as the risk increases, the specific ratings of some of those issues decrease, which is why at Robeco they have a highly experienced team of managers and analysts, where 90% of the professionals have over 17 years experience, having dealt successfully with both bullish and bearish markets.
As contrarian investors, they believe that the credit markets are inefficient and that they usually incur a higher or lower valuation than what actually corresponds to an issue according to its fundamentals.
As an example of this investment philosophy, Hawa cited the purchase of subordinated debt from financial institutions when it increases market volatility. “Following the Brexit referendum, bank spreads in the United Kingdom skyrocketed, but in terms of fundamentals there were new opportunities, on that occasion we bought Barclays issues. Another example was what happened in Catalonia. On this occasion, with the increase in political risk, we increased our bets in Sabadell and Caixabank, which have solid financial balances. We have also bought other national champions among European banks such as Santander, Nordea and Credit Agricole.”
Recently, the strategy has increased its allocation to insurance company bonds, which are achieving greater spreads than issues by national banking entities. Some examples would be Aviva, NN, Generali, Swiss Re, as well as other less known names such as the Dutch company Delta Lloyd, the Belgian company, Belfius, and the British company, Direct Line Group, totaling some 70 issuers, which maintain the fund’s quality bias.
“The quality of insurance companies and the banking sector has improved in terms of fundamentals, with the progression of deleveraging of the balance sheets after the implementation of Basel III and the European Central Bank forcing banks to redistribute their financial balances to prevent what happened in 2008. Loan default levels and risk asset volume has decreased, so that banks’ balance sheets have been strengthened, but it is important to know which names should not be included in the strategy. As the level of subordination and risk increases, a greater spread is obtained, but whether or not the risk incurred is being compensated, must be taken into account. We can obtain better spreads betting on Tier 2 issues from insurers and banks, than for some of the credits with additional Tier 1 subordination level. That is our responsibility, to search for how we are being compensated for the risk we are taking in the strategy,” Hawa said.
Regarding investment in contingent convertibles, despite having investment-grade at the issuer level, it is possible that the issue has a much lower rating. That is why the Robeco Financial Institutions Bonds strategy limits its position in CoCo’s. “We want the strategy to always maintain the degree of investment in aggregate terms, so we use a tactical allocation in contingent convertible bonds, not founding the achievement of a good performance on this type of asset. Since the launch of the strategy in 2014, we have always maintained the percentage of investment in CoCo’s below 15%, allowing us to keep the investment grade in an aggregate manner “.
“In January 2016, Deustche Bank experienced a series of problems: the price of shares declined and there was a real concern that its issuance of Tier 1 contingent convertible bonds was unable to pay its coupon due to the ECB’s impositions. At that time, the spreads of UBS, Barclays, Erste Group or Raiffeisen Bank skyrocketed due to the fear of contagion. On the other hand, at Robeco we decided to buy those names whose fundamentals were attractive to us, based on transactional and liquidity risk. After this, spreads were strongly compressed, and we were rewarded for the risk of having these CoCo’s in position.
Currently, the total exposure to contingent convertible bonds exceeds 10% slightly, with a 9% exposure in the Tier 1 subordinated class and 2% in Tier 2,” concluded Hawa.