Analyse the characteristics, inherent risk, behavior and correlation of asset classes when it comes to fixed interest securities.
1. The bond universe
2. Credit agencies and ratings
3. Credit yield curves
5. Inflation and bond returns
David Parsons, Fixed Income Product Specialist, BlackRock
Presenter: Hello and welcome to Akademia. The following module is about understanding the corporate bond market, and it’s presented by David Parsons of BlackRock.
David Parsons: What are corporate bonds? Within the sphere of bond markets, corporate bonds have become an increasingly important part of the market over the course of the last ten or so years in particular. The corporate bond market can be traced back quite a good deal further than that, but really in modern times we’ve seen significant growth in corporate bond new issuance and investors in the corporate bond asset class particularly over the last ten years or so. Corporate bonds are issued for a number of reasons; amongst them would be things like a company that wishes to diversify its financing base.
It may well feel that it has a lot of equity and issuance, or it may be a bad time to tap the equity market for finance. So bonds provide a ready source of alternative finance for companies and corporate treasurers who are looking to come to the markets. In addition to that, we’ve seen with the very low interest rates available over the last few years a resurgence of bond issuance as companies have taken advantage of low interest rates to either add to their borrowing at cheap levels or alternatively to refinance expensive outstanding borrowings with cheaper new borrowings.
In addition to that, we’ve also seen companies coming to the market because they’ve effectively been shut out of their traditional borrowing relationships. Following the Lehman’s debacle of 2008, a lot of banks, who were traditionally directly lending to corporations, were reluctant to do so, and where they were prepared to extend credit terms to companies they were perhaps on less attractive terms. Corporate treasurers turned to the corporate bond market as an alternative source of finance and found a pool of investors who were perhaps less restrictive in terms of the rules and guidelines that they would put on the borrowing, the so called covernance, and in addition to that they found that the markets were broad and deep and looking for good quality corporations to lend money to. Unlike banks who at that time were actually trying to shrink their balance sheets.
In addition to that, some corporations would also issue bonds in order to finance overseas subsidiaries. A case in point might be a company like Tesco. Tesco launched Fresh and Easy into the United States a number of years ago, and actually soon afterwards, having all of these US dollar denominated assets of property and stock, in denominated in dollars, thought it would be appropriate to have dollar borrowings to offset against their dollar assets, thereby hedging their balance sheet exposure. They bought a dollar denominated deal in the US and interestingly it was priced cheaper than deals in the UK because the United States investor base was perhaps less familiar with Tesco as a name. Perhaps we’ll come back to deals like that at some point later in the presentation.
One of the key characteristics though of corporate bonds is that a corporation is deemed to have a higher risk of default or non-repayment of its loan than perhaps a government. Now arguably in recent times one could say that governments’ risk of default as risen significantly; they’re no longer regarded perhaps as the risk free assets that they traditionally were; having said that, the corporations will generally have a risk premium, an additional yield that they would pay to an investor who’s prepared to take the risk to lend to them rather than to a government.
Now this additional yield that an investor would demand would vary often according to the riskiness or the perceived riskiness of the corporation they were lending to, and perhaps be it a function of a number of other factors such as external opinions as to its creditworthiness, the nature of the industry that it was operating in, and also specific factors relating to that corporation itself that might make it more or less risky than a similar corporation. This additional risk premium that investors demand is known as the ‘credit spread’ or ‘spread’ and is the additional yield above government bonds that they demand for taking the risk of owning a corporation rather than the government.
The corporate bond market, as I previously discussed, has grown quite extraordinarily over the course of the last ten years in particular, to point where today the corporate bond market is approximately $21trn in size. Now you’ll recall that contrasts with the government bond market of $24trn and the equity market of $26trn. So as you can see taking the government bonds and the corporate bonds together they’re a substantively larger pool of risk than equity markets are.
When thinking about corporate bonds we have to think about the nature of the corporate bonds and the types of corporations that are issuing them. The pie chart on the left illustrates the different sectors that issue, and we group bonds together there when we think about these sectors, but within each of those sectors, as you may be familiar with within equities, there are often subsectors of bonds as well that we can discuss. You’ll see that one of the largest sectors is actually the government related or government guaranteed sector, which is approximately 27% of the market. This represents those bonds issued by government agencies, supernational bodies and other institutions where the government of a country or countries have afforded a guarantee to those bonds.
Examples might be the European Investment Bank, the World Bank and other such institutions, including some bonds issued by parts of the European Union, including the EFSF. Another important sector is the financial sector, which includes predominantly banks but also insurers as well. It’s a very important sector. And if you look in different marketplaces you’ll find that the extent to which the financial sector is a significant sector will vary from market to market. So, for example, if you looked in the UK market for corporate bonds you’d find that the financial sector was significantly larger than it is in the global market place.
The industrial sector is probably fairly familiar and relates to a wide range of corporations, from retailers through to telecom companies. It could include as companies as diverse as cement manufacturers and car manufacturers. But if you look perhaps at the asset backed sector it’s a little less clear as to what that actually represents. Asset backed securities are those securities where there are either a financial asset or a physical asset that actually underpins the bond, if you like the security for the loan. It’s a sector that’s grown very strongly over many years. It does include things like mortgage backed securities and also commercial mortgage backed securities, as well as asset backed securities relating to auto loans, to home equity loans, but in different markets there are perhaps different nuances in terms of the composition of that sector.
So for example in the United States the mortgage backed securities market is actually quite dominant there. Whereas if you look at asset backed markets in, for example, the UK corporate bond market, you’ll find that there’s a more diverse base perhaps of asset backed securities and less of a predominance of mortgage backed securities. The right hand pie chart shows us the breakdown of the credit ratings of the non-government bond sector, and you’ll see there’s still a very high proportion of AAA rated bonds; however they are very highly correlated with the asset backed sectors and the government guaranteed sectors, where typically the government guaranteed sector tends to be largely AAA rated, and a lot of asset backed securities are also AAA rated, given that they have very high quality collateral underpinning the bond markets. What we have seen, and I’ll illustrate later on, that there has been a gradual drift towards lower ratings of credit, and we’ll talk about credit ratings next.
Credit rating agencies perform an important function in bond markets in giving investors invaluable and independent advice as to the expectation of default that they should consider when looking to buy a bond. They provide a rating, and this can range from AAA at its highest to default at its lowest, and the major rating agencies of Standard & Poor’s, Moody’s and Fitch have slightly differing scales, which roughly equate to one another, but they are the best guide that is publicly available as to the expectation of the risk of default of buying a bond.
So, looking perhaps in a little more detail, you can divide the ratings broadly speaking into investment grade, which would be bonds rated generically between AAA and the bottom end of the BBB side of things, and sub-investment or high yield is the other side of the marketplace, which is perhaps slightly riskier. A long time ago when that side of the market first started up, they were actually known as junk bonds, but nowadays, they’ve come of age, it’s a deeper more liquid market, and certainly the investor base of people who are prepared to buy higher yield bonds has actually grown quite significantly over the course of the last 10 years or so.
Investment grade bonds, between AAA and BBB- are actually typically strong corporations, banks, insurers, a wide range of companies. At the highest ratings you typically find government guaranteed institutions, and banks these days are broadly rated in the A/BBB area for the most part, having seen their ratings move sharply lower over the course of the last few years. In the high yield space, you often find quite well known household names, but perhaps they are in the high yield space because the company’s maybe very heavily indebted, or it may well be that it’s a company that has a very small capital base. So often the reasons for why they’re high yield can vary. Typically though high yield debt tends to be an area of perhaps more specialist investing and requires a good deal more knowledge of the underlying covernance or rules if you like governing that bond issue, and requires a good deal more expertise in terms of portfolio manager skill to be able to identify the value and understand the differing nature of the bonds that are in that part of the universe.
Let’s return to credit spreads? We’ve established that the credit spread is the additional risk premium or yield that an investor is seeking for buying a corporate bond in preference to a government bond, and the factors that can drive that credit spread will be related to factors that maybe specific to the company, to the sector that it operates in, or to the credit market as a whole and its relative attractiveness. Credit spreads are expressed as a yield. And like all yields, if you recall when we considered government bonds, as a yield rises so a price falls, and as a yield falls so the price rises.
We can apply this to corporate bonds. If for example, the credit risk of a company is deemed to have become greater, one would expect that the investor would demand a higher risk premium for owning that security. In this situation a company where, for example, we might have expected to demand 1½% additional yield for owning that retailer for example, it could well be that in a difficult retail environment a company that perhaps has issues and concerns might see its borrowing cost rise to 2%, or we would say 200 basis points above government bonds. In that situation that would be an example of the credit spread widening.
Similarly, if that company were on a strong positive path and perhaps the leader in its sector, perhaps very strong results, it may be that the market will take a very positive view of the credit, and it may well be that the yield spread that which was previously 1½% above government bonds, or 150 basis points, would actually be driven lower. The demand for that bond would actually push the price higher and the yield lower. In this case, the yield being that credit spread. So the credit spread might come down to 1%, or 100 basis points, over government bonds.
That would be an example of the credit spread tightening. The credit spread then compensates us for the risk of default of buying a corporate bond in preference to a government bond, and in the same way that yields can move for interest rates so the credit spread can move independently of interest rates according to factors that we’ve identified, such as company specific factors, a company selling off an important division, or a division that generates a lot of its income, which would certainly move sentiment very negatively, or equally it could move as a consequence of something that’s going on in the sector. It may well be that the sector itself is facing challenges, for example the auto sector where there’s very significant overcapacity, and it could well be that it’s part of a generalised negative sentiment that’s driving the spreads wider or, if you like, the risk premium higher. Equally credit spreads can be driven tighter by very positive news, and again that can be stock or sector specific.
We’ve equated the credit spread to yields, and thinking about it in interest rate terms, in the same way that there is a yield curve for interest rates as we’ve seen in earlier parts of the presentation, there is actually a credit curve as well. In other words, if one is borrowing for longer, you’d have an expectation that the credit risk premium would be higher, because the risk of something going wrong would obviously increase and the risk of default would increase over time. As a consequence, if a company, for example, in the retail sector were borrowing for five years, it may well be that they could do so at a risk premium of 1.5% above government bonds. If they were borrowing for 10 years, it might be 2% above government bonds, and if they were borrowing for 30 years, it might be 2½% above government bonds.
In the same way the government bonds yield curves can be distorted by investor preference, you can also find distortions in the yield curve as well for corporate bonds. For example, a very strong demand for longer dated corporate bonds from insurance companies can have an effect on pushing overall yields of long dated corporate bonds slightly lower than would otherwise be implied. Credit markets though are changing, and have been since the credit crunch. The table on this slide actually illustrates how taking together the AAA rated and AA rated bonds back in 2007, you can see that together they were about 61% of the sterling corporate bonds market. If one looked at that today they would actually be closer to 38%. But what we’ve seen over time has been a gradual migration of credit ratings lower as credit rating agencies have responded to some of the criticism that was levelled at them around the time of the Lehman’s crisis and in addition banks in particular have seen credit ratings coming much lower, reflective of their overextended balance sheets at that point in time, and the need for them to deleverage to a level where they were perhaps no longer so dependent on governments to bail them out.
The financial sector, however, remains a very significant part of, for example, the UK credit markets, and if you look at the proportion that it is of the overall market at 26%, when you look at a A and BBB rated segment of the market and finds that financial sector bonds are actually now one-third of the marketplace, and that will be the debt of insurers and banks that has gradually over time been downgraded from higher ratings to the lower end of investment grade ratings.
So we’re seeing here over time a trend towards lower ratings, particularly in the financial sector, but also more broadly across the market. And that means that investors and also portfolio managers have to think perhaps wider universe beyond just investment grade. Traditionally, bond funds used to be either investment grade or high yield; nowadays one finds for example in the strategic sector that there’s a lot more cross over where managers are actually investing in both investment grade and to a certain extent in the high yield markets as well. And that really is a response to the changing structure of the market, the demand for yield, the ability of high yield bonds to deliver a higher yield for investors, and also the opportunity to diversify into other segments of the marketplace.
Let’s take a close look at the financial sector because it is, as we’ve deduced, a very important sector. One of the key tenets of the financial sector is that not all bonds issued by the same bank for example would actually rank equally in the event of a bankruptcy at the bank. So it’s fair to say not all bonds are created equal. If you look at the structure that’s laid out on the slide, you’ll see at the top of the structure are covered bonds. Bondholders who own covered bonds in banks effectively have a floating charge over the bank’s assets. So these bonds are very highly secure and would really rank up there with depositors in terms of their seniority and the structure. As you work your way down through the structure through senior bonds, what are called lower tier two bonds, upper tier two bonds and tier one bonds, which have varying degrees of moving towards being more and more junior as we go down the slide, then you find that you eventually get to equity holders.
So, from the point of view of investment, buying a bond of a bank, a portfolio manager has a very wide range of bonds, which may have different characteristics, different credit ratings from the most senior and lowest risk, through to the most junior and highest risk, to choose from. And it means that investing in the financial sector is actually quite challenging and complex and requires a fairly deep understanding of the nature of the bonds that you’re buying and the particular characteristics applied to them. This was made very clear during the course of the credit crunch, where in some instances coupon payments were withheld from junior subordinated bonds given the parlour state of banks finances. This was rare, but nevertheless it just brings into focus the need to really understand the nature of the bonds that are being invested in when ones looking at the financial sector.
We discussed asset backed securities or ABS at the start of this section of the programme, and I felt it was worth returning to the subject of asset backed securities to give perhaps a little more colour to them. Now asset backed securities is a generic term, often they’re referred to as securitised bonds or collateralised bonds, so you may come across these terms from time to time. Essentially though they relate to bonds where there is a physical or financial asset underpinning the bond that is there to provide comfort and security to investors that there is a steady flow of payments in order to cover the coupons and ultimately the final maturity. Some of these bonds may amortise over time as well, and they have other features as well that enhance their creditworthiness from the point of view of an investor.
This may be the case that they have perhaps a larger amount of collateral than the actual face value of the bond. So for example if the bond were £100m value then they may have a £130m worth of assets underpinning it, again giving the investors a heightened sense of security and probably the bond a higher rating as a consequence. Now amongst the different types of asset backed securities can be a whole plethora of different assets. Everything in the UK from the assets of British Telecom, the BBC have securitised some of their property assets, in addition to that property companies themselves often do this in order to refinance their borrowings, and some of the assets can actually be of a financial nature. For example, in the pub sector, it’s often the case that the bonds are backed not only by the tenancies but also by the food and beverage sales that go on in the pubs.
Mortgage backed securities, as they would suggest, relate to bonds that are backed by pools of mortgages. Now in the UK these are traditionally mortgages from the big six lenders in the high street, so tend to be very different from the US mortgage backed securities which have gained such a poor reputation as a consequence of the failures of many of those mortgage backed bonds during the course of the credit crunch. In the UK, we have a small subsector within the residential mortgage backed securities, bond market that’s called non-conforming mortgages.
So for those investors who are looking for slightly riskier investments, then these packages of bonds that deal with buy-to-let mortgages, and self-certified mortgages are one aspect of the residential mortgage backed securities market. In addition, there’s also the commercial mortgage backed securities market. This often relates to bonds that are backed by property developments, warehousing, office developments, out of town shopping centres, such as Trafford, such as White City. So these bonds also are asset backed securities of a fashion as well. There are also bonds that are backed by financial assets. This would extend to bonds, for example, that are covered by the repayments on car loans, or student loans as well. So a very, very wide variety of assets can be used to back bonds that would be classified as asset backed securities.
Now, beyond this, there’s a range of what are called collateralised obligations, the most famous of which would be collateralised debt obligations, which are effectively bonds of bonds, where there are a portfolio of bonds grouped together that are then used as the collateral for a new bond. These kind of collateralised bond obligations, collateralised loan obligations and security obligations, are not mainstream investments typically for corporate bonds funds, for example. As a consequence I’ve put them below the line on the page here. There is certainly a ready market of investors who are prepared to look at these investments which are perhaps potentially higher risk, potentially less transparent in terms of the underlining investments, and certainly it has been a market that’s been relatively quiet until recently following the difficulties that experienced post Lehman’s.
When we talk about asset backed and mortgage backed securities, often you’ll hear the term pools of securities or pools of mortgages, and it would be useful at this point just to give a little more colour to how an asset backed security is created. Typically, an asset or assets are grouped together in a pool of similar characteristics. So for example if it was mortgages it would be a range of mortgages which had similar loans to value, that were geographically diverse for example within the UK and probably all came from the same lender so that common credit standards have been applied to them. You could take the pool of mortgages then and break into a series of bonds backed by that pool of mortgages, and the bonds would be targeted to different investor groups. For those investors who were looking for a relatively low risk, low return investment, you might have the AAA tranche, and then you would issue AA, A and BBB and even a BB high yield tranche. Progressively the additional risk premium you would earn would be going up, but obviously your risk of loss in the event of some of those mortgages failing to be repaid would actually be rising as you moved to the lower rated tranches.
I’ve put there the first repayments and the first losses and you can see that the higher rated AAA bondholders would actually be repaid first from the proceeds of any mortgages that were repaid and all cash flows would go to them ahead of other bondholders. Equally, if there were any defaults or any mortgages that had lost money then effectively the BB holders, the high yield holders would actually take the first losses. So if you’re a AAA holder, then actually you’re quite happy because everybody below you, AA, A, BBB, BB, would all have to have lost all of their money in terms of the underlying mortgages defaulting before you have any risk of capital loss. So these structures should on the face of it be very secure for AAA rated investors.
A final thought, just to finish with them, back to really where we started initially when we started talking about bonds: what is a bond? Well, a bond is the discounted value of known cashflows, whereas an equity is the discounted value of unknown cash flows. Bonds will always have the advantage that if something goes wrong, if a company goes bust, then equity holders take the first losses before the bondholders do, and if there’s any cash left after the liquidation of a company then it goes to the bondholders first. And typically when there isn’t very much left, there’s precious little left for the equity holders. So bonds give you a known income, and they give you a stronger position in terms of in the event of liquidation or the bankruptcy of a company.
A final thought then. We’ve looked at corporate bonds, and we’ve thought about corporate bonds in terms of the additional risk premium that one takes, but from just an overall perspective where do they sit next to equities. A bond is the discounted value of known cashflows, and when one’s valuing an equity, you’re thinking about the discounted value of unknown or assumed cash flows. So bondholders straightaway have an advantage in having a known income that they can rely upon. And also, if something went wrong with an investment, from the point of view of where you sit within the capital structure of a company, in the event of a bankruptcy, for example, equity holders typically have to take all of the losses first before anything is lost by bondholders. And equally that means if there’s anything left over at the end of the day, it typically goes to the bondholders first, rather than the equity holders.
So, as a parting thought, we would just say that we feel that there’s strength in bond market investing from the point of view of the more secure position that one has relative to equity holders, but also bonds gives you very strong income characteristics that we believe commend them.
Presenter: Well, that’s the module on understanding the corporate bond market, but just to talk through some of the finer detail of it, I’m joined now by David Parsons. David, you talk there about the ratings agencies, what exactly is their role to date, how important are they?
David Parsons: They are still very important because they’re one of the few publicly available independent means of judging the creditworthiness of a bond. Many portfolio managers these days will do their own independent research, but obviously that isn’t necessarily in the public domain or there for people to look at. But what they do, they provide an opportunity for people to form their own judgement as to the relative risk between different bonds that they might buy, of differing ratings, because there’s an expectation attached to each rating as to the likelihood of default on non-payment of coupon. So obviously buying a high rated AAA bond carries very little risk, whereas carrying a lower rated bond, it might have a significantly higher risk of default. So for example buying a BB rated bond in the high yield segment of the market would be a very different kind of risk with a much higher risk of default than buying a AAA rated bond.
Presenter: And what are the consequences to a company of a downgrade?
David Parsons: It can certainly have an impact in terms of the credit spread. You’ll recall the credit spread is the additional credit premium that an investor demands for investing in a company. If people perceive that the rating agencies are seeing a company as inherently more risky, then it may well be that somebody who wants to buy the bonds for that company would expect that they’re going to get a higher credit risk premium for doing so. In other words to get paid more for taking that risk because obviously there’s a perception on the part of the rating agency that the credit has deteriorated and therefore the risk of default perhaps still small has nevertheless increased.
Presenter: Where do corporate bonds fit into a client’s portfolio?
David Parsons: Corporate bonds are an excellent source of income in a client’s portfolio, particularly in a low income environment that we find ourselves in these days. So first and foremost I think they’re a strong income generating asset and the power of compounding means that that over time could be particularly beneficial to a portfolio. Also, at a period of time as we are now where perhaps the economy is weak, it may well be that investing in corporate bonds, which have slightly higher seniority if you like in the capital structure than equity holders, may also give people a little more peace of mind that they have somewhat more security in their investment than perhaps buying equity or traditional shares.
Presenter: You talked about defaults, what happens in a default exactly, does the investor lose all their money?
David Parsons: That’s a very good question. A default doesn’t necessarily mean as a bond investor that you would lose any or all of your money. A default can actually just be technical in that for example a company has failed to make a coupon payment that was actually due, and there’s often a grace period after that, within which they still have the opportunity to make good on their coupon payment. But default in its more usual sense eventually revolves around some kind of bankruptcy or administration or liquidation of a company whereby those shareholders of the company and possibly the debt holders may lose some proportion of their capital. But there is a concept known as recovery as well, because typically what happens in a wind up of a company where the assets are sold off and liquidated, the bondholders would be paid first, and the bondholders who are most senior would be paid first down through the most junior bondholders. But, typically over the last 40 or so years, data that we have available to us from the rating agencies suggests that on average in the event of a default recovery of capital is somewhere round about 40% for bondholders. Now obviously there’s wide variations around that, for Lehman it was virtually nothing, but for a typical corporations, industrial companies, the recovery rate would be expected to be around that area, based on historical data.
Presenter: How do you expect corporate bonds to behave in an inflationary environment?
David Parsons: We would expect them to have some positive characteristics in an inflationary environment. But the extent to which they would be giving you inflation protection would be somewhat constrained by the extent of the inflation problem, the reaction of a central bank to that problem through perhaps rate increases. But if you think about it implicitly, if you have debt, inflation is effectively reducing the value of that debt over time. So that’s a small positive for a company. If you look at it in an inflation environment, then one could say that effectively debt is being inflated away, at the same time companies tend to have slightly increased pricing power in an inflationary environment which can feed through to a stronger bottom line as well, which. So broadly speaking there are some positives in an inflationary environment, but they’re by no means an inflation linked or inflation proofing asset, but like equities they have some useful characteristics.
Presenter: In that module you also mentioned the new issue market, how important is that to corporate bonds investors?
David Parsons: At certain points in time, it has been very important. It’s been a great source of new capital coming into the market, of new issuers joining the market. Particularly post Lehman’s, where we saw a wealth of new names who had found that their traditional access to finance had been shut off to them through bank lending lines and who instead came to the corporate bond market as a way of raising new capital. And I would say that that’s been a very positive experience. It’s broadened the range of names that are issuing in corporate bonds. At the same time, for those issuers, many of whom had outstanding borrowings who have refinanced them, there’s been opportunities to add value for managers through selling older issues that are being effectively paid down and buying the new issues that are coming at a discount to existing levels in order to attract investor interest.
So new issuance has always been important in the market, and I think will continue to be so, and it’s a good source of value add for investors as well to take advantage of the discounts that are attached to new issues on more often than not.
Presenter: David Parsons, thank you very much.
David Parsons: Thank you.
Presenter: In order to consider the viewing of this video as structured CPD, you must complete the reflective statement to demonstrate what you’ve learned and its relevance to you. This session has covered elements of the following learning outcome: analysed the characteristics, inherent risk, behaviour and correlation of asset classes, fixed interest securities. Well the remainder of the learning outcome will be covered in other videos in this series, but during this session the following key points have been discussed: why companies issue bonds, credit ratings, their definitions and implications, credit spreads, the varying risk levels of different bond types, and mortgage and asset backed securities. Please now complete the reflective statement to validate your CPD.
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