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œGo Long Credit Selectively

by FIIG Research | Dec 09, 2008

“Go Long Credit…Selectively”

The coming year presents some very good opportunities for investors to lock in high, guaranteed returns in credit as opposed to equities, which we consider will remain volatile due to higher corporate default levels, cuts in dividends to protect capital and the higher cost of refinance (which if unattainable may also be a primary cause of default). From August 2004 to June 2007, FIIG viewed credit markets as not fully compensating investors for risk. Ultra tight credit spreads could only widen.

Around July 2007, the US sub-prime crisis hit and credit spreads finally started moving wider; however, the risk premium was also increasing. As we know, this sub-prime crisis rolled into the credit crisis and then the banking system crisis and so on. Throughout this time we have still held the view that credit was not paying sufficiently for the risks, which had increased exponentially. For the reasons below, we think selective, well-researched credit investments are now offering very attractive returns. On this basis, we are officially changing our view to “Go long credit…selectively”

To put the last 18 months into perspective, the Aussie iTraxx spread graph has been reproduced below. This graph shows that spreads for the top 25 most liquid, investment grade Australian bond issuers has moved from 42.53 at 20 September 2007 to 377.00 as of 8 December 2008, a massive move by any standards to make new record highs in Australian corporate borrowing costs.

This unprecedented widening in spreads has finally resulted in a level of return which is commensurate with risk. It is this movement of over ten-fold that has lead us to change our view on credit. Whilst credit risk remains and we anticipate an increase in corporate defaults, it is important to remember not all companies will fail. In fact, the majority will survive. The market is currently pricing in a high chance of default for many companies with strong balance sheets and good management. The key to success in the current market is to conduct detailed research in order to separate those companies at high risk of failure from those that will survive and even benefit from the reduction in competition. Hence the subscript “…selectively.”

The key components upon which we have formed this view are:

1) Credit spreads are at historic wides - investors are being compensated for taking risk. It has not been widely reported, but credit spreads have practically doubled over the past 2 months. Whilst base lending rates/official cash rates have been slashed, these historically wide credit spreads present an opportunity for investors to obtain an absolute high rate of return, in many cases 9%-11% for highly-rated, well-respected and well-managed companies. It is our expectation that spreads will slowly tighten over time. However, in such a volatile and dislocated market such as this there are selective opportunities to invest in strong banks and corporates at extremely cheap levels. Such investments may see material spread contraction in a recovering market, presenting sizeable capital gain prospects, especially for longer dated exposures. Our research department has seen an increase in opportunities where the market appears to have oversold the risks of a specific name. In many cases this can be linked to technical factors (i.e. demand and supply) as opposed to any deterioration in fundamentals or credit risk. Now is the time to take advantage of these opportunities to build a selective, high quality, high yielding credit portfolio.

2) The risk of financial system collapse has been greatly reduced - global governments have taken unprecedented measures to stabilise the financial system. Whilst risk is still present, the fear of a systemic collapse has been materially reduced. Governments have injected capital (albeit at different levels within the balance sheet) to prevent collapse of banks considered systematically important to their economies. Positions in banks that rank in priority to government investments are recommended. Further, the backstop of Government Guaranteed deposits and wholesale funding provides a great deal of liquidity and funding flexibility for banks and finance companies across the globe. Such organisations can now be assessed using a fundamental view of balance sheet strength which concentrates on the asset quality as opposed to funding concerns which have been the focus for the past six months.

3) Massive amounts of liquidity and budgetary stimulus are being pumped into the world’s major economies. Certain sectors are also major beneficiaries of rescue packages/bailouts - global governments have taken unprecedented measures to stimulate the broader economy and rescue many specific sectors. Political decisions can and will have material implications. Government support is now a key factor to be assessed in determining creditworthiness of a company or industry (and this factor is often not incorporated into credit ratings).

4) Official cash rates have been slashed around the world reducing the base lending rate – this reduction in the base rate is expected to reduce the pressure on both the consumer and company interest costs over time. However, for most borrowers, the reduction in the base risk-free rate over the last 3-4 months has been offset by an increase in credit spreads. Over the coming year, this trend is expected to reverse and the interest costs of most corporates will fall materially. Further official cash rate cuts are expected and our view is that the credit spreads are near their peak and will gradually tighten over the coming year. 

5) A “normal” yield curve is evident for the first time in many years which pays investors to go longer out the curve - both the Australian Government and swap yield curves have a positive gradient, meaning that investors get paid even more for going out longer on the yield curve. Combined with wide credit spreads, the absolute returns available for longer dated investment grade bonds is still as high as 9-11% whereas the cash rate is expected to be below 4% (and possibly even below 3%) by March 2009.

The importance of detailed analysis and credit research has never been higher. The folly of relying on rating agency assessments has come to bear. Whilst 2008 appeared to be the credit market’s “annis horribilis”, corporate failures have not yet peaked. Default rates are expected to climb significantly in 2009 and the key to investing in credit for the coming 12 months will be to avoid those companies at risk of failure (often those highly leveraged with high concentrations to cyclical industries) and as mentioned above, the is the rationale for  the subscript “…selectively.”

Whilst there are a number of risk factors that need to be assessed, the greatest concern for 2009 is refinance risk.

Any companies with significant amounts of debt that need to be refinanced in the next 12-18 months are to be avoided unless there is proven access to the current credit market or that company has access/support from one or more of the many government sponsored liquidity facilities available.

The numerous global banks with access to government guaranteed debt issuance now fit the category of having access to finance and at reasonable cost. Without the funding concerns, there are many highly rated (predominately AA- and AA), household bank names that can be assessed as having sufficiently strong balance sheets and acceptable loan asset quality. Our research team has highlighted a number of US, European and domestic bank A$ issuers that fit this category with some very attractive entry levels still present; JP Morgan, Deutsche Bank and the four Aussie majors to name just a few. Moreover, these best of breed, large organisations have an extremely high level of implied government support, as failure would lead to significant losses to global governments who have now guaranteed large amounts of their commitments.

Despite media reports over recent months that the credit markets have “thawed”, the ordinary/non-government backed credit markets remain well and truly frozen. Once again, it has gone unreported but credit spreads have doubled over the past two months (and the starting point was close to historic wides at that time). Access to finance is severely limited as banks worldwide have cut new lending targets as a means to strengthen capital ratios.

Foreign banks will continue to retreat to their domestic markets, in part due to their new owners and/or insurers – the government – reiterating that the bailouts they have received are for the benefit of the domestic economy/borrowers. To some extent the price of the bailout/capital injection is “national service” at the expense of global expansion. This trend is expected to persist for 1 to 2 years as a structural change in global banks takes place with investors and moreover regulators demanding less leverage. This may even become a longer term trend that takes 3 or 4 years to complete. Governments around the world have guaranteed vast amounts of deposits and wholesale funding – in the tens of trillions. To “protect” from large scale payouts on those guarantees, de-leveraging, de-risking, increased capital and increased regulation is and will continue to be forced upon the global banking system.

In summary, refinance will be difficult. It is not a question of price but rather one of access. For this reason, a very strong business case is required for an investment requiring refinance and it is expected that our recommendations will mainly come from the banking sector and those defensive corporates that have long term, secure funding already in place.

In fact, our current view of the fixed income market in Australia can be generalised as follows:

Banks: Invest in senior or subordinated bonds. Government guaranteed deposits also remain attractive, but deposit rates will fall as RBA cuts continue so lock in the current high rates now. Bank hybrids in general are not paying sufficient return for the risk. Investors with exposure to bank hybrids or considering bank hybrids should look to move up the capital structure into subordinated debt to access lower risk for only a slight reduction in return. Equity upside and/or debt protection can also be obtained via use of cheap, far out of the money equity calls/puts.

Corporates: Opportunities exist but require sound research and analysis. Significant risk is present as we go through a deep global recession. Any company with refinance risk is to be avoided unless the return fully compensates the risk. With a general lack of strong corporate issuers in the Aussie bond market, there is little senior debt recommended. However, for investors with a higher risk appetite, there is some very good value in corporate hybrids that have been severely beaten down as investors flee the market. Further details are provided in the 2009 Hybrid Outlook below.

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