Corporate bonds - as good as they look?Maybe – but some are better than others

Owen McCrossan FIA Standard Life InvestmentsRoger Sadewsky Standard Life Investments

Corporate bonds – as good as they look

Actuary’s take on it Closer look at the market How does credit fit with institutional investors?

Fund manager’s view What happened? Where is the value? Where is the market going?

Corporate bonds in the news

Asset Managers and strategists turn to top-grade corporate bonds

FT 6 January 2009

Asset Managers and strategists turn to top-grade corporate bonds

FT 6 January 2009

Corporate bonds are the favourite asset class for financial advisers in 2009, a new survey of nearly 1,500 IFAs shows.

Citywire 1 March 2009

Corporate bonds are the favourite asset class for financial advisers in 2009, a new survey of nearly 1,500 IFAs shows.

Citywire 1 March 2009

Corporate bonds can offer an attractive level of incomeBelfast Telegraph

Corporate bonds can offer an attractive level of incomeBelfast Telegraph

What’s all the fuss about?

Source: Merrill Lynch, as at 30 March 2009

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Long Term Capital bailout

Spreads at record levels despite low default environment: banks stressed initially then corporates

Enron, Worldcom, Tech Bubble

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Global Corporate Default Rates - S&P

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Default Rate (%) Investment Grade Default Rate (%) High Yield Default Rate (%)

Historical Default Risk

Extra yield(% pa)

Credit quality 1920-2007 1970-2007 1920-2007 1970-2007 1920-2007 1970-2007AAA 1.83 1.20 0.06 0.04 0.66 0.59 0.62AA 5.27 1.88 0.19 0.07 2.25 2.06 2.18A 6.33 4.08 0.23 0.14 2.54 2.32 2.40BBB 12.91 10.51 0.47 0.38 2.94 2.47 2.56*Adjusted to average annual risk, allowing for 30% recovery on defaults Source Moodys' & iBoxx (March 2008 extra yield)

20 year default risk (%) Annual risk (% pa)(%)*

Extra yield over risk

Default risk – the credit puzzle

On average 0.19% of AA bonds have defaulted each year (after allowing for some recovery)

Extra yield has historically been rewarding

Sources: Bloomberg, Merrill Lynch, Thomson Datastream and Bank calculations.

(a) Option-adjusted spreads over government bond yields, decomposed into different factors using the model described in Webber, L and Churm, R (2007), ‘Decomposing corporate bond spreads’, Bank of England Quarterly Bulletin, Vol. 47, No. 4, pages 533–41.s

The Actuary magazine Bank of England Inflation report

Illustration of illiquidity premium incorporate bond spreads

Default risk Expected defaults Risk of greater than expected defaults

Liquidity premium

Ratings migration – not just about defaults

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02/01/09 16/01/09 30/01/09 13/02/09 27/02/09 13/03/09 27/03/09

Non-gilts

Gilts

So why still underperforming?

Given the attraction of credit and new allocations, why has the market continued to underperform?

Source: Merrill Lynch (UN00, G0L0)

Composition of bond indices

Financials make up 1/3rd of market

Industrials, 17.5Utility, 7.3

Quasi & Foreign Government, 32.2

Covered, 1.2

Securitized, 9.2

Financial, 32.6

Source: Merrill Lynch non-gilts index UN00

Closer look at credit spreads

Financials are exceptionally wide Utilities/ Telcos still come at significant premiums

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Non-Gilts

Financials

Utilities

Telecom

Source: Merrill Lynch

Bank Debt: not homogenous – which tier?

Increasingsubordinationand threat to

capital

Senior

Lower Tier II

Upper Tier II

Tier I

Preference

Equity

Lower Tier II: no coupon deferral possible, final definite maturity date with possible early call

Hybrid preference shares: payments may be made at discretion of bank and may not need insolvency or non-payment of equity dividend.

Upper Tier II: gives more options to borrowers – perpetual possible. Coupon may be deferred (cumulative)

Tier I: non-cumulative deferral of coupons and may or may not permit equity dividends to be paid simultaneously

Senior: no coupon deferral possible, bullet structure,ranks pari passu with retail depositors

Financial spreads

Some parts of banks capital structure are being priced as equity

Source: Barclays Capital, iBoxx

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Upper Tier II

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Senior

Why invest in corporate bonds?

Match liabilities?

Good absolute return potential?

Pension schemes Is ‘matching’ FRS 17/ IAS 19 a reason for investing majority of

assets in credit? How much does it alleviate funding costs?

Life insurers Implications as a result of MCEV and ICA capital requirements

£ Credit spreads – the historical perspective

Source: Merrill Lynch, as at 30 March 2009

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Long Term Capital bailout

Spreads at record levels despite low default environment: banks stressed initially then corporates

Enron, Worldcom, Tech Bubble

0

100

200

300

400

500

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1/09

Global Corporate Default Rates - S&P

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Default Rate (%) Investment Grade Default Rate (%) High Yield Default Rate (%)

Corporate bond’s 2007-08 – what happened? Centre of the storm : too much debt/ music stopped…………….

US housing collapsed, Mortgage paper hit – accelerated from 2007 and spread

2003-2007 banking model “unstable”- Shadow banking / Securitisation

Asset liability mismatch and reliance on “liquidity”

Short term assets froze / CP died – MTM encouraged this

Deleveraging (SIVs / Banks) = Forced selling :

Ratings (and Bank solvency) confidence hit

Feedback loop hit’s economy

Simplification – what’s all this about defaults?

Say 100m of capital - if 2% defaults

But you get back 40% of that (a recovery rate)

Your loss is not so bad – it’s only 2% x 60% = 1.2%

So 1.2% is the additional return required to breakeven against 2%pa defaults

Source: Moody’s

Investment Grade Spreads Offer Default Protection

Investment Grade Peak in 1938 at 1.6%

1930s saw 10 years defaults above 0.2%

Average 0.75% pa

Hi Yield peak in 1933 at 15.4%

More sustained default levels in recent times

Hi Yield market still to see defaults and genuine funding problems…

…also, banks are still overweight loans0

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Speculative Grade (LHS)

Investment Grade (RHS)

Key characteristics of credit indices – a basketIndex Constituents Average

Credit RatingIssuance Cost versus

Corporate Bonds

ITraxx Main

(Inv Grade)

125 Investment Grade European Liquid names

A-/BBB+ Every 6 months for 3,5,7,10 year maturities

Eur 150m typically deals with a 1bp spread versus Eur10m of corporate bonds dealing at 10bp spread on value

ITraxx High Yield (Crossover)

50 Higher yielding names (Sub IG)

Similar to ML High Yield Index (45% commonality)

BB-/B+ Every 6 months for 5 & 10 year maturities

Crossover deals Eur40m on a 2bp to 3bp spread versus high yield bonds dealing on 2% to 4% on value

• Liquidity (20+ market makers)• Transparency: rules based, pricing/trading standardization• Roll procedure: one mechanism agreed across market• Structure: no fees, static basket, equal weightings

ATTRIBUTES

iTraxx index vs cash bonds

Difference between iTraxx and swap spread on cash bonds is another measure of illiquidity

Arguably iTraxx is a better measure of the default risk priced into market

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Corporate Asset Swap Spread iTraxx Europe 5Y

What’s all the fuss about implied defaults? The (low) A rated iTraxx index of credit spreads is 170 bp (1.7%)

(links to cash credit at 400bp) – no funding cost etc. ‘A’ rated companies do not default – they are well rated – historically probability 0.04% 1985-2006.

What’s implied?

170bp or 1.7% return. Divide by 1-recovery rate 1.7/(1- 0.4 = 0.6) = 2.8%

Vs 1938 depression 1.6% .(!)

Note: 5/12/08 was 220 bp = 3.7% !

We do question recovery rates If recovery rate is 15% breakeven default rate is 2.0% - closer to 1938 .....

but still we look cheap !!

BNP say 5 year cumulative rates were 6.5% for low A rated in the 1920’s today the 5 year breakeven in iTraxx is 14% (based on 40% recovery)

High Yield less convincing

High Yield Index (low BB) 5 year cumulative default rate is 58% (using 40% recovery) with spread of 1,000bp

Using 15% recovery it’s 45%

Great Depression – low BB is at 39%

So sure it’s higher but not much

MORE value & less risk in Investment grade…………

Hence the fuss !

Sovereign risk is deteriorating too!Several countries ratings cut Greece/Spain/Portugal

Source: Barclay’s Capital

Policy action?

Flood of liquidity (Bank guarantees) eases money market

Bank bailouts : lower capital requirements : Schemes: / Asset protection/ Asset Purchase BUT

Banks nervous about lending in weak environment

Global rate cuts

Fiscal stimuli

Next impact………….Scary stuff Asset quality deterioration – auto loan, car loan’s etc Ratings down grades Defaults EMEA Company earnings : weaker Economy weaker

Glimmers of hope Resolution of Banking markets: “Nationalisation” vs Non

Nationalisation Lending survey – past the peak in tightening Sign the Economic medicine is working and not killing the patient Asset price stability – old fashioned lending re-start Private credit becomes Public credit <?>

Corporate bond outlook

Investment grade credit offers value for long term investors

Why? Already anticipates defaults and liquidity is poor

Low returns on cash and drive for transparency favours the asset class

Economic weakness / uncertainty / volatility to continue

Looking for triggers for improved sentiment

The end of deleveraging Credit availability returns and is taken up Full bank recapitalisation US housing market reaches a floor

Questions

?… and discussion