Corporate bonds: Trapped

With companies carrying too much debt and profits looking unsustainable, Elizabeth Pfeuti looks at how pension schemes could avoid a potential default.

Sometimes in life, you do not get rewarded for doing the right thing.

Since 2009, defined benefit (DB) pension investors from all over the world have been quickening their portfolio shifts from risky stocks to more stable bonds to avoid falling victim to another market crisis – only to potentially end up in one.

Over the past 10 years, UK pension funds have moved 10% of their portfolios out of equities and into fixed income, according to Mercer’s 2018 European Asset Allocation Survey. Now making up half of the average pension fund holding, this allocation is mainly held in government bonds, but these investors also hold a third of it in domestic and corporate issuance.

This should come as little surprise. The yields on gilts of all durations have more than halved in the past decade, according to the Debt Management Office, as interest rates were sliced by central banks. Given the gaping deficits some pensions had to make up following the crisis, a steady 2% return (or lower) was not going to cut it. Elsewhere, investors in some European government bonds have also ended up paying the state for the privilege, something that goes against the grain for those with liabilities to meet.

Corporate bonds, therefore, seemed to be the best bet for pensions post-crisis, as even a couple of percentage points of spread looked like the way to get back on an even keel – and there was plenty to choose from.

With borrowing costs at their lowest point in decades, companies in all sectors and from all over developed markets began to tap investors for capital.

Against this backdrop, some 20% of respondents around Europe told Mercer at the start of 2018 that they were looking to buy even more corporate debt.

Roll forward just 12 months, however, and things have begun to look very different.

STING IN THE TAIL

Unlike many well-laid plans, the one to get companies issuing lots of cheap debt worked. Each year that followed the financial crisis saw global issuance records being broken.

By the end of 2018, some $9.2trn (£7trn) of corporate debt was outstanding in the US – the world’s largest debt market – up from $4.6trn (£3.5trn) in 2005. Moody’s said in February that US non-financial corporate debt rose to a record 46% of GDP in September 2018 – beating the previous record that had stood since the second quarter of Investors bought bonds worth more than $1.75trn (£1.3trn) from companies in the US, Europe and other developed markets in 2017 alone, according to data provider Refinitiv. The trend was accelerated by Central Banks buying existing corporate bonds as part of QE. By becoming the lender of last resort, they gave confidence to investors to buy new issuances. Over the past three years the ECB alone has purchased some €177.7bn (£153.9bn) in corporate debt.

But investors are discovering that there might be a sting in the tail to all their well intended bond-buying.

Central banks, who brought down interest rates to encourage lending and borrowing, are now warning about the volumes of debt that companies are carrying.

In June 2018, the Bank of England was one of several developed market financial regulators to say it was worried about the level of debt in the US and thought risky corporate borrowing in the UK was a becoming a concern, too. This served to put the brakes on issuance, according to Refinitiv, with around a quarter less debt being sold than in the previous year.

This leaves investors with a couple of real conundrums.Firstly, as the equity bull market begins to stutter and government bonds are not a viable option – where should they look for yield?

Jennifer Bishop, one of the managers on Willis Towers Watson’s (WTW) £3bn alternative credit fund, says that her team is staying away from investment-grade bonds. “Companies are overleveraged – investment grade in particular – and much of it is low quality,” she adds.

In March, a note by the Bank of International Settlements highlighted where most issuance – and investment – had occurred across the corporate bond spectrum in the past decade.

In the note the Bank said: “Since the global financial crisis (GFC), investment grade corporate bond mutual funds have steadily increased the share of BBB bonds in their portfolios. In 2018, this share stood at about 45% in both the US and Europe, up from roughly 20% in 2010. As interest rates remained unusually low post-GFC, portfolio managers were enticed by the significant yield offered by BBB-rated bonds, which was substantially higher than for better-rated.”

From yields hitting a high of around 8% in the immediate aftermath of the crisis, according to Markit iBoxx, the average for investment-grade credit has struggled to get above 2% since 2014 – and in some cases has been well below it.

Andy Cheseldine, a professional trustee at Capital Cranfield who works for several large pension schemes, questions whether investors were getting enough bang for their investment-grade buck.

“From what I have seen over the years, no,” he says. “But we are in a new normal of low interest rates. There are places where you can get a good return for the risk you take, but the question is where to find it.”

SAY YOU’LL BE THERE

The second conundrum for investors is the viability of what they have sitting in their portfolios that they bought when lending and borrowing were cheap.

One of the biggest questions has become not what to do if a bond defaults, but when. A recent note from Moody’s showed that unlike in previous cycles, the default rate does not seem to be rising in line with the debt-to-GDP ratio.

However, many in the market, including WTW’s Bishop, foresee a wave of defaults around the corner as conditions have changed over the last decade. “So many companies are overleveraged,” Bishop says.

“Borrowing was what was getting the economy going, and regulators were mainly focusing on the consumer after the crisis, so now we are at 2007 levels of corporate debt – if not higher.”

An additional factor has been the weakening of many debt and bond covenants – taking advantage of a desperation for yield – that means investors often do not find out about a default until the last minute, when there is suddenly no room to move.

This phenomenon of “cov-lite” deals, which has worked its way down to even some of the lowest quality corporate debt, may have contributed to the stubbornly low default rate, which Moody’s said sat at 2.6% in October, its lowest level for three years.

A rate rise is usually enough to start a wave of defaults, but as the US seems to have pulled back on its path to normalising economic policy many companies – and their debt holders – may have earned a brief reprieve.

However, even if there are no rate rises on the horizon, Bishop believes the profitability of some of these over-levered companies is not sustainable. The so-called “zombie companies”, which have been given an extended lifeline by quantitative easing and purposely soft economic conditions, may be the first to fall.

It is therefore imperative to choose the right bonds, says Cheseldine, who advises some of the City’s largest pension funds.

“There are lessons that people should have learned about defaults in 2008,” he adds. “You should not just be looking at the rate of return vs the likelihood of default, but the recovery rate, too. Experiencing the loss of a bond is not the end of the matter.

“The most important thing for pension funds to do is look at their managers’ recovery process and skill set,” he says. “When it all goes wrong, how are they going to get their money back? In a shocked market, which could happen sooner rather than later in my opinion, this will make the difference between a good and bad manager.” Krzysztof Lasocki, senior investment and finance analyst at the Royal Mail Pension Plan, says that yields had fallen everywhere and, despite a strong first quarter, 2019 looks like it will be a tough year so good portfolio positioning is critical.

Lasocki adds that his team was moving away from corporate debt in favour of asset backed secured (ABS) finance.

“There are many reasons to be bullish about European ABS because this is one of the few areas that will not be affected when the European Central Bank pulls the plug and all the other assets with valuations inflated by the asset purchase programme will suffer,” Lasocki says.

“Also, mortgage-backed securities in continental Europe are strong and secure, with models showing a huge distance to defaults so there is a lot of safety cushioning even if some sort of crisis reappears.”

Bishop at WTW is also a fan of securitised mortgage mortgages. “We like consumers more than companies,” she says.

In the US, after the crisis, mortgages fell under a raft of new regulation and availability has been pulled right back, according to Bishop. “While companies have become more and more leveraged, the consumer is around a third as leveraged as in the run up to the crisis.”

Indeed, according to Moody’s, at the peak of the crisis, total liabilities as a percentage of disposable personal income for US households stood at more than 130%; today it is around 100%. As an economy, the US gives hope to investors due to its strong fundamentals and highly-employed consumer driving demand, Lasocki says, but adds that he is keeping an eye on bond activity as a leading indicator.

In recent months, market commentators have noted the yield curve of the US treasury inverted – and it spooked many investors. “There is some statistical significance to the predictive power of the yield curve inversion as there were only two false alarms in the past and pretty much every big crisis was preceded by it,” Lasocki says. “This is a strong warning signal,” he adds. “Maybe the last order bell is not ringing just yet but 2020 looks more and more a likely year for a clear end of this cycle.”

DON’T MIX, JUST MATCH

For independent pension consultant John Ralfe, if you are asking which type of bonds will get you to full-funding and beyond, you are asking the wrong question.

“There is no magic formula,” he says. “The company sponsoring the pension has made a lot of promises that have turned out to be more expensive than they expected.”

He adds that managers and consultants would try to push new products to match assets to liabilities, but the market had seen – and would continue to see – many flavours of the month come and go.

“Once you have worked out what you need to match, it is all variations on a theme,” Ralfe says. “Pension trustees who are trying to beat the market are looking for a unicorn.”

However, Bishop warns that despite being encouraged about pension funds matching their cash-flows with their liabilities, they could still come unstuck by paying too much. “A lot of the assets pension funds are buying are massively overbid,” she says. “This means some are buying highyield debt to match their cash-flow, but just look at the default assumption. People are paying too much for cash-flow matching while there is still value elsewhere.”