March 2011

PROFOUNDLY IMPACTED: fixed income still in trouble

ImpactThe knock-on effects of the European debt crisis continue to exert pressure on the fixed income market, says Coline Fernandez of Standard & Poor's Valuation & Risk Strategies.

The financial crisis gave rise to a wider market sentiment that the pricing of financial instruments did not always reflect the risks associated with them – this sentiment is well reflected in the European bond market. It is more important than ever that all funds looking at the fixed income market understand the relationship between a bond’s various risks – market and credit risk in particular – and evaluate how well the bond compensates an investor through its yield.

Concerns of contagion risk became widespread across the European Union when observers feared the possibility of a sovereign default. Asset managers became cautious as they waited to see if Greece would default on its debt and what the ramifications might be if the EU determined to provide them with financial support. It was unclear where the true counterparty risk would lie if a ripple of defaults occurred through a multiple event risk.

Fund managers attempted to find out the counterparty risks involved in their funds by analysing the credit health of a much wider array of counterparties to their various transactions as well as what risk limits would be appropriate for investment purposes and how their allocation strategies should adapt to the emerging environment.

Both corporate investment grade and high-yield markets experienced, at least temporarily, a significant decrease in issuance as a result of banks reassessing appropriate risk levels for their lending and underwriting activity.

In terms of issuers, the European high-yield market is still relatively small. However, Europe saw the most sustained return to the high-yield bond market for the past ten years immediately before the Greek sovereign debt crisis.

European investors began to favour guaranteed government-backed securities, cash and commodities as the crisis continued, all of which have provided relatively consistent returns historically. Demand also increased for shorter duration corporate bond portfolios which moved from an average duration of five years to three. Lower risk assets were proving more attractive.

However, the average duration on bond portfolios has increased again to five years recently as concerns over credit quality and sovereign defaults have eased. Despite the return in risk appetite demonstrated by this trend, transparency still remains an issue for structured finance investors. A European Central Bank and Bank of England-led initiative aims to increase adoption of loan level data and loan level data modelling in a bid to deliver this transparency.

Robust credit models are also beneficial for investors – in addition to loan level data – to be able to effectively simulate defaults and recoveries that respect the unique circumstances of each pool of loans backing a structured asset. These and other similar tools developed by analytics providers will allow for a greater depth of valuation information – something market participants indicate is currently being encouraged by the market.

This means not just evaluated and/or model-based prices but also making the underlying inputs that generate those prices and the market data used to generate those inputs available more widely to investors, especially for asset backed securities. This is a vital step in restoring investor confidence in the asset class, where distressed sales have sometimes resulted in depressed valuations and confused the intrinsic, economic valuations when assets are held to maturity.

Two primary causes led to the general decline in issuance that has taken place in Europe. First, significant amounts of issuers refinanced in late 2009 or early 2010 after forecasting increases in cashflow risk. Second, the need to compensate investors for higher levels of risk they were being asked to take was identified by issuers.

The importance of relative value analysis that incorporates a view of both credit and market risk within fixed-income instruments has led investors to address information asymmetry concerns. Meanwhile, demand for relative value and risk benchmarking in combination with counterparty risk monitoring and stress-testing analytics from some companies is set to continue increasing in expectation of increased regulatory oversight.

Market participants are increasingly likely to utilise cross-asset class analytics to improve how they measure correlation risk and how they stress test an increasing number of factors. Asset managers will continue to improve these techniques and look for more ways to evaluate whether they are being fairly compensated for the risks they are taking.

©2011 funds europe