October 2012

INSIDE VIEW: Solving the puzzle

PuzzleIt is difficult to explain the continued high level of risk premiums in bond markets. Valentijn van Nieuwenhuijzen, of ING Investment Management, tries, and suggests we are still in a credit sweet spot.

Bond yields have been falling almost everywhere in recent years and have now reached record lows in government and corporate debt markets. This is partially a reflection of the underlying trends in the economy as growth seems to have shifted to a lower gear in both nominal and real terms.

Lower growth, modest to falling inflation and a reduced likelihood of central bank rate hikes help to explain remarkably low levels in yields. On top of this, the high ex-ante savings desire of many sectors in the developed world – households, corporates and governments – provides another important explanation why savings continue to flow into global bond markets.

However, the fact that bond yields are low does not mean risk premiums in bond markets are compressed. Risk premiums are mostly above long-term averages and in some cases even at levels only observed in recessions or market crises.

In government bond markets, yields have dropped to record lows, but that has not prevented these markets from having to have fairly steep curves.

Given that many money market rates have fallen to zero or below, the low long-term yield environment coincides with yield differentials between two and ten-year maturities of around 1.2% in Germany and the US. This is a significant yield pick-up that can be earned by taking on duration risk in these markets, especially in times when yield and returns are so hard to come by.

A combination of unusual uncertainty surrounding macro variables in the short-term because of instability in the system, and expectations of normalisation in macro-economic variables in the long-term, have led to these risk premiums in treasury markets. However, they are not necessarily fully consistent with the most heard-of explanation for risk premiums in other parts of fixed income markets.  

Above average spreads
For example, in the corporate bond space, significant spread levels – yield differential over equal-duration treasuries – are observed. Although spreads are clearly below the all-time highs that were seen after the Lehman Brothers default in 2008, they are currently still well above average and at levels that are only seen during recessionary periods.

Given the weakness in the eurozone economy, which is in another shallow recession and systemically instable, and the increased bail-in risks for senior bond holders of financial sector debt, this might not look too strange.

However, if the US economy strengthens and stronger corporate and credit conditions are taken into account, it is much more puzzling to understand the elevated level of non-financial corporate bond spreads. Despite the weak macro-economic environment, the corporate sector has remained profitable and has further strengthened its balance sheets in recent quarters.

Corporate leverage has come down significantly in terms of net debt to equity. Moreover, near-term refinancing schedules are relatively light and expected default and downgrades are rare by historical standards.

A slow global growth environment with low interest rates and improving corporate credit fundamentals suggests we are still in the sweet spot of the credit cycle. It is arguably the final part of this sweet spot as some companies are starting to exploit the low absolute level of yields to re-lever modestly by financing mergers and acquisitions, by cash or issuance of new debt, but still a point in the credit cycle that has historically justified significantly lower spread levels over government bonds.

Persistent uncertainty
What then can explain the persistence of elevated risk premiums in fixed income markets? The first thing that springs to mind is the persistently high level of uncertainty that seems to be with us ever since the collapse of Lehman Brothers. Despite relatively low levels of volatility and flows in markets, it seems fair to say that investor uncertainty, expressed by their defensive positioning and depressed sentiment surveys, and the perception of high tail risks are pushing risk premiums higher in almost all parts of financial markets.

However, it could also be used as an argument to expect lower than usual risk premiums in treasury markets because of strong safe haven flows into these markets. If one then counterbalances this view with the argument that treasury markets anticipate a normalisation of growth and central bank dynamics in the long run, then the phenomenon of elevated credit spreads becomes more difficult to understand.

If markets somehow have faith that macro conditions will indeed normalise in three to five years’ time, then credit spreads would not be at recessionary levels given the strength in credit fundamentals that are observed today and provide guidance for the near to medium-term outlook for credits.

An additional explanation of the level of risk premiums, therefore, needs to be found. Part of the answer could well be seen in an increase in market segmentation, especially within fixed income markets. Shifting regulation for institutional investors and a rising loss of faith in benchmark approaches seem to have contributed to a stronger segmentation within bond markets.

While “total yield” investors, like pension funds, have grown in size and increased their desire to allocate money to bond markets since 2008, the size of fixed income “relative value” investors, like bank trading desks, has decreased, and leverage of more speculative investors, like hedge funds, has fallen substantially. The resulting increased dominance of total yield investors in markets has probably increased segmentation in investor flows and reduced the willingness to arbitrage away the relative price opportunities between parts of the credit markets and treasuries.

None of the explanations for the remarkable risk premiums of today solves the puzzle completely, but they do help to understand the phenomenon better. One might be tempted to feel that they offer support for the view that there is significant value in credit spreads. But it should not be overlooked that the return benefits of this view might not be reaped over the next couple of months or quarters unless there are additional, more short-term focused, reasons to expect excess returns of credits over treasuries.

Valentijn van Nieuwenhuijzen is head of strategy at ING Investment Management

©2012 funds europe