2014: A Good Year for Illiquid Credit?

(January 10, 2014) — The best opportunities for credit investments will be in the less liquid, more esoteric sectors in the year ahead, according to Insight Investment.

Alex Veroude, head of credit markets at the firm, told a briefing for investors, consultants, and the press that 2014 looked positive over the whole sector, but it looked particularly bright for illiquid assets.

“Financials will outperform non-financials, and emerging market corporate credit should theoretically be attractive, but that assumes that investors are rational, and this is a sentiment-driven market,” he said. Insight Investment expects emerging market corporates to return 9.5% in 2014.

But it’s further up the risk curve where the real opportunities lie. CIOs have told aiCIO they are increasingly being forced to consider more illiquid options in credit as the search for yield intensifies.

Leandros Kalisperas, credit manager at the Universities Superannuation Scheme (USS) said in December that he feared the low-hanging fruit had gone, and investors would have to work harder for returns.

One sector Insight Investment highlighted was mezzanine asset-backed securities, an asset class that gained popularity last year. Insight said the default rates had been surprisingly low in 2013 and not that different from investment grade loans, leading it to expect a 2014 return of 10.16%.

The phenomenon is particularly evident in Europe: research published by Standard & Poor’s in April this year showed from mid-2007 to the end of 2012, the default rate for European asset-backed securities as a whole was just 1.37%. US paper by comparison saw 16.76% default rate.

High yield loans were also more attractive in 2013, and were expected to do well in 2014, Insight’s Veroude said. The excess return in 2013, taken after any losses were accounted for, totalled 244 basis points (bps).

For those willing to take on the due diligence, collateralised debt obligations (CLOs)—packages of loans put together according to ratings—the potential upside is even more attractive. For BB-rated loans, the default rate accounted for 86bps, meaning the break even spread was 166bps. That meant that the overall excess returns for CLOs was 584bps.

“CLO default risks are much lower than other loan classes,” Veroude said. “But very few investors are currently considering them. You can tailor the risk—there’s AAA-rated CLOs if you want them.”

Veroude said take-up of CLOs had been seen in the US and Scandinavia, although the rest of Europe and the UK had yet to invest. “The 2006 vintage of CLOs was almost exclusively held by hedge funds and private investors, but those trades have almost gone now,” he added.

For those investors happy to use active credit managers, even more esoteric options are being put forward for 2014 in the form of corporate hybrids and contingent convertibles—known colloquially as CoCos.

Corporate hybrid bonds saw a surge of issuance in 2013 due to an increasing standardisation of structures, the fact investors are searching for more yield, and some high profile special situations, such as two Italian telecommunications companies who used them to raise debt without affecting their corporate rating.

Their main appeal is that they are treated by rating agencies as part-bond, part-equity. Issuing a hybrid bond is cheaper for the company than raising the same amount of money in the form of simultaneous bond and equity issues, not least because the interest on bond issues is tax-deductible for issuers, but the dividends on equity are not.

From an investors’ point of view, they can also be seen as attractive because in theory, they have very long maturity dates. Some have notional lifetimes of 60 years, others are perpetual, meaning that the principal is never repaid and the bond keeps paying interest forever.

Insight’s Head of Credit Analysis David Averre told the briefing: “€15 billion worth of supply is due this year. Don’t buy it if you wouldn’t by senior debt on fundamental grounds, and you must have the resources available to analyse the bonds properly.

“The main risk is extension risk, i.e. that they don’t call the bond. Another key risk is the option for the issuer too call bonds back if the credit rating agencies’ methodology changes, or there’s a change in tax and accounting rules. A change of ownership can [affect their decision] too. There’s also very little chance of recovery if the company goes into default.”

CoCos meanwhile saw $17 billion issued in 2013, and are expected to see issuance rise to between $125 billion and $140 billion over the next three years. These bonds are bought on the understanding that the investor can convert them into equity once the company’s stock price has hit a “strike” point, which is usually a higher price than a traditional convertible bond.

Swiss banks are currently issuing CoCos which are deemed to be extremely attractive, but there were warnings around this investment too: these are not viable for buy and hold investors.

In September 2013, aiCIO spoke to consultants how their clients viewed illiquid credit options such as those mentioned above, and it appears there is a distinct lack of appetite in the main.

Pete Drewienkiewicz, head of manager research at Redington, said he hadn’t seen significant interest in ABSs since the spreads tightened in 2012.

“Although we believe that spreads in many areas of the ABS market still overcompensate for default risk, the spreads available on investment-grade ABS no longer meet our clients’ strategic needs,” he said.

“Many clients still have concerns over certain areas of the ABS space, particularly around double securitisations. But we have had clients investing in the space since 2009 who have experience super-normal returns as a result of their early allocation to the asset class.”

Aon Hewitt Partner Tim Giles meanwhile said the interest level from his clients was decidedly mixed. While some were still nervous because of the dramatic falls ABS saw during the beginning of the financial crisis, others were more concerned with obtaining better yields, and were able to ride out liquidity problems if they arise.

“You need to make sure you’ve got a good handle on the quality of the assets and how it might suffer if a market crisis hits,” Giles said.

“Will you see great returns from the sector in the future? Probably not, but it’s still got a place in the portfolio, as long as you can cope with the possible lack of liquidity.”

Related Content: Is the ABS Market Making a Comeback? and Is Credit the Saviour of Fixed Income… and if Not, What Is?