This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Royal London Asset Management's head of fixed interest, Jonathan Platt, asks if credit market liquidity is improving or deteriorating.
Credit markets have been very volatile over the last six years. Prior to the financial crisis of 2008/9 the average credit spread on investment grade sterling credit bonds was around 0.5%. In the depths of the crisis this spread reached 4.5%, falling fairly steadily since then to around 1.1% at present. This still significantly over-compensates investors for holding credit risk, rather than government bonds, and it is our expectation that credit spreads will continue to decline, although they are unlikely to challenge the levels seen prior to the crisis. This reflects a combination of structural changes, such as a higher weighting of lower rated investment grade bonds in the market, and some psychological factors - including the fear of a repeat of 2008/9.
One factor that is often cited for the relative undervaluation of credit bonds is liquidity, that is the higher transaction costs and the lower dealing sizes in credit bonds relative to government securities. At this point some historical perspective is helpful. In Europe and the UK, credit markets have grown very strongly over the last two decades. This has reflected many factors, including low absolute interest rates, the desire for long term finance, the maturing of pension funds and, more recently, the deleveraging of bank balance sheets.
In the ‘sunny uplands' of the earlier 2000s it was envisaged by some that the characteristics of the credit markets would mirror those of equity markets: high liquidity, greater price transparency, active derivative markets. For a variety of reasons the evolution of credit markets has been patchy. Credit derivatives have developed, but liquidity and transparency have not followed suit. In part this reflects the differences between credit bonds and equities. While on the face of it there is not much difference, with both representing corporate funding, in practice, there are key structural variations.
End investors in credit markets typically want predictable long term cash flows, they tend to be risk averse and focus on what can go wrong, whilst equity investors are more interested in long term growth opportunities and what can go right. This results in credit markets adopting a ‘feast or famine' nature – small changes in investor sentiment can have disproportionately large impacts on relative valuations; the net effect is that at various times markets lose their ‘two-way' status, with the majority of investors all looking to execute the same trade; this can make trading bonds very difficult and expensive. Trading venues are also more developed in equity markets, with credit investors more dependent upon primary issuance to create liquidity.
These structural impediments on liquidity have, in recent years, been exacerbated by banks facing pressure to boost capital ratios and withdrawing resource from their credit trading businesses. As a consequence, there is increasing evidence that credit markets are dividing, with liquidity being concentrated in the largest issues and the rest experiencing lower price transparency and liquidity. This process is self-reinforcing as large asset managers, coping with high cashflows, and momentum-based trading funds are forced to buy the largest issues. So, increasingly, many managers are chasing the same liquid bonds, forcing credit spreads on these particular bonds ever tighter.
While this may sound like a recipe for buying only liquid bonds, we would argue firmly that the reverse is the case. With large swathes of credit bonds being overlooked this means that there is a significant valuation gap opening up between the large liquid issues and those bonds which trade less frequently and where patience is required to source.
For long term investors, this presents a real opportunity. First, valuations are more attractive. Second, they can offer greater economic and sector diversity. Third, they often have features that are particularly attractive, e.g. enhanced security and better covenants. This strategy may not appeal to investors looking for quick moves in and out of credit but, in truth, a credit approach that was reliant on the ability to generate value through short-term trading, whilst always low conviction, is now becoming increasingly ineffective in the new credit landscape.
Ultimately, and somewhat perversely in our opinion, the credit market is reducing its emphasis on fundamental credit risk within its allocation decisions. We have always believed that the first question to be answered when buying a credit bond is whether we are being adequately compensated for that bond's specific credit risk. More generic, technical factors, such as liquidity, can then be managed appropriately at the overall portfolio level.
