Global Credit Markets: From Crisis to Opportunity

History tells us that the best long-term investment opportunities are often created in the aftermath of a crisis. Just as the later stages of a bull market sends valuations to stratospheric levels the reverse is true during the later stages of a bear market creating opportunities for patient investors.

The current bear market started in the fixed income market and it is here that we are starting to see significant valuation anomalies. During the first half of 2007 the credit markets were displaying all the classic signs of a bubble and while it is easy to say with hindsight, this should have been a warning of trouble ahead.

Fixed income volatility had declined to practically nothing, credit spreads had narrowed to all-time low levels in most markets, and in the securitization markets the level of issuance seemed to be on a stable, if exponential growth path. The degree of innovation in structured products reached dizzying heights. Not only was there fantastical growth in issuance volume, there was also an impossible array of innovations in the market for securitizations. The traditional set of collateralized structures underwent a series of iterations and upgrades hitherto unprecedented in the history of fixed income markets. The innovations were not confined to cash-settled instruments, either. With the help of the credit derivative market, almost any conceivable exposure could be created, hedged or traded.

Asset managers were not the only ones to extend their focus to securitization-style markets. As became apparent later, investment and commercial banks around the world were eager to use the synthetic technology of the credit markets to hedge exposures, trade views or engage in balance sheet reconfigurations. Of course the hedge fund industry was at the forefront of the use of the new ideas.

It is perhaps then no coincidence that the collapse of two hedge funds run by Bear Stearns may well come to be regarded as the first dominos to fall over. The procession thereafter has been more or less uninterrupted, and continues unabated in some sectors of the market. The demise of the Bear funds has been repeated elsewhere and was in essence a simple mix of too much leverage in an asset that suddenly started exhibiting unexpected drops in value. The well-known unwinding follows: margin calls from brokers, forced selling to meet the calls and a sudden and rapid end to a fund with a previously unblemished track record.

Far more than just an interesting academic exercise in behavioural finance and how people failed to appreciate the potential for disaster, we view the current situation as providing one of the best opportunities in markets for the last decade. The degree of dislocation should provide those with time and liquidity on their side with excellent opportunities. As with all previous market panics, in this cycle there has been indiscriminate selling with no differentiation between good and bad credits based on fundamentals.

The chart below shows how spreads have changed for some of the major fixed interest asset classes over time. In a typical credit spread widening environment, like the 2001/02 period, there is a hierarchy across the credit spectrum, with lower quality credits like high yield and emerging market debt widening more in relative terms compared to higher quality credits. This has not been the case in the current cycle. The chart shows that with the exception of emerging markets, credit spreads have widened out but investment grade and capital securities in particular (deeply subordinate fixed income securities, typically issued by banks, that qualify as regulatory capital and are generally recognised as quasi-equity by the rating agencies), are at all time highs and this, we believe, offers value. Our fixed income team thinks capital securities, which have historically traded tighter than investment grade debt, appear very attractive.

While this is not surprising given that the root of the credit crisis has been in the banking sector, the current level of spread should be sufficient to compensate for a 28% default rate over the next 5 years and while it is likely that more banks will fail in the coming months we do not see almost 1/3rd of the banking sector going bust. The actions of the Fed and other central banks have done a lot to stabilise the financial system – as those banks that are seen as too large to fail will be acquired or, in extreme situations, nationalised – and we feel that the high level of defaults being priced into the market is unrealistic.

Credit spreads for various sectors in fixed interest markets

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Source: Bloomberg / Credit Suisse / Lehman Brothers. July 2008

In addition, the current high level of yield in the capital securities market provides a sizeable cushion should spreads widen further. Below are indicative total return and excess return over Libor (alpha) for a range of scenarios.

Capital Securities return scenarios

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Source: RMB Asset Management. July 2008. For illustrative purposes only

Our expectations are for returns over 10.0% p.a. for several years in a row. Even if we are early and spreads continue to widen, at current levels, there is good downside protection. For example over a 12 month period even a further 100bps increase in Tier one spreads could still result in a positive 3.3% return.'

Just like previous market dislocations the current ‘credit crunch’ is likely to present patient investors with tremendous opportunities. Often the area of the market at the epicentre of the crisis is where valuation anomalies first appear and in this cycle that is fixed income. For managers with expertise at assessing relative value across a broad spectrum of fixed income sub-sectors the current market environment offers rich pickings.