The fixed income market, from investment grade to junk bonds, remains fragmented with the distorting impact of the financial crisis continuing. The dislocated profile of the bond market is likely to remain throughout 2009.
Investment grade bonds continue to trade at an average price of 85. The unprecedented nationalisation and financial support from authorities globally to banks have resulted in governments becoming crucial players in the bond market, as the financial sector is the most important area in the fixed income markets. Strategies and investment in the fixed income arena must now acknowledge this factor.
Governments and central banks have become both creditors and equity holders. Although huge amounts of capital were raised last year as banks wrote down assets, this was not enough and, combined with liquidity stress and further asset write-downs, governments begun offering banks state guarantees on senior debt together with injections of equity. A number of financial institutions have either been nationalised or partly nationalised. As the crisis continues, government support is moving beyond the banking sector. Although this is largely focused to key industries, such as automotives, there may be no clear pattern going forward although, as always, the political factor will be important.
It is likely that new capital injections from governments will subordinate some investors, hence the focus on senior debt is important in order to reduce risk. Investment firm Pimco considers an appropriate strategy is to align interests and try to co-invest with policymakers. It also suggests credits that are under the umbrella of policy support. Umbrella credits could emerge from sectors with many employees (voters), regulated industries (utilities and telecoms), sectors affected by liquidity problems rather than solvency risk, and industries where other governments are already lending. Credits outside this opaque level of protection are likely to be more volatile and subject to re-pricing risk.
However, the situation requires not only the corporate issuer but the specific bond issued to be under the 'umbrella'. It is possible for the issuer to be under the umbrella but for certain parts of the capital structure to more negatively impacted. Bailouts could see deeply subordinated capital to lose out to senior investments. The market is also seeing a transfer of value from equity to credit as companies look to preserve cash through dividend cuts.
Although nearly all funds have been hit by the severe weakness in the credit markets over the past year, many investment houses continue to hold selective bank bonds, believing that bondholders will continue to receive coupons and call date buybacks will continue to proceed. Most investment houses believe that governments and banks will want to move back to a more normal state of operation in the future and, accordingly, will need the support of bond investors. The impact on the banks' future ability to raise capital should ensure bondholders receive their coupons. In association, this should lead to bonds being bought back on their call dates.
There is some value in some Tier one and Upper Tier two bonds. With a number of Tier one bonds trading at prices of around 20, only a few coupon payments are needed for investors to receive back the current value of their investment. Some bank bonds trading at low prices have call dates which are within two years, giving potential for large returns. There is of course still risk in holding some banks bonds.
Traditionally, bonds have been priced in the expectation that call dates would be honoured due to the cost of penalties and the reputational impact with long term capital providers. Recently Deutsche Bank chose not to call a lower Tier two bond.
Due to the exceptional market conditions Deutsche decided it would be cheaper to continue with the existing bond rather than refinance it. However, the longer term increase in the cost of future capital raising is likely to outweigh the short term cost saving.
Government intervention in the UK, such as Royal Bank of Scotland, all bond holders continue to receive their coupon payments. Provided governments receive their preference dividends, bondholders will receive their coupon payments. However, the government could exchange preference shares for ordinary shares. The government may not insist on a dividend and coupon dividends on Tier one bonds might not be paid.
- The author is a US-based commentator on business issues.