Let me start by restating our opposition to index investing when it comes to corporate bonds (we would say that, wouldn’t we). An equity index is an index of success – as the company prospers and its market capitalisation rises, its weighting in the index increases. Bond indices are buckets of failure. The more a company borrows, the greater its weighting in the bond index. If you follow a bond index, and a company within it doubles its leverage, making its failure more likely, you will have to increase your exposure to that company. Companies like Ford and General Motors were at one stage 23% of the European high yield market – today GM bonds trade at between 15 and 30 cents in the dollar. There is no more depressing sight in the world than a bond fund manager rejoicing in the default of a company because he or she was “underweight” the benchmark. If you don’t like a company, or even a whole sector, don’t invest in it. The index issue might soon become very important for high yield investors, as bank bonds continue to tumble.
We have been very clear on our views on Tier 1 bank bonds over the course of this credit crisis. These bonds just had their worst week ever, with prices down on average around 20%. A new Lloyds 13% Perpetual Tier 1 was issued at a price of 100 on Monday, briefly traded at a 2 point premium, before falling by 50 points by the end of the week, as nationalisation fears accelerated. One broker held a competition to see if this was the worst performance from a corporate bond ever (the “winner” though was a high yield deal issued in the last cycle where the issuing company had a major accounting fraud discovered on the weekend after issue, although at least in this case the sponsoring investment bank made investors whole, taking the loss themselves).
RBS has just had its T1 bonds downgraded to sub-investment grade (BB+ or below). This means that they will enter the high yield bond indices in February, and, when the rating agencies catch up with our internal ratings, there are likely to be many more bank bonds entering the high yield universe.
The European Tier 1 market has a value of Eur 40.7 billion, compared with the European High Yield market which is Eur 49.5 billion in size. On a worst case scenario, Tier 1 could therefore become 45% of the high yield market. This raises a lot of questions – not least, do high yield investors have the skills and appetite to invest in financial bonds (a very different animal to the usual LBO industrial and media names that are the mainstay of high yield investing). Also, will downgrades from investment grade provoke heavy selling from funds which are not allowed to hold high yield?
So more bad news for Tier 1 – but perhaps one crumb of comfort. The prices have fallen to such levels that for some bonds, the bank needs only to keep paying for 2 more coupons before an investor has seen a full return of capital. Whilst full nationalisation of some banks is a step nearer, governments are making it up as they go along, and there is obviously some option value to owning subordinated bank bonds at extremely distressed levels. Full wipe outs can still occur, but the risks are at least a bit more symmetrical at these super-distressed levels.