Investor strategy

Credit markets are beset by worries over the potential fallout from a correction in fast-expanding world of derivatives and structured finance. Interest rates are on the rise, commodity prices are surging. Yet equity markets are still rallying, boosted by continuing mergers and acquisition activity.

To make sense of all this, Tim Bond, head of global asset allocation at Barclays Capital and one of the most authoritative and widely-respected commentators on markets, will answer your questions in a live debate on Monday from 12.30pm BST.

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Do you believe the debt markets - especially bank debt - still have a significant capacity for the leveraged private equity demand?
Paul Shovlin, Dublin

Tim Bond: I think the debt markets do have a capacity for lending to private equity but not at the terms that were current as recently as a week or two ago.

The sector is re-pricing and that process has further to run. Spreads were far below fair value and are correcting back to fair value. For the sake of example, US high yield bond spreads should have been in the 350-400bps region if you regress them off default rates and measures such as debt/cashflow. Yet this year, they traded down towards 200bps. So pricing became remarkably easy and we are now see the reaction set in, as sub-prime losses remind everyone what can happen if credit standards are eased to an excessive degree.

So what will happen - in fact is happening - is that lenders demand greater protection and wider spreads. Some deals get cancelled, but others with still go ahead with lower IRR than would have been the case a few weeks ago. But this process is different to a fully-fledged credit crunch.

Crunches occur when profits decline against a backdrop of a highly leveraged corporate sector. Then, nobody wants to lend to anyone apart from governments. Right now, the corporate sector as a whole is not highly leveraged and profit growth looks fine. A handful of PE deals were certainly excessively leveraged, but in general credit quality is fairly sound. So a re-pricing, rather than a cruch, which will slow the deal flow, not terminate it.

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In an emerging market like Central America small and medium size businesses struggle to keep up with the competitiveness globalisation carries along. Clusters represent specific sectors which highlight the strengths of a nations ability to compete in a global scale. Therefore, what role could the small and medium size businesses in emerging markets play in attracting regional and foreign investment? How can small and medium size businesses market themselves as part of a nations strategy to compete in a global scale?
Carlos Eyl, Tegucigalpa, Honduras

Tim Bond: This is an interesting question. In terms of sales, the internet clearly allows small and medium-sized companies to access a much more global market than was the case just a decade ago. In terms of production, the ease of communication does make a breakdown of the production chain more feasible. So emerging market producers can access skills elsewhere in the world in the same way that a European or US firm can outsource various bits of the production chain to wherever they are done best or cheapest.

That is the theory. In practice, it is going to be much harder. Perhaps there is a role here for larger institutions to act as an intermediary for smaller companies’ attempts to outsource and make their production chain more efficient. Having a large bank or multinational as an intermediary in this process would certainly add to trust on all sides of any transaction and it is probably trust that is is the missing ingredient in many attempted deals.

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What is the future of CDOs, given that these instruments face a lot of criticism for being complex and face challenges such as high default rate in US sub-prime mortgage, high leverage and marked to market risk?
Vivek Hans, Manchester

Tim Bond: Sub-prime will certainly take a further toll of CDOs and may cast a pall over the whole sector. The logic of collective investment is sound, but the logic of relying on ratings and valuation models - as opposed to secondary market pricing - is more questionable.

I honestly don’t know whether the losses from sub-prime will serve to discredit the whole idea of CDOs. It may do - but one could equally argue that the business model just needs greater levels of protection and more pragmatic pricing. The main question to ask is has the CDO concept actually contributed anything to capital market efficiency?

Clearly, the response is strongly negative in US mortgages and is quite likely to be negative for loans as well. Substituting collectivisation and collateralisation for credit analysis really does not work and merely exacerbates the market’s innate tendency to misallocate capital during the more enthusiastic parts of the cycle.However, it is important to stress that the concepts of diversification and collateralisation are sound - provided it is combined with some judgement.

Historical losses are certainly a part of the analysis, but they need to be combined with more forward-looking analysis. The analogy would be investing purely on the basis of past average equity performance.

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What are your thoughts regarding the implementation of Trace in the high yield corporate bond markets, and the subsequent dry up in liquidity brought on by razor thin bid/ask spreads making it a money-losing endeavour for broker-dealers to trade non-investment grade bonds. If or when a global credit crunch occurs, will junk markets have a fate similar to what sub-prime markets have undergone? How might CDS markets, not yet a stress-tested instrument, fare in such an environment?
Daniel Glazer, Stamford

Tim Bond: I don’t think a lack of bid-ask spread should have a lasting impact on liquidity. We ”abolished” bid-ask in FX and rates long ago, yet liquidity is fine. Credit markets have always been rather illiquid because investors tend to buy for keeps and do not trade their positions much.

Certainly that is true for corporate bonds and loans. My first job in the markets was a rookie - and rather bad - market-maker in floating rate notes in the mid-1980s. That market had tried to create artificial liquidity by the device of head-to-head trading between different bank trading desks. The rules of the game were quite bizarre and akin to eighteenth century duelling.

Of course this very elegant system failed to survive the first proper bear market in the sector (neither did I, actually!). I think CDS has improved liquidity in credit generally, much as swaps did in the pure rate markets.

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How much effect will the decline of credit markets (e.g, increased aversion to risk and run-up of interest rates) have on private equity’s ability to finance acquisitions including deals that have yet to close? Won’t this have an immediate impact on M&A and, therefore, the equity markets especially if some of these deals start to unwind?
John Kresse, Indiana, US

Tim Bond: There has already been some impact on M&A etc from the tightening in credit conditions. However, I would stress that so far, the tightening has only repealed an extraordinary easing that occurred in the first 5 months of the year. So if you look at high yield spreads and interest rates, they have returned to the sort of levels we saw last year and in 2005.

We probably have some more tightening to go, but actual levels of average corporate leverage are still low, so the risk of spreads exploding to really restrictive levels is fairly low. Bouts of illiquidity are certainly plausible, since we are in phase in which leveraged investors are stepping back from lending to the corporate sector, to be replaced by real money investors.

However, I do think credit will continue to be available, albeit at tighter terms. So the deal flow will slow, but not stop. It is worth noting that the economics of M&A and LBO are determined much more by prospective earnings than by the interest rates. At the moment, internal rates of return will have been reduced by high rates and some deals have consequently fallen by the wayside. But the relative pricing of debt and equity is still very favourable and it would take substantially higher interest rates - by 2.5 per cent in Europe - to bring debt and equity pricing back in line with the long run average.

Broadly speaking, we have not seen equities trade as cheaply to debt as they have since 2003 for a better part of 40 years.

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A lot is being said about the risks of the credit derivative markets. It is also widely acknowledged that the more transparent and open a market is, the less likely it is to fail (because liquidity is encouraged). How important is transparency in the CDS markets, how transparent are they, and what role do data providers and market initiatives play, such as the ones administered by Markit?
Stephan Flagel, London

Tim Bond: Personally, I find the credit markets very opaque compared to the 1980s and 1990s, although I doubt many credit market participants would agree with me. But speaking as an analyst, I find data quite hard to find and there are some very complex relationships between actual corporate bonds, default swaps and the indices of those default swaps.

The sector is characterised by a remarkably high level of jargon and acronym which does not, in my view, contribute very much to transparency. Furthermore, the CDO world has added further layers of complexity in the structuring of deals. I worry that these complexities are often only understood by a handful of participants in the markets.

Price discovery is important and I am bothered by the fact that price information in many key areas is not freely available. The ability to access secondary market pricing quickly and easily is cornerstone of confidence in financial markets and I would not say that this is notable characteristic of the credit markets at the moment. Acronyms should be banned for all credit market instruments and secondary pricing should be available to all in the same way that operates in other markets.

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I can’t understand why the dollar is so weak, given that we keep hearing about the many Asian countries stocking up on US assets. This buying should surely cause the currency to rise yet it’s inexorably sinking. Can you solve this conundrum?
Dan Slater, Hong Kong

Tim Bond: The dollar is sinking largely because the US needs to import capital to cover a very sizeable current account deficit. The US can attract capital via a cheap currency, high relative interest rates or a high relative return on capital. But the key point is that something in the US needs to be cheap to attract the necessary capital.

Right now, the return on equity in the US is the same as it is Europe and some parts of Asia, so US assets have no advantage in this respect. Nominal interest rates are quite high in the US, but real interests are as high in other major economies. Meanwhile, for the time being the consensus does not expect the Fed to tighten anymore, although we disagree with that proposition. So really the main way for the US to attract capital is to have a cheap currency - which means a trend towards depreciation.

I would also highlight that the US has a less favourable growth-inflation trade-off compared to other countries at the moment. This is because the labour market is extremely tight and productivity growth has slowed a good deal. Hence, to evade inflation, the US needs a period of sub-trend growth.

So any resurgence in growth back above trend - such is occurring at the moment - will quickly force the Fed’s hand. We must recall that the US dollar benefited from the surge in productivity in the 1990s, but this trend is now over and productivity growth has decelerated in the US, whilst it is accelerating elsewhere. That means that potential growth rates are converging. To stay competitive, the dollar does have to trade lower.

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Back in March many market pundits such as William Rhodes of Citibank and recently Anthony Bolton of Fidelity have warned of market overheating and possible correction. However, many other experts hold the opposing view that as market fundamentals are basically sound, the rally will continue. What is your view on this subject? Also do you see dollar strengthening against the pound within next few months?
Subrata Biswas, Solihull, UK

Tim Bond: We think large cap equities are not expensively priced, although small cap and midcaps are - on average - very dear. It is in these latter areas that some rather bubbly behaviour has been visible and that was very much a reflection of excessively easy credit conditions.

Credit is now re-pricing and so too will these sectors. But large caps are cheap and have been unloved this cycle. Profit growth looks fine in Europe and Asia - mid teens for at least the next 12 months. US profit margins are a little more suspect, given strong unit labour costs, which have been pressuring margins a bit.

However growth has picked up there and some of those costs will be passed on. That suggests more Fed tightening. Meanwhile, the trends in unt labour costs are much more investor friendly in Europe and Asia. Overall, we think profits have more upside. - albeit less in the US - and that large caps are cheap. On Cable, sterling has more upside before it has downside.

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What is your view on inflation and how you would structure the asset allocation in an inflationary world?
Arun Bharath, Irvine, CA

Tim Bond: We believe that the risks to inflation are mostly on the upside. De-synchronised global growth, very weak commodity prices and a labour market ”supply” shock all conspired to give us depressed inflation rates in the 1990s. Now, we are seeing the other side of globalisation, which is pressure on scarce resources.

We are also seeing the externalities of a carbon-based economy starting to work their way into the price structure, a process that will intensify in the years ahead. The positive global labour supply shock is still extant, but much less powerful than it was a few years ago.

Central banks will need to work harder to control inflation over the next few years, compared to the 1990s. The energy sector requires massive investment over the next decade or so, both to meet demand and to ”green” supply. That means energy prices will have to stay high or move higher. So all in all, investors need to have inflation protection. That means index-linked bonds, of course, but it also means basic resources, energy and industrial goods and services as equity sector preferences. Along with banks, these were the only sectors that delivered positive real returns during the last major inflation cycle in the 1970s.

All these sectors are quite inexpensive at present. As as a final point, I would caution that every great inflation upwave in recorded history is presaged by rising food and energy prices!

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Tim, I really like your research. We live in the golden economic age. A lot has been said about the rise of Brics economically. Can you give us some forecasts about Brics financially? What do you think will be the ratio between stock market capitalisation of China, of India, Russia, EU, Japan, and US by 2020 and more long term by 2030 and 2050? Given this enormous potential, how much of very long term money (for my retirement 25 years from now) should be allocated to emerging market stocks?
Stan Maydan, New York

Tim Bond: Thank you for your very kind comments. Personally, I would be fairly cautious in Bric investing. I certainly agree with the consensus that these economies should grow fast over the long run, but the ride will be volatile and not without significant levels of political risk.

At the same time, the current OECD economies benefit from enhanced global growth and the opportunity to move up the value added ladder. The Brics are all characterised by fairly extreme income inequalities which could be the source of social instability at some point. I think - and hope - that more equitable distributions of the gains from economic growth will take place and that levels of political risk will fall.

Additionally, China’s growth model is threatening significant environmental problems that will demand a switch to a less resource intensive and more sustainable growth path. Russia is oil dependent and I would question whether that is a good thing given the emerging consensus amongst energy consumers to de-carbon their energy supplies.

India is attractive but the economy has a potential inflation problem and equities are expensive there. Brazil is attractive both on low valuations and the general trend in the social and economic environment. But overall, I would not want to have more than 15-20 per cent of my portfolio in emerging markets. The post-2003 environment is not going to be characteristic of the levels of risk and volatility likely to be seen over the next decade.

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The US is no longer the only important driver of world economic growth. In this context, how can we explain the fact that European bourses seem to be taking their direction from US stock markets?
Emanuel Leao

Tim Bond: The correlation between US and European bourses is indeed still high on a day-to-day basis, but when we look at annual or even quarterly returns, it is clear that Europe has outperfomed.

I think the high correlation is mostly a habit of mind. The US market still has a PE advantage over Europe in most sectors. That tells me that most investors still see the US has a higher long run sustainable growth rate. In that sense, investors still see - wrongly in our view - the US economy as the growth leader. Indeed, the outperformance of European equities has been mostly due to profits, not a marking up of PE ratios relative to the US.

I believe that relative valuation will eventually alter, with European PEs rising relative to US and Asian PEs. As this happens, correlations will drift lower, over time. For now, the high correlation offers sporadic opportunities to buy Europe cheaply.

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Background

Based in London, Mr Bond is responsible for producing trading ideas across asset classes and markets including fixed income, foreign exchange, commodities, emerging markets, credit and equities.

Mr Bond has been with Barclays Capital since 1998. He joined the firm from the hedge fund, Moore Capital, where he worked as a portfolio strategist. Prior to Moore, he worked in sales, strategy and proprietary trading roles for ten years at Tokai Bank London. Before joining Tokai Bank, Mr Bond spent three years as a market-maker in floating rate notes.

Mr Bond has been ranked number one Investment Analyst for Fixed Income Strategy in the Thomson Extel Survey for three years running.