At Room151’s recent conference for local authority treasurers, 32% of the audience said they were likely to ‘significantly increase their allocations’ to corporate bonds over the coming year. That was higher than both money market funds (with a 16% increase) and other local authorities (28%). As a provider of Sterling denominated, short-term bond funds, the news was of course welcome. But what’s the story behind the number?
Firstly, I would make the point that the conference audience reflects, as we see it, the mood of local authorities more widely. We know that about 30% of local authorities invest in our funds already and that a similar percentage of councils have amended their treasury management strategies to include corporate bonds over the last few years.
The trend is interesting because if you go back to 2007 to 2009, we saw a swathe of local authorities terminating their external manager contracts and getting out of so-called alternative investment strategies. Then there just wasn’t enough of a premium compared to the straightforward options like bank deposits or the DMADF.
So why are we now seeing local authorities allocate to externally managed bond funds? The first reason is old news but news which is now taking effect and can be summed up in a well-used phrase: ‘bail-in’. The Directive of the European Parliament and Council established in 2012 a framework for the recovery and resolution of credit institutions and investment firms in the European Union. This power handed the fate of potentially failing banks to the control of local central banks. The policy gives power to central banks to reorder the balance sheets of failing banks in order to arrive at an orderly resolution, this reordering already seen in Cyprus and the Netherlands can include ‘haircuts’ to depositors. Governments (and the tax payer) are therefore unburdened of the requirement to bail-out banks who find themselves in trouble.
One of the main consequences of the directive is that ratings agencies are expected to no longer factor in potential government support when setting a rating with potential downgrades a consequence. This helps explain the interest in bonds, or more precisely it explains why treasurers are closely evaluating their bank deposits and counterparties and considering other options. If we take an example from a long list of bank credit ratings I’ve been looking at today, let’s say a major UK high street bank with a single ‘A’ rating, a ratings agency will value sovereign support in the institution at up to three notches on its ratings scale. If one or more of those notches is removed the formerly A-rated institution soon finds itself falling to the bottom of the investment grade universe. Lower rated banks could find themselves with high yield ratings. It is not yet clear the extent to which ratings will be reduced and the impact should be lessened by the measures banks have taken to shore up their balance sheets. Nonetheless treasurers have expressed the concern that some counterparties in the already lowly rated sector may soon fall outside their TMS guidelines and they see the need for counterparty diversification.
So why then, might you consider corporate bonds?
If I look at a classic short-term corporate bond portfolio used by local authorities, I can see that the minimum credit rating of any one issuer is not less than AA-. In fact, in a typical local authority corporate bond mandate the lowest rated issuer will have a higher credit rating than the highest rated bank which the authority has deposits with. So what the credit rating agencies are telling us is that you can buy bonds with a lower probability of default than the banks where you deposit money and when your options may be tightly constrained by your treasury strategy, that’s quite a compelling message.
Rating agency classifications tell us about the strength of an institution and its likelihood of default. When building a defence against default, quality and diversification are essential. We advocate bond portfolios spread across 60 or so counterparties from the corporate and sovereign sectors. Deposits clustered around four or five bank counterparties with quite low credit ratings, ensure exposure to any one may be as high as 20%. Spreading risk across higher-rated corporate and sovereign institutions limits the risk of default and limits a single default to less than 2% of a portfolio.
With short-dated bonds, where you’re investing in paper with a duration of less than one year, in blunt terms you, the investor, only needs the issuer to survive for that period of time for your bond to be money good. If you’re talking about highly rated, publically audited companies who you’ve done your due diligence on, default is highly unlikely.
So, will we then see a significant increase in bond investments from 32% of councils over the coming year? It’s difficult to predict with any certainty but I would argue that there has been sufficient quality issuance in the Sterling corporate bond market to absorb rising interest from treasurers and there are some very good reasons to consider it.
Robin Creswell in managing principal of Payden & Rygel