European Corporate Bonds: Market evolution, liquidity and active management

Executive Summary

The Euro corporate bond market has grown strongly in recent years. Replacement of bank financing and issuance by ex-eurozone corporates were the main drivers of this growth. After the financial crisis liquidity and trading volumes have declined, mainly because of reduced market-making by investment banks. The ECB’s bond purchase program has also reduced liquidity. This has challenged most active strategies’ ability to add value through bottom-up credit selection. CDS index trading and the use of ETFs by asset managers have become much more common. Top-down credit beta management is a more important source of excess return because of liquidity constraints.

Our survey of European corporate bond managers shows that a few large bank and insurance related mangers appear to have a dominant position. However, the concentration in active mandates is quite moderate. There are thirteen euro credit managers with over €10bn in dedicated active credit mandates, the level at which we believe it becomes difficult to add material value after fees.

Investor implications:

  • We recommend clients review their Euro corporate bond holdings. Clients should switch away from large managers running core active portfolios as these are unlikely to justify their fees.
  • Clients who wish to use active managers and have the governance to support such a program should favour moderate-sized managers with strong credit capabilities that pursue a ‘conviction’ style strategy that has the potential to add material alpha.
  • Alternatively, clients should invest in a low-turnover, smart beta strategy (an approach that sytematically exploits market inefficiencies) at a significantly lower fee. WTW has negotiated attractive fee deals with a number of our preferred managers. Please contact the Credit Europe ASK for futher details.
  • We recommend broadening the opportunity set to global corporate bonds. While the Eurodenominated corporate universe includes a large number of non-euro area issuers, it only captures a small part of the diversity and liquidity that global markets offer, the US-dollar corporate market in particular. However, clients should consider the consequent need to replace foregone euro duration and the the cost of currency hedging before making this decision.

European corporate bonds in a global context

The Bloomberg Barclays Global Aggregate Corporate index had a market capitalization of c$8.5tn on 31 March 2017 of which about 68% was USD issues, 22% EUR issues and 5% GBP issues. Unlike the dollar and sterling markets, corporate bonds account for only a relatively small part of the Eurodenominated fixed income market, which is dominated by government and quasi-government bonds.
This is because European corporates have been mainly funded by bank credit historically.

More recently, euro corporate bond issuance has accelerated as a result of bank deleveraging. The growth of loan funds, both liquid syndicated loans and bespoke direct loans, has complemented this process in recent years. However, banks still dominate corporate lending, and hence they also appear more prominently as bond issuers than in the dollar market. 51% of outstanding European corporate bonds are financial sector issues, relative to only 39% in the US.

Secondary Market Liquidity

Euro corporate trading volumes are significantly lower than in pre-crisis times. This parallels what we have seen in other credit markets globally. While there has been an upward trend in bid-ask spreads in both the EUR and USD markets since 2014, levels are not high relative to preceding periods. This is perhaps not surprising given it has been such an extended period of benign credit market conditions and acknowledging the significant role played by central banks. What we can say is that financial bonds trade at wider bid-ask spreads in Europe, and that this trend has persisted over the last 3 years (see figure 1). Given the large role that financials play in the European market, this implies higher trading costs.

It has been observed that spreads have gapped up less sharply during ‘credit shocks’ in recent years, particularly when compared to the 2008/09 credit crisis. This has been attributed to the increased importance of ‘agency trading’: only the amounts for which buyers can be found can be sold. Trade data generally show that average trade sizes declined in recent years while the number of trades has increased. However, fund managers have substituted short-term trading in CDS index contracts and ETFs for trading in cash bonds in many cases, and shocks have led to spikes in activity in these markets, accompanied by a widening of bid-ask spreads well beyond historical levels.

Figure 1: Bid-Ask spread across iBoxx universe

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Source: Deutsche Börse

In short, the European bond market remains quite liquid in smaller ticket sizes. This means larger managers making portfolio changes or accommodating investor flows need to write more tickets to get the job done. Re-allocations take significantly longer to implement than in previous periods. Hence the true cost of trading (including the time factor) has gone up. Larger credit funds have shifted to trading in and around the primary market, rather than extracting value from the secondary market. Bigger sizes can be traded in the first few weeks/months after a new bond is issued, but after that liquidity tails off sharply. This phenomenon has existed in previous periods and the ratio of trades in month 1 vs. month 2 etc. has not changed much. However, big active managers now depend much more on short-term pockets of liquidity, while smaller managers may find relative-value opportunities that have been left behind as bank market-making has dropped away.

Portfolio managers now rely more heavily on credit derivatives, both single-name credit default swaps, if liquid, and CDS index trades (iTraxx Europe and Xover) in order to manage credit exposures. This is also a reflection of the more prominent role of multi-sector credit strategies, which apply a top-down approach to credit management. However, index CDS are a beta-management tool and do not give any opportunity to add value by bottom-up credit selection.

Pooled funds and Total Expense Ratio

The European corporate bond market is dominated by segregated accounts, which are often constrained by bespoke investor guidelines and employed as much for liability hedging as for return generation. In contrast, pooled funds are predominantly used by smaller institutions and wealth managers, and in the retail market.

When compared to the large overall holdings of insurance and pension investors mentioned above, it is clear that individual pooled funds in Europe are generally not very large: we are only aware of one with more than €5bn AuM. The bigger issue here is fees and expenses. Many charge a TER of 50bps or more. Fees have generally not been adapted to the reduced outperformance potential and the higher trading costs. WTW has negotiated a number of preferential fee deals with our favoured managers.

Pooled funds that are managed against a Euro Corporate benchmark fit well as building blocks in a strategic asset allocation mandate. As a result pooled funds are more exposed to short-term in- and outflows, which can be a drag on performance unless managed by strict swing-pricing rules, an antidilution levy or even a system of ‘exit gates’ to protect long-term investors. Clients should allocate to pooled funds that protect long-term investors in this way, even if it increases trading costs on entry, as those funds will also have a lower proportion of short-term investors and will be less exposed in the event of a sudden outflow from investment-grade credit.

WTW Survey: Corporate bond investments of large European Asset Managers

In our survey of Euro Credit Managers we asked about total Assets under Management in Euro Investment Grade corporate bonds, in active mandates and specifically in active corporate credit mandates.

  • The biggest holders of Euro credit securities in our survey were AXA IM, Allianz Global Investors, Natixis, Deutsche Asset Management and Eurizon (more than €60bn each). In the case of AXA IM the data appear to include holdings of the parent company’s life fund (which does not seem to be the case for other asset managers that are also part of an insurance group). Most of the 29 firms surveyed had total Euro credit holdings of less than €20bn.

Figure 2: Total Euro IG corporate credit and covered bonds under management, in € million

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Source: WTW survey

  • When looking at active mandates (total € 498,941 million), AXA is no longer among the giants in Euro credit, instead AGI and Eurizon stick out with over €70 bn in holdings. Then there is a cluster of managers with around €30bn, Amundi, Deka, PIMCO and Deutsche, followed by BNP and BlueBay with €20bn.

Figure 3: Total amount managed in active mandates, in € million

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Source: WTW survey

  • Narrowing things down further to dedicated active credit mandates only (total assets € 281 bln), AGI and Eurizon are no longer prominent. Amundi, PIMCO and Deutsche have the biggest presence here with actively managed credit-only portfolios of around €30bn. All others are below €20bn, with only BNP, Deka and Union exceeding €15bn.

Figure 4: Total amount managed in active Credit/Covered Bond mandates, in € million

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Source: WTW survey

According to ECB statistics, total European Investment Fund holdings of corporate bonds (financial and non-financial) amount to about €650bn. Based on this figure, the largest active managers own about 4.5% of the relevant universe (the total Euro corporate bond universe is much bigger, approx. $8trn, but it is dominated by direct holdings and private placements).

The ECB member central banks have so far bought €82bn in corporate bonds as part of the Asset Purchase Programme (April 2017). In a way the ECB has been as big a player as AGI and Eurizon. However, the ECB’s central banks are not active managers but buy-and-hold investors instead. Nonetheless, the central bank purchasing activities have drained liquidity and skewed the market, as they have massively reduced the willingness of market makers to quote in size, and in particular to short securities, meaning an investor can only buy bonds another investor is willing to sell at that moment. Bigger ticket sizes only work on an agency trading basis (brokers acting like agents that go out and try to find matching positions). Portfolios are difficult to fund as there are generally more buyers than sellers for size positions.

Reduced market making by proprietary trading desks due to changing bank regulation has also drained liquidity from the bond markets. Generally, liquidity is patchy and depends on the type of instrument as well as investor behavior.

Disclaimer

Towers Watson Limited, part of the Willis Towers Watson group, has prepared this material for marketing purposes only. The analysis in this material is based on limited information about your circumstances. No action should be taken on the basis of this material as we have not been appointed to give you advice.

The assumptions used in this material have been derived by Towers Watson Limited using a blend of economic theory, historical analysis and opinions provided by investment managers. They inevitably contain an element of subjective judgement. Any opinions or return forecasts on asset classes contained in this material are not intended to imply, nor should they be interpreted as conveying, any form of guarantee or assurance by Towers Watson Limited of the future performance of the asset classes in question. The Willis Towers Watson Investment Model is designed to illustrate the likely future range of long-term returns from different asset classes and their inter-relationship. No economic model can be expected to capture perfectly future uncertainty, particularly the risk of extreme events.

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