Credit markets back from the brink, says Deutsche's Nolting

Christian Nolting is regional head of portfolio management and lead strategist for Asia-Pacific at Deutsche Bank Private Wealth Management in Singapore, a post he has held since March this year. He advises clients on investment strategy, asset allocation and discretionary portfolio construction, and monitors portfolio managers on their investment strategies, performance and risk management.

Nolting began his career at Deutsche Bank in 1991, serving in roles including head of private portfolio management for the west/northwest Germany region and senior asset management consultant. In 2002, he was named head of the team of investment officers at the bank's private asset management unit, then in 2005 became head of portfolio management for both the private and business clients and private wealth management businesses.

Fixed income as an asset class appears to be coming back from the brink and is featuring prominently on the radar screens of investors. What do you think of this asset class?

The credit markets have gone through a roller-coaster ride, much like other asset classes through the global crisis. But credit market developments require a closer study, as the recent financial crisis appears very much a credit crisis. The timing for the analysis seems apt, given that various parameters like three-month Ted spreads (the spread between three-month dollar Libor and three-month US Treasury yield) are all back to pre-Lehman levels, and we have also seen credits issuance pick up significantly this year. The Ted spread on October was 0.23% on October 9, compared to a high of 4.35% in October 2008.

If we turn the clock back to the peak of the crisis in October 2008, credits were pricing in more pain than credit markets had ever experienced in the post-World War II era. The default rates implied by spreads then, using Bloomberg's US industrial curves, exceeded the worst experiences of the 1980s and 1990s, whether we used the standard recovery rate assumption of 39% or a more conservative assumption of 20%. The implied cumulative default rate curve was well above the historical peaks in default rates as reported by [rating agency] Standard & Poor's.

Around October 2008, after unprecedented government action to support the banking sector and resolve the credit crisis, the Libor-OIS (overnight indexed swap) spread compressed. But on a broader basis at that time, the systemic risk from financials seemed to be redistributing itself to other sectors. If we looked at the financial sector then, there was a significant focus on reduction in gearing.

There was also a noticeable impact on bond funds, particularly those in the emerging-market and high-yield spaces. Adding to the pressure from decline in asset prices were significant outflows. The corporate sector was under severe stress due to anticipation of a sharp increase in default rates. We saw Moody's Investor Services estimate corporate defaults would rise to 10.4% by November 2009, and it further increased the November default rate forecast in Q1 2009 to 16.4%.

There was, at this juncture, a clear disconnect between credit spreads and what typical fundamental models showed. Despite the challenging environment, there were ample opportunities, and it proved to be the right decision for investors to make such investments.

Why are you so positive about fixed income?

Global markets and especially credit markets entered 2009 in a stressed condition, with every financial time series reflecting an unprecedented economic downturn. But while the credit market was mirroring the global financial crisis and economic woes, parts of the credit market showed potential of becoming an attractive asset class. Asian credit outlook was favourable given: the developing macro policy environment, attractive valuations globally, Asia's more benign credit outlook, and Asian valuations relative to global credit.

On the global policy front, the broad policy focus on containing the worst of the credit crisis was clearly intended to support this asset class, and soon the desired effect was taking place. Governments and central banks -- particularly in the US -- progressively broadened their support for the private sector beyond the financial system, either in the form of increased lending, broader asset purchases or recapitalising consumers with fiscal expansion.

Asian credit ratings were holding up better than global counterparts, and were expected to continue. However by looking at the liquid CDS [credit default swap] markets, we found that while Asian names did not see the same degree of negative ratings drift as in Europe or the US, the vast majority of Asian names were still traded wider than the global median. This was primarily driven by the over pessimistic recovery rate assumptions applied to Asian credit.  

What is your overall view on the performance of high-yield bonds given the turn of events in the past few months?

While the credit crisis did persist for a significant period, gradually risk taking returned to the markets. In the initial phases (starting in March), high-yield and emerging-market bonds outperformed the investment-grade sector as the rally in risky assets and global policy measures boosted demand for these sectors. High-yield bonds in particular performed strongly as the global depression scenario became less likely and with the emergence of green shoots.

Also, we noticed that global new issuances -- particularly by non-financials -- performed very well, indicating client receptiveness. Better corporate earnings, especially in financial companies, in Q1 2009 reduced some of the default fears in the credit markets. Credit markets were pricing in benefits of restructuring of balance sheets -- such as raising cash through equities and reducing dividends. In the next phase (starting in the third quarter) the rally in corporate credit continued, but with greater leadership from the investment-grade category, which was supported by retail demand.

What about emerging-market bonds?

Normalcy has nearly returned to the market, and this is also evident from the issuance pattern. In July alone, emerging-market corporates issued $25 billion in new bonds, the highest level since May 2007. We doubt that we will surpass 2006 and 2007 issuance levels of $130.6 billion and $156.1 billion, respectively, but it seems very likely that we will surpass all previous years. In the year to September, the total issuance figure ($138.4 billion for corporate and sovereign) is 46% higher than the total issuance for 2008.

Yet that is still a fraction of US market volumes, where investment-grade issuers have placed $745.9 billion in the year to September. Globally, the market has been surprisingly receptive to a wide variety of credits in a way that would have seemed quite shocking at the start of the year. This reflects the turnaround in sentiment and the optimistic assessment of the global recovery.

What is your outlook for the credit market?

High-yield and investment-grade bonds have both rallied significantly this year. Despite the recent spread widening in high-yield, we prefer investment-grade from a risk/reward perspective. We continue to see value in emerging-market credit. EM spreads on hard-currency debt have been trading in a 300-350 basis point range in recent weeks (they were around 700bp in January). In the absence of a new bout of heightened risk aversion, further tightening toward 300bp is possible, but even at current levels, spreads appear attractive (compared to roughly 200bp in the years before the crisis).