Private banks thinking more in real terms, says Axa IM

Philippe Descheemaeker is a director of fixed income at Axa Investment Managers in Paris, covering US credit and global inflation-linked bonds and products. He joined the firm in May 2001 as a fixed-income portfolio manager in the euro-aggregate team.

The French firm has $435 billion invested in fixed-income portfolios as of September, representing more than half of its global assets under management.

Descheemaeker spoke to AsianInvestor last week during a trip to Asia to market Axa IM's global inflation-linked bond fund and its US investment-grade and high-yield funds.

Fixed-income markets have had a great run in the past year -- is it still a good time to buy?
The main problem at the start of last year was getting investors to pull the trigger [on investments], even though they were in full agreement with us that 2010 would be the year of credit.

The timing was more difficult -- clients were not so eager to allocate to [fixed-income] funds. Internal processes for most of our clients were probably lengthier last year, in terms of risk management, for example. They had had such difficulties previously that it was difficult for them to take a really strong internal view on what to invest in.

So we aren't seeing the same absolute levels [in terms of credit opportunities] now. But paradoxically it's probably easier for clients now to make decisions on moving into credit.

What were inflows like last year into the funds you manage?
For fixed income, net inflows were roughly €2 billion [$2.7 billion] last year. The start of the year was very slow, and the asset-raising momentum picked up at the end of the first semester.

There were two hot topics for us last year. One was euro and US investment-grade and high-yield credit, and the other was inflation-linked.

Looking at US high yield at the start of last year, what was being priced into the deeply discounted prices of these securities was a default rate of around 20% for 2009 and 75% cumulative defaults for the next five years. These were record levels; the worst seen previously were just over 10% -- and the number of realised defaults last year was quite extreme.

The 75% level of expected high-yield default also indicates a relatively high level of expected default for investment-grade credit of, say, 10%-plus, which was probably even more extreme [than the high-yield figures].

This year, there's been a complete change in mind set and we are now very far from those extremes; investors are not nearly so bearish.

What about inflation-linked bonds -- how have they performed and what were the drivers behind that performance?
At the start of last year, markets had priced in a number of years of deflation, especially in the US. That didn't really make sense to most investors -- [those prices] were simply down to there being so much forced selling, especially of US Tips [Treasury inflation-protected securities], so that prices offered a great opportunity.

Investors took advantage, which resulted in close to 60% performance in the US high-yield market last year, quite strong performance (20%) in the investment-grade market last year and global inflation-linked bond returns of about 8%.

If you put that into perspective, you were buying an asset class when there was no inflation last year, but it was returning 8%. The point is that you're not only buying the realised inflation but also the inflation anticipation.

Last year there was some issuance of inflation-linked bonds globally, and they performed very well. You had rising demand for these products, because more and more people wanted to take this exposure and hedge out inflation. There was also a requirement for many investors to diversify and buy those products.

On the supply side, compared to the huge amounts of straight government debt that was being issued, the relative amount of issuance of inflation-linked bonds is a lot smaller than it used to be.

The reason? If a country starts to print money very aggressively by issuing a lot of debt -- one thing that helps reduce the weight of that debt is rising inflation. Countries issuing inflation-linked bonds give investors a free option to benefit from that, but as issuers governments are shooting themselves in the foot. Hence, proportionally, governments issued less inflation-linked bonds.

However, demand was rising -- investors were seeking three- or fourfold the amount actually available. At the same time, the nominal [non-inflation-linked] government bonds clearly didn't attract as much demand.

That major imbalance is changing slightly this year. The imbalance led to a positive repricing of this asset class and anticipations have normalised, which has enabled a very good performance for the asset class.

While last year was a particularly good opportunity for buying inflation-linked bonds, this year we feel there is still an opportunity, mainly because demand is continuing to accelerate. Even though there will probably be more issuance this year, we still expect demand to outpace supply and we expect some positive results in terms of performance.

Have you seen interest in inflation-linked from more or different types of investors as a result?
Newer types of investors have shown interest in the asset class as a result of this opportunity. For example, private banks started to invest quite strongly from the start of 2009. The rationale of private banks and their clients looking at these products is that you should think in real -- that is, inflation-adjusted-- terms, instead of nominal terms.

Last year they were looking for no risk, maximum safety, low potential nominal returns. At the same time, the main risk is that of higher inflation. If you make 1% return but inflation is at 3% or 4%, you are seeing an erosion of capital -- that's not something private investors were prepared to accept. Hence, they went into an asset class that is almost fully government bonds, but which is providing an indexation to inflation.

What about issuance in Asia?
You don't have a lot of Asian issuers. You have Japan, but that's a very specific case, and clearly not the best way to play rising inflation, as we're still talking about potential deflation from time to time.

Usually when trying to play Asian-market inflation, people look at Australian inflation-linked bonds, which are quite liquid and are forecasted to double in terms of issuance levels this year.

In Europe, people also want to play the inflation theme from commodities being bought by Asia. The natural question is: should you play that by buying Asian inflation-linked bonds? Clearly lack of supply is one issue. Another is liquidity, because you're going to have to cope with pricing behaviour linked to the liquidity issue rather than what you're seeing in the underlying.

However, in the short to medium term, the main inflation risk globally is probably inflation imported from emerging markets. So you can play Asian inflation, for example, by buying liquid G7 inflation-linked bonds.

Are you likely to launch an Asian or emerging-market inflation-linked bond fund?
There is not enough supply at present -- you'd need to look at doing that through other means, other asset classes. Playing commodities or emerging equities or debt is one way, listed real estate is another. But there is no perfect hedge.

Trying to play domestic inflation in Asia would not be such a good idea, because the liquidity is not there, currencies can be quite volatile -- it's not optimal.

However, as liquidity evolves, Asian inflation-linked bonds will be something we will consider more and more. Currently one of the main proxies we use for Asia is the Australia bond market. Our allocation/weighting to Asia ex-Japan inflation-linked bonds is around 2% (of which Australia is 0.4%).

In terms of Axa IM's US high-yield and global inflation-linked funds, what kind of performance do you expect this year?
It's always hard to give actual figures. First off, for inflation-linked bonds, we expect normalisation to continue. Even though much has been done already, because of rising demand, this will be the main driver of further appreciation in terms of the asset class.

Another driver will be the fact that in some countries, such as the US, it's likely that the Federal Reserve would be inclined to be relatively lenient, if inflation is expected to rise. Economic recovery is more important to the Fed than price stability, so even if inflation rises a bit more than it might ideally like, it wouldn't see that as a major problem.

For US high yield, average yields are around 9%, comprising around 650-675 basis points of spread over US Treasuries at present. That's fairly high -- it's not that far from what it was at the peak of the last credit crisis at the end of 2002.

To put it into perspective, 2003 to early 2007 was an extremely good period for credit. So we may not see a tightening to the same degree as in those years, but clearly we have attractive yields and extremely attractive spreads, so you're well paid.

Everything being equal, 9% would be an average performance you'd expect from the US high-yield market going forward. We would expect demand to increase for that asset class and the normalisation to continue as well.

Beyond these yields, what could be expected is a continuation of the momentum we've seen going forward. We can differentiate between the good, the bad and the ugly. The good will tighten further, the bad will not tighten and the very ugly may widen.