By Patrick Janssen and James King, fund managers, M&G Lion Credit Opportunity fund
The age when you could simply select sovereign debt for AAA rated bonds is long gone.
Some of Europe’s sovereign debt remains AAA-rated. There is a choice of the Republics of Germany, Austria and Finland, the Kingdoms of Denmark, Sweden and Norway, the Swiss Confederation, the United Kingdom and the Isle of Man. Of course some, such as the UK, are on negative downgrade watch. Moreover, none of them yields much. Norway’s 10 year bond offers a comparatively high 2.06% but Denmark’s sits at 1.26%, Sweden’s at 1.47% and the UK’s at 1.70%. The Isle of Man’s are small and traded too infrequently to price accurately.
One glimmer of hope sits in credit markets: many residential mortgage backed securities (RMBS) are just about the only corporate bonds available today with an AAA rating. Europe’s ABS market held up very strongly since the crisis, unlike much of its larger counterpart in the U.S. The data tell a stark story: European ABS had a cumulative five year default rate that didn’t exceed 1.0%. The nearest US equivalent, which includes riskier home loans, was 13.1%. So why are some of these residential mortgage bonds rated higher than just about every other credit investment in Europe, including their near bed fellows, commercial mortgage backed securities? They could well be the most robust investment available in Europe. For an investor in an AAA prime UK or Dutch RMBS to experience an interruption of income or loss of capital they would need:
1. A fall in domestic house prices by 50% and for those prices to remain at that depressed level for around four years 2. The rate of repossessions to rise from its current level of around 0.6% per annum to an unprecedented 10% and, again, stay there for about four years Of course when an AAA rated RMBS defaults, or the issuing bank enters restructuring, your recovery rate tends to be quite high. Depending on the structure of the bond, you also have access to the underlying collateral – the mortgage repayments and, behind them, the actual houses.
It seems highly likely that, should the conditions arise that create this scenario, then just about every other type of investable security, including government bonds, would fail. These bonds also yield a little more than most equivalent rated sovereign debt. Today, a basket of AAA rated prime RMBS offers an income of about 2% – this is about 1% above libor and so it should rise when interest rates pick themselves off the fl oor. Given there are next to no other AAA rated credit investments available, a working comparison is with the unsecured, 1.5% yield of a typical ‘A’ rated corporate bond issued by a UK non financial company. Banks are issuing new bonds, although not as many as they used to. That’s because they are lending much less to residential mortgage borrowers, meaning fewer such loans to package up into RMBS and sell on to institutions, but the market remains large at about €1.2trn and new RMBS are issued with much greater frequency than other types of ABS. Many investors have fl own the low yields and newly-noticed riskiness of sovereign bonds, seeking unsecured bonds issued by global blue chips as a safer haven. A better bet, and one that could well pay more, is AAA rated RMBS.
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