Forensic skills at a premium as investors turn to bonds

By Paul J Davies Published: February 11 2009 20:16 Last updated: February 11 2009 20:16 Investment grade corporate bonds are increasingly touted as the best deal in the markets. The lack of buyers compared with sellers has made them wildly cheap against even the worst economic outlooks. The proposition is so popular that even retail investors are jumping on board, according to some independent financial advisors. Investors must avoid the potential bad eggs, but there is a basic idea that it is quite simple – and safe – to apply a broad economic view to a diverse basket of companies that make and do things the man in the street can understand. And all for returns of 4-6 per cent. However, this kind of “macro” bet is a far trickier proposition with regard to the highest-rated, mortgage-backed bonds and other asset-backed securities. The complexities involved make it far harder to attract money back into securitisation markets, which means they will recover much more slowly. At first glance, the problem does not seem so huge. Even under what seem like extreme scenarios for UK and US house prices, many people agree that few mortgage bonds outside subprime definitely look expensive. Also, for example, Fitch Ratings recently said that under its stress testing, which included the assumption of a 30 per cent fall in house prices, no mortgage bond rated triple A in the UK would see a downgrade. The conclusion was based on deal performance relative to an average pool of mortgages, constructed with and tested against assumptions that many would at least tweak if not argue with stringently. However, attractive as this view may seem, they are no recommendations for investment. Andrew Wilson, co-head of global fixed income at Goldman Sachs Asset Management, says investors cannot just buy the prime mortgage sector in the US, or anywhere and get a good deal. “Because of the differences between and even within mortgage pools you need to do that real forensic analysis,” he says. “Investors cannot as they might have done in the past treat any section of the mortgage market as a homogenous asset class.” The problem for investors – and for the markets – is that there are so many variables. Within countries and among mortgage-backed bonds, there are, for example, regional variations in house price changes and unemployment rates as they are now and even more variation in forecasts of where they will go. Then there are different potential outcomes depending on whether homes are owner-occupied or on where they are located. Assumptions like these have to be made and tested before investors can try to fathom prepayment rates, which feed into what the maturity of a bond is likely to be, which in turn has a huge bearing on whether the yield is anything like what it should be. Analysts at Barclays Capital have examined hundreds of ABS bonds in Europe and do have a broad view of what is a “buy” – it is any triple A bond that survives their severe stress testing and has a spread, or yield over interbank rates, of more than 500 basis points. However, out of 400 ABS bonds rated at triple A, they could only get pricing from at least two sources on 199 bonds – cutting the investable universe in half before they even applied their tests. Yet even assigning a “buy” is not the same as putting a definite fair value on a deal. “The assumptions that feed into assessing ABSs are all very difficult to set and can vary in unexpected ways,” says Hans Vrensen, head of securitisation research at Barclays. On top of which: “All assumptions are interlinked and feed off each other.” And as if this were not enough, there is then a wide variation in how bonds are structured, which dictates how well protected a triple A bond is versus lower-rated bonds in the same deal – which again influences what the spread ought to be. One large European investor adds that – if there are new deals – it will help to have much greater standardisation in structures, data reporting and terminology because it will cut out half the analysis now necessary. “Only in the 1980s did you get research people really focusing on corporate debt and now there is a great opportunity for some people to get into this area – and probably a lot of spare talent around to do it,” the investor says. There are early signs of some expressions of interest in investing new money in mortgage-backed and other ABS markets, some analysts and investors say, but these are mostly just that. Mr Wilson says that while most agree many mortgage bonds look cheap, there does not yet seem to be the risk appetite or the broad understanding to take them on. “The next phase is investment in the analytic capability; the resources needed to do this have gone up significantly.”