Bankers lose interest!

Transcription

1 1 Bankers lose interest! Bankers lose interest! How changing financial regulations affect all investors

2 1 Bankers lose interest! Contact: Doug Steevens Senior Portfolio Manager +44 (0) Contact: Steven Peake Consultant +44 (0) Summary Lending is increasingly bypassing banks and going directly through bond markets. This is increasing the size of bond markets and changing their composition. However, the costs of trading corporate bonds have risen, and investors need to ensure they are being adequately compensated for the risk of holding them. A lack of lending and new developments in property markets has created a supply freeze, and with the economy growing, so too is demand. This supports the outlook for property. Banks are being penalised in certain business areas, and the costs of transition management have risen. Derivatives are being moved to being cleared through an exchange, reducing the risk of loss if a counterparty cannot pay. However, this means more collateral posted at the outset, making derivative strategies such as liability hedging more expensive and less flexible.

3 2 Bankers lose interest! Introduction Stricter regulation of the financial sector is creating long term change in financial markets. Aon Hewitt has conducted significant research into the implications of these changes for our clients and they are far reaching. While this paper focuses on the long term issues, banks making fewer loans will create some medium term investment opportunities for new lenders to step in and profit. These will be discussed in a separate note. Background When anyone puts money in a bank account, they are providing the bank with a loan on which the bank pays interest. In turn, the bank lends to businesses, projects and individuals at a higher interest rate, and typically over several years. The bank profits from the higher interest rate if all the loans and interest due are repaid. As the bank runs the risk that borrowers cannot pay back all they owe, the bank needs to hold capital to cover potential losses on the loans. In the early noughties, banks lent more and more to riskier borrowers. They also did not hold enough reserves to cover potential losses from borrowers not being able to repay loans. When the Global Financial Crisis took hold, governments around the world supported banks, and banks reduced the amount of money they lent. Regulation Governments and regulators globally have introduced rules to make the financial system more robust and stable. Banks need to hold more capital relative to the amount of loans granted, so that they can withstand borrowers not being able to repay. This means either increasing capital held, or reducing lending, or a combination of both. Regulators are penalising banks which engage in activities which are deemed to be risky, so banks are changing their business models.

4 3 Bankers lose interest! Lending bypasses banks to go through bond markets The new regulations are very prescriptive and increase the cost to banks of lending in certain areas. Banks are lending less to companies, but companies still need loan financing to operate or expand their business. Therefore, companies have increasingly issued debt (tradable IOUs, often called corporate bonds) directly to investors. As the chart below shows, this has helped to significantly increase the size of debt markets, and we expect this trend to continue. Face value, US $tn Source: Merrill Lynch Global High Yield In Europe, most lending goes through banks, and a minority through debt markets. The opposite is true in the US. Therefore, lending moving away from banks to debt markets will be a much larger process in Europe. and changes bond index composition US Bank Loans European and US Investment Grade Corporate Credit rating agencies, such as Standard & Poors, assess the ability of companies to repay their debts, and assign corporate bonds a credit rating such as AAA (most creditworthy) AA, A, BBB, BB, B, CCC, CC and C (least creditworthy). The largest corporate bond issues are classified into indices, and investors can invest passively in such indices which evolve as corporate bond issuance changes. As banks have reduced lending to companies, non-financial companies have issued more corporate bonds. The weighting of non-financial corporate bonds in the sterling investment grade corporate bond market has risen from 23% to 37% since 2007 to the end of 2013, with a corresponding fall in financial corporate bonds. This is shown in the next chart, and the trend may well continue Sector composition of sterling investment grade corporate bond index 100% 80% 60% 40% 20% Financials Quasi Government Source: Merrill Lynch It appears to be positive for corporate bond investors that they are lending less to banks and are lending to more companies as it spreads the risk that one issuer cannot repay its debt. However, credit ratings of the debt constituting corporate bond indices have also changed as riskier companies have issued more debt. Quality of sterling investment grade corporate bond indices has declined 100% 80% 60% 40% 20% Source: Merrill Lynch Non Financials Securitised AAA AA A BBB Those who invested in passive corporate bonds several years ago, and have not changed the index being tracked, might assume that their investments are broadly similar. They are not, and investors should periodically review the index composition to check that they are being adequately rewarded for such changes and the risks currently being taken.

5 4 Bankers lose interest! But watch the availability and costs of trading corporate bonds Buying bonds when they are first issued (primary market) is straightforward, especially given increased issuance in recent years. Once issued, bonds can be traded through intermediaries such as banks, unlike shares which are traded on the open market. When wanting to buy bonds, fund managers ask banks if they have the bonds and to quote the price. Or, when selling, fund managers ask banks if they are willing to buy and at what price. As banks need to hold some stock on their books for this activity, they run the risk of the market falling in value. They are rewarded for this risk by buying bonds at a lower price than they sell them at. New regulations mean that banks are not holding as much corporate bond inventory as they used to. This has made it harder to buy and sell corporate bonds and the cost of doing so is higher than before the financial crisis (the gap is higher between the purchase and sale prices). It now costs around 0.8% to buy and sell passive UK corporate bonds. Investors therefore need to evaluate whether corporate bonds are providing a sufficiently high return after allowing for such transaction costs. We view corporate bonds as only having a narrow advantage over equivalent government bonds. Investors with significant amounts of corporate bonds should consider other approaches to make returns from the bond markets, such as absolute return bond strategies, total return bond strategies and multi-asset credit. Corporate bonds should not be traded frequently. Transaction costs can be reduced by transacting in pooled funds at quarter ends when many other investors are rebalancing portfolios. If there are many buyers and sellers of a fund on the same day, the manager can match these off at zero transaction cost, as they do not need to buy or sell underlying bonds. Securitisation market growing Banks can continue to lend to different borrowers, and then pool these loans together. The underlying loans can be credit card debt, mortgages, car loans, or company loans. The pool of loans is sub-divided (tranched) into different securities, each with a different risk-return profile. This is known as a securitisation. Banks sell the securitisations to other investors, so that they pass on the risk of borrowers not repaying their loans. For taking this risk, investors expect higher returns than cash interest rates. The banks can retain their relationship with borrowers and earn a fee for arranging the securitisation. Key entities within Europe, including the European Commission, believe that securitisations play an important role in financial markets. They allow banks to continue to provide loans, but to manage the risk of loans not being repaid. But, regulation may need to be relaxed to make this attractive for banks. Indeed, the European Central Bank is looking to directly purchase securitisations to stimulate lending to companies. As the chart earlier shows, securitisations have increased as a proportion of the UK corporate bond market. Effects on commercial property market The property market in recent years has been characterised by a lack of new development projects and less money has been spent on existing assets. With the economy picking up in the UK, tenant demand is improving on a more widespread basis and we have seen property producing strong returns recently. As it will take time to increase the supply of property, the outlook for the market is positive over the next few years.

6 5 Bankers lose interest! Larger, less competitive, transition managers Regulatory pressures mean that banks are reducing or exiting business units with low profit margins or which are not their main focus. We have already seen major banks such as JP Morgan and Bank of New York Mellon exiting from the transition management business. This makes a small pool of transition managers even smaller and has driven up costs for pension schemes using transition managers. More transparency in derivatives but less flexibility for investors Regulatory changes are also changing the way derivatives are being traded. Take an interest rate swap as an example. Here, one party to the contract periodically receives a fixed amount and, at the same time, the other party receives an amount which varies over time with short term interest rates. These two payment streams are calculated to be worth the same at the outset but, over time, their values will change; one party will make a loss and the other a gain. The party that makes a loss must put money in an account to cover this loss, which is known as posting collateral. Such derivatives will now be traded through an exchange, which is a counterparty that acts as a middle man. To protect the exchange, investors will also need to post collateral at the outset to cover potential future losses. This will make derivative strategies, such as liability hedging, more costly and less flexible. The positive side is increased confidence in the derivatives market and greater standardisation of products for investors. Private lending Many entities that have traditionally been reliant on banks for their borrowing needs are finding that, due to regulatory changes, financing is less forthcoming than it used to be. However, they are often too small to raise finance by issuing their own bonds. This creates an opportunity for institutional investors, such as pension funds, to provide the financing these parties require. We look at these opportunities, which include financing infrastructure and property projects, in more detail in a separate note. Conclusion Investors have traditionally held corporate bonds to provide a higher return than government bonds. With the additional yield over government bonds now much lower than it has been in recent years and with trading costs high, investors may wish to consider alternative approaches. A lack of lending and development has created a supply-demand squeeze in the UK property market, which should perform well. Transition management has become more expensive. Derivative markets will become more robust, but also more costly and less flexible.

7 6 Bankers lose interest! Disclaimer Nothing in this document should be treated as an authoritative statement of the law on any particular aspect or in any specific case. It should not be taken as financial advice and action should not be taken as a result of this document alone. Unless we provide express prior written consent, no part of this document should be reproduced, distributed or communicated. This document is based upon information available to us at the date of this document and takes no account of subsequent developments. In preparing this document we may have relied upon data supplied to us by third parties and therefore no warranty or guarantee of accuracy or completeness is provided. We cannot be held accountable for any error, omission or misrepresentation of any data provided to us by any third party. This document is not intended by us to form a basis of any decision by any third party to do or omit to do anything. Any opinion or assumption in this document is not intended to imply, nor should be interpreted as conveying, any form of guarantee or assurance by us of any future performance or compliance with legal, regulatory, administrative or accounting procedures or regulations and accordingly we make no warranty and accept no responsibility for consequences arising from relying on this document. Copyright 2014 Aon Hewitt Limited Aon Hewitt Limited is authorised and regulated by the Financial Conduct Authority. Registered in England & Wales. Registered No: Registered Office: 8 Devonshire Square, London EC2M 4PL