Featured Solution November 2012 Ken Miller Your Global Investment Authority The SSA Market: a Legitimate “Safe Spread Alternative?” As persistent debt and deleveraging challenges impede a more robust global economic recovery, major central banks have had to apply greater doses of unconventional monetary policy (QE) to suppress the level and volatility of interest rates. These potentially inflationary central bank asset purchases together with multiple sovereign ratings downgrades have led more fixed income investors to search beyond a shrinking universe of AAA assets for high-quality investments offering “safe spread” (incremental yield over U.S. Treasuries but with the potential for minimal additional credit risk). Issuers in the global Supranational/Sovereign/Agency and Provincial (SSA) market have been major beneficiaries of this crowding-in effect to high-quality fixed income assets. Debt from these issuers periodically offers value for PIMCO clients, and we regularly evaluate U.S.-dollar-denominated securities in this sector versus competing Ken Miller products such as U.S. agencies or comparable debt issued in different Senior Vice President currencies. Portfolio Manager A developing landscape Twin financial crises in the U.S. and Europe have challenged borrowers and savers alike – the deleveraging and austerity exercised by those with unsustainable debt has been painful and recessionary, with the outcome for some large sovereign debtors still undetermined. Meanwhile on the global lender side, in addition to having to upgrade investment playbooks with sovereign credit risk capabilities, fixed income managers have grappled with a shrinking risk-free investment universe. Debt formerly perceived as “riskless” and having U.S. Treasuries as the cornerstone had included other G-10 sovereigns, agencies, and supranational organizations. Yields and spreads in the sector were then sent into disarray by successive sovereign downgrades, distortive central bank asset purchases with associated seniority uncertainty, regional bailout fund machinations, and Greek debt restructuring. Dual debt crises rattle AAA/AA universe A look back at the U.S. experience illustrates the uncertainty and complexity of this changing landscape. Investors began to question the underlying safety of AAA and AA assets across sectors, particularly in debt which had not carried an explicit government guarantee such as agencies. As a result of the 2007–2008 mortgage crisis and failure of Lehman Brothers, the primary government-sponsored enterprises (GSEs) – Fannie Mae (FNMA) and Freddie Mac (FHLMC) – were forced into conservatorship. These agencies reduced loan portfolios and subsequently pursued smaller debenture issuance. Understanding SSA Issuers Meanwhile, U.S. Treasury issuance expanded amid political dispute over deficit reduction, eventually leading to S&P’s downgrade of the U.S.’s credit SSAs issue debt on a regular basis rating to AA+. to fund regional projects and More recently, and a continent away, the European debt crisis erupted, development programs, but must sparking a new series of ratings downgrades, rising market volatility and adhere to relatively conservative capital flight. Many asset managers who had held passive allocations to fixed capital requirements, balance sheet income assets for reserve diversification purposes began to direct funds away constraints and lending standards from peripheral sovereign debt into core fixed income AAA and AA written into their charters. These alternatives, with much of these destined for U.S. dollar assets. guidelines limit the type and Filling the gap: agencies wane, foreign issuers gain amount of direct lending possible, As investor demand for liquid high-quality fixed income assets grew amid this with recourse on many public turmoil, the global SSA market expanded, almost tripling in size from 2005 to sector borrowers (many of whom 2012 (see Figure 1). Much of the growth has come since 2008 as SSAs have taxing power) to mitigate expanded balance sheets, taking advantage of low interest rates, allowing ultimate exposure. issuance in the sector to supplement the loss of other formerly high-quality assets. These borrowers attempt to The SSA market now embodies traits of both government bonds and investment maintain benchmark issues grade credit, occupying a corner of the spread sector typically favored by buy- denominated in the major reserve and-hold-oriented central banks, as well as reserve and sovereign wealth fund currencies to maintain the (SWF) managers. Yields on SSA debt inhabit the range between core sovereign necessary liquidity to retain end debt and investment grade credit, and valuation at any given point can be investor interest. A similar viewed as either government or corporate surrogates (much like agencies). symbiotic relationship to that of Dollar-denominated SSAs official investors and the U.S. As shown in Figure 1, the total amount of debt outstanding in the U.S.-dollar- Treasury is in play in the SSA denominated SSA sector has increased to $650 billion as of 1 May 2012, an market, as foreign issuers benefit amount equivalent to 75% of the outstanding market value of U.S. agencies. from the ability to borrow cheaply U.S.-dollar-denominated SSAs (frequently classified as high-quality “Yankees”) in USD, while global investors account for roughly 35% of global SSA market issuance. continually need to recycle dollar The U.S. dollar SSA market in particular includes names (see Figure 2) that may funds. This dynamic perpetuates be familiar to many, such as European agencies (European Investment Bank, current reserve allocations among KFW), sovereigns and sub-sovereigns (e.g., Canadian provincials), all of which central banks/SWF. compete with FNMA and FHLMC for end investor capital. SSA investor considerations SSA issuers adhere to conservative lending standards (see details in sidebar), and the demand for such high-quality paper makes these investments generally trade at lower yields than competing spread product but still above sovereign debt from the respective country. Once SSA investors become comfortable with the underlying credit quality of any given sovereign issuer, they typically view familiar names as yield enhancers to lower-yielding core sovereign debt. NOVEMBER 2012 | FEATURED SOLUTION 2 Figure 1: Amount outstanding in government-related sector subcomponents of the Barclays U.S. Aggregate Index 1,400,000 1,200,000 1,000,000 800,000 600,000 USD millions 400,000 200,000 0 Jul-08 Jan-06 Jan-11 Jun-06 Jun-11 Oct-09 Apr-07 Apr-12 Feb-08 Sep-07 Dec-08 Mar-10 Aug-05 Aug-10 Nov-06 Nov-11 May-09 Supranationals Sovereigns Foreign Local Authorities (incl Provincials) Foreign Agencies US Agencies Source: Bloomberg, Barclays as of 31 July 2012. Note: Not included in these totals is the related covered bond market, which is instead classified as the securitized component of the Barclays Aggregate Indexes. Note that 98% of SSA issuance is denominated in the six major currencies of U.S. dollar (39%), the Euro (28%), British pound (4%), Japanese Yen (19%), Canadian dollar (5%) and Australian dollar (3%). Figure 2: Top foreign SSA issues in Barclays U.S. Aggregate Index USD debt S&P/Moody's outstanding Rating (billions) KFW (German Development Agency) AAA/Aaa 142.8 European Investment Bank (EIB) AAA/Aaa 142.3 Ontario (Canadian Province) AA-/Aa2 42.4 CADES (French social security finance AA+/Aaa 35.0 agency) Bank Nederlandse Gemeenten AAA/Aaa 34.0 (Dutch public finance agency) JBIC/JFM (Japan public finance agencies) AA-/Aa3 28.0 Rentenbank (German agricultural bank) AAA/Aaa 27.6 Republic of Italy BBB+/Baa2* 25.2 Quebec (Canadian Province) A+/Aa2 23.6 Source: Barclays, Bloomberg, PIMCO as of 30 Sept. 2012. * Rating would not be classified as “safe spread”. NOVEMBER 2012 | FEATURED SOLUTION 3 SSA investors often are indifferent to duration and liability-matching sensitivities and manage without fixed income benchmarks. On the other side of the equation, typically upward-sloping yield and spread curves make shorter-dated borrowing by SSA issuers less expensive. These mutually congruent dynamics skew the average life of the sector toward shorter maturities, generally to a maximum of 10 years, fostering a symbiotic relationship. Another important characteristic of sovereign USD issuance and agency debt is the ability of investors with captive currency allocations (e.g., restricted to USD) to access country credit risk in U.S. dollar-denominated instruments (e.g., a Scandinavian country issuing in dollars). This is especially important for investors looking for an alternative to credit default swaps (CDS), which may be an eligible means of expressing a positive credit view. Returns and spreads From an annual return standpoint, SSA securities’ duration-adjusted returns (shown in Figure 3a as Government-related) have ranged between those of Treasuries and corporate bonds in all years since 2008. Over the last four years, in periods where corporates outperformed Treasuries, SSAs have also outperformed Treasuries, but by a smaller margin. Conversely, when Treasuries have outperformed corporates, SSAs also posted higher returns than their corporate counterparts. Figure 3a: Duration-adjusted total return 16% 14% 12% 10% 8% 6% 4% Percent (%) 2% 0% -2% -4% -6% 2004 2005 2006 2007 2008 2009 2010 2011 Barclays U.S. Aggregate Treasury Government-related Corporate Securitized Source: Barclays, PIMCO. Note: Note: All categories are unhedged USD and are represented by applicable Barclays indices. NOVEMBER 2012 | FEATURED SOLUTION 4 However, Figure 3b shows that while the annualized return of the government- related sector over the last seven years has been just slightly lower than the Aggregate Index and comparable to Treasury returns, the volatility of the sector has been less than both. Figure 3b: Annualized 7-year risk/return 8% Corporate 7% Barclays U.S. Aggregate 6% Securitized Treasury Government- 5% related 4% Return(%) 3% 2% 1% 0% 0% 1% 2% 3% 4% 5% 6% 7% 8% Standard Deviation (%) Source: Barclays Note: All categories are unhedged USD and are represented by applicable Barclays indices. Figure 4 shows five-year constant maturity spreads versus U.S.