Corporate bonds, preferred bank debt and
convertibles are becoming increasingly attractive for investment
managers, with equity markets tipped for a shaky start to the year
and government debt looking expensive. But how do private bankers
persuade clients to expect more modest returns? William
Cain
reports.

The threat of deflation and global
recession are the prevailing themes for wealth managers entering
2009 – placing an even greater emphasis on sound asset allocation
strategies.

Bonds, particularly investment grade
corporate and convertibles, have emerged as the asset class of
choice in the early part of the year, with spreads pricing in
depression-level default scenarios. There is less consensus on
equities, with investment strategists divided on whether early 2009
will be a good time to start picking up stocks on deflated
price-earnings ratios. Most continue to focus on blue chip
businesses with good earnings transparency.

Carl Astorri, head of investment strategy
at Coutts, the private bank owned by Royal Bank of Scotland Group
(RBS), told Private Banker International a typical balanced client
portfolio would have a 36 percent allocation to equities, 44
percent in bonds and 20 percent in alternatives, which includes
property, commodities and hedge funds.

He said the bond holdings in the portfolio
included 1 percent cash, 26.5 percent in UK Government debt, 13.9
percent in global investment grade bonds and 3 percent in UK index
linked bonds.

Investors flocked to the safety of
government bonds towards the end of 2008 in an attempt to preserve
capital. Over the course of 2008, US Treasury bonds outperformed
the S&P index by 53 percentage points. But yields have reached
historic lows in many countries and, with official interest rates
approaching the 0 percent level instigated by Japan during its own
financial crisis in the 1990s, some have labelled them “return-free
risk”. Now the increases in spreads for investment grade corporate
and convertible bonds have become particularly attractive.

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“The area of biggest opportunity is in the
corporate credit world rather than equities. It is very
attractively valued when you look at spreads relative to government
bonds,” said Astorri. “If you look at investment grade versus high
yield, it’s investment grade which looks particularly attractive to
us. What we would classically do is go into investment grade then,
as the cycle matures, eventually into high yield.”

Gary Dugan, chief investment officer,
EMEA, at Merrill Lynch said he liked high-grade corporates and
bank-preferred debt. In the corporate space he said Merrill was
looking for blue chips with strong cash flows, modest refinancing
needs and short to medium maturities.

Bank-preferred debt had exceptional
spreads and benefited from active government participation at
equity level, Dugan said. He recommended a modest holding in a
diversified portfolio.

Convertible bonds are also believed to
have some potential following a 40 percent decline in 2008,
according to UBS’s global index, and have been heavily tipped for a
recovery in 2009.

Fund houses with convertibles funds are
reporting brisk interest, with recent fund launches from Aviva
Investors and credit manager Blue Bay Asset Management in the UK.
But while the fundamentals for the bonds look good, there are
technical reasons to be wary.

“If you looked at the valuations of
convertibles alone you would put all of your money in them,” said
Dugan.

“The main risk is if there’s a meltdown in
the balance sheet of the issuer and the other is the inventory
which sits within hedge funds, which will be forced sellers in the
coming months and could make them even cheaper.”

Girish Nayak, head of global private
clients at India’s ICICI bank, said sentiment in the Asian market
was increasingly similar to that of the US and Europe, and that
clients were waiting and watching, particularly on equity
investments. He said there were opportunities in bonds held to
maturity, and that many clients favoured a risk-averse strategy
with a high percentage of bonds and deposits.

He added: “At present, I do not think
there’s much difference between the risk appetite, whether it’s the
US, Europe or India.”

Equities

Allocation to equities has been
dramatically reduced over the past year at most wealth managers, a
strategy that made sense given steadily sliding values from the
third quarter of 2007.

While 2008 will be remembered as one of
the worst on record for the asset class, the big dilemma now is
whether to start increasing equity weightings ahead of a potential
rebound or to further reduce, particularly after the Christmas
bounce in indexes across the world.

Market timing in such volatile conditions
has proved next to impossible even to those, like Personal Assets
Trust (PAT), which had the foresight to liquidate their equity
holdings at the start of last year. The London-listed closed-end
investment trust went back into the market in July 2008, going
overweight on the banking sector prior to the collapse in
September. Still, its share price has fallen by a relatively modest
8 percent since the decision.

But the heavy falls in the latter half of
2008 mean investors are spoiled for choice in finding attractive
opportunities, compared to very few 18 months ago, according to
Bruce Stout, senior investment manager at Aberdeen Asset
Management. Although he said the general outlook for equities was
weakening in the short to mid-term, he believes current conditions
present an opportunity to upgrade the quality of holdings in equity
portfolios, with some blue chip companies attractively priced. He
said Aberdeen had recently been adding large caps like Rio Tinto,
Dow Chemical, and Schneider Electric. Aberdeen’s overall strategy
is to incrementally increase equities at the expense of government
bonds.

Dugan had a less optimistic view, saying
some people were still wearing rose-tinted glasses regarding the
prospects for 2009. While price-earnings ratios are in line with
historic lows, he said the threat of deflation and global GDP
growth of just 2 percent made it difficult for businesses to
generate returns of 10 percent. He said inflation expectations
would need to be re-established before PE ratios in the range of 10
to 14 could be justified.

“Corporate profits have only recently
begun to fall and analyst ratings have not yet caught up with the
market,” Dugan said. “We’ve had only two months of downgrades of
earnings and if we compare that to previous recessions, we still
look like we are in the early stages of this one.”

He said typical allocation to equities in
one of its client’s absolute return portfolio would be around 25
percent, with 60 percent focused on Europe and the UK ahead of
potential fiscal stimuli from European governments, which have so
far been more cautious than the US.

Alternative assets

Hedge funds have come under the spotlight
in recent months, with various predictions of demise for the
industry. A PBI survey of private bankers showed they expected the
number of hedge funds to have halved from a figure of 10,000 by the
end of the current crisis (see PBI 243) as they are hit by
deleveraging in the global economy.

That pessimism is not shared by all. The
investment class outperformed higher risk assets like global
equities and high yield bonds in 2008 and some private banks –
including Citi – are recommending clients allocate up to 20 percent
of their portfolios to hedge funds.

There are divided opinions on the
prospects for commodities because of the economic slowdown.

UBS said it expects a modest rebound in
some commodity prices later in the year. Private bankers have
reported an increasing interest in physical gold from clients as
concerns over the economy mount.

Dugan at Merrill Lynch also highlighted
private equity as an attractive investment proposition. He said
private equity funds raised during the economic downturns of 1991
and 2001 generated some of the best vintage year returns.

Client focus

Managing clients’
expectations important in uncertain year ahead

Clients will need to get used to the number
zero in 2009, with diminishing inflation and growth forecasts
making any returns in positive territory attractive, according to
Gary Dugan, chief investment officer, EMEA, at Merrill Lynch.

With most wealth managers advising a cautious
stance going into 2009, they face a difficult task convincing
clients to accept rates of return which would in previous years
have been considered unacceptable. Dugan said it will take time for
clients’ expectations to adjust and that real rates of return of 3
to 4 percent were realistic.

“I do not think client expectations have
changed and it will take some time,” Dugan said. “Early last year,
some clients were asking for returns as high as 25 percent and
that’s not realistic any more. In the developed world, a normal
rate of return has been considered to be between 10 and 12
percent.

“People have not quite got used to the number
zero yet and that lots of assets are yielding close to 0 percent.
We are talking about real returns rather than nominal returns –
clients’ buying power increases even if the yield on bonds look low
because GDP forecasts are around 2 percent and inflation looks
likely to be 0 or even below. A real rate of return of 3 to 4
percent through 2009 would still be a good year and in line with
long term averages.”

Carl Astorri, head of investment strategy at
Coutts, said clients were getting used to the idea of lower
expectations for returns on investments in the current climate. He
said it was also encouraging clients were beginning to move out of
cash and government bonds into better yielding assets.

“There is an element of this in conversations
with clients,” Astorri said.

“On a non-advice basis there is a preference
for safety and an increasing interest in yield. Going back three to
five months clients were just interested in safety, but now they
are dipping their toes back into the water.”

Dugan summed up: “We want to be positive, but
we are being realistic. We are looking at damaging news flow and
more readjustments at government and corporate levels.

“We need to see these problems have been
addressed and we will not advise clients to take risks in their
portfolios until we have seen these underlying issues dealt
with.”

2009 estimates and historical ranges

 

Comparing current US writedowns to the Japanese financial crisis