Yield curve/duration

Market liquidity often worsens as end-of-the-year housekeeping and the holiday season approach. It is a regular, usually seasonal, pattern. What is different about the latest year-end is that the bid/offer spread widening spilled over into the futures contracts for the first quarter 2008.

Widened spreads reflect heightened tension in the markets, as worries over banks’ balance sheets translate into concerns about counterparty risk and the perception that systemic risk is rising. All the major central banks have been pumping in
extraordinarily large volumes of emergency funds, in an attempt to stop the capital markets’ liquidity crisis from spilling over into the ‘real’ economy.

Economic data from the US is deteriorating, and its housing market remains in virtual free-fall, making it more straightforward for the US Federal Reserve to further ease monetary policy. In Europe the picture is more complex. Euro-zone growth remains positive and inflation is edging higher: for a central bank whose sole mandate is inflation fighting, any easing of monetary conditions seems off the agenda. But the consequences of monetary inaction may be devastating.

Covered bonds

This year was challenging for the jumbo covered bond (CB) market, and proponents of CBs will not remember it with much pleasure. Liquidity - arguably one of the market’s most important features - collapsed across much of it, twice.

As the US sub-prime market tumbled and the market worsened across the entire securitised product universe trading conditions, the CB market was unable to withstand the pressures and trading started to fail, particularly in UK, Spanish and Irish CBs but, eventually across the whole market.

It was clear that a two-tier market was developing. In September, the European Covered Bond Council (ECBC) which represents 85% of all CB issuers in the EU, said it was “strongly opposed… to the idea of differentiating between covered bond products”. At the end of the year, maximum bid-ask spreads were widened and regulated trading amounts lowered in an attempt to rekindle the market.

It remains to be seen whether the ECBC can maintain its stance as there have already been rumblings from Germany’s Pfandbrief banks expressing veiled irritation that its market is being disadvantaged by association with ‘other’ covered bond countries.

Investment grade credit

Credit market spreads remain volatile. Such is the tension they have even been testing the highs of the summer, then equally sharply have swung back down, taking their cue from surging equity markets. As long as this volatility remains, it seems unlikely that credit markets will stage any meaningful rally, although historically equity markets have usually enjoyed strong starts to the year.

The EU economy faces an uphill battle: a strong currency; high energy prices; the US economy clearly slowing and strains within the money markets that show no signs of abating. For corporate Europe, 2008 will be much harder than 2007. Banks are already passing on higher interest rates to corporate and retail customers.

On the positive side, Europe’s companies have enjoyed a benign working environment for several years and are mostly in reasonably strong financial health. For credit investors, as always in times of market stress, name selection becomes critical if there is to be any chance of outperformance.

High yield

Challenging would be an appropriate word to describe the outlook for high yield (HY). Though it may not feel like a happy year, the default rate actually declined over 2007 to between 1.0% and 1.5%. A cyclical downturn seems almost inevitable for 2008 and there now appears to be a growing consensus that the default rate is bound to trend significantly higher through the year. Indeed, various investor surveys suggest a default rate of about 3% by year end 2008.

The more optimistic view suggests that liquidity is not a huge worry at the moment among European HY entities and
consequently they are well funded, thus cushioned, from the current tight conditions in the money markets.

For several years HY markets have been well supported by a strong ‘technical’ picture: demand constantly outstripping supply in the search for yield.

If one considers fund inflows and the thin dribble of supply, perhaps supply will be easily absorbed. But with macroeconomic fundamentals deteriorating and confidence rocked, 2008 will indeed be a challenge for HY.

Emerging markets

The turbulence in the money markets means risk appetites remain low for the foreseeable future, and EM debt and equity asset prices will find the going tough. EM policy makers have done so much to convince the rest of the world they can run their economies in a credible, enduring manner. Now all that hard work, throughout much of the emerging market (EM) universe, is really being put to the test.

On top of the precarious global liquidity situation, inflation is on the increase throughout the EM universe. Monetary conditions will need to be tightened, in contrast to the developed world, in order to fight these inflationary pressures. While this will clearly have negative implications for fixed income assets, it may prove to be a good mix - high growth and high interest rates - for the EM currencies.

As in all other markets, it is likely that will be a greater  differentiation between the performances of the good and the bad. EM investors will be hoping their markets really are assessed on their own merits and that ‘contagion’ is a thing of the past.

Credit derivatives

There is as much, if not more, tension in the markets now than in the spring and summer of 2007 when the sub-prime market blew up. Having got over Q3 earnings, Q4 looms large and dark. Rating agencies Moody’s and Standard and Poor’s have been downgrading CDO tranches. There were 20,000 separate downgrades in 2007, compared with 2,500 in 2006. More distressing has been the damage inflicted on even the highest rated securities.

There is much talk about the effect of CDO troubles on (US) monoline insurers. When CDOs arrived, many insurers focused on ‘super-senior’ tranches and reaped the benefits of extra revenues set against low capital charges. Now it is clear many of these CDOs are backed by shaky collateral, namely recently originated US subprime mortgages. Unlike banks and other investors, bond insurers do not have to mark-to-market, but have to hold extra capital against downgraded bonds. It remains to be seen whether they will be damaged enough to suffer downgrades themselves.

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