Yield curve/duration

Both the European Central Bank (ECB) and the Bank of England acted predictably this month, the former leaving rates alone and the latter hiking by a quarter point. The ECB stated that it would be maintaining its ‘vigilant’ stance, and the majority view is that European rates will most probably be raised in June, with the fainter possibility of more hikes in second half of the year.

Economic growth across much of Europe has continued to confound the pessimists. In particular Germany, once the sick man of Europe, is enjoying a very impressive turnaround in its economic fortunes. Europe-wide business surveys have generally been coming in more optimistically than expected, and companies have been increasing output to fill depleted inventories. It is likely that this economic strength was boosted by the extraordinarily hot and dry April weather experienced across the Continent, but it is certainly no surprise that the ECB stuck to its hawkish bias.

The UK base rate has reached a six-year high. With British consumers persistently spending more than expected and inflation hitting a ten-year high of 3.1%, plus an extremely buoyant - maybe very over-heated - housing market, the authorities had little option but to tighten policy and to imply that they were not yet finished.

 

Covered bonds

In the immediate wake of the uncomfortable stock market news about certain Spanish property developers Spanish Cedulas spreads did widen out several basis points (bps). However, although some of those property stocks fell by almost 60% at their weakest, Cedulas reversed most of their underperformance. According to some observers it seemed to be the case that the market makers were more nervous than end-investors who, for their part, seemed to be more comfortable with both the security of their Cedulas investments as well as with the strength of the Spanish banks in general. Indeed the new issue Santander Cedulas was very well received by the market, suggesting that investor interest does indeed remain strong.

The first Norwegian covered bonds should be ready for issuance in June. The changes to Norway’s Financial Institutions Act were approved in March. Norwegian covered bonds appear to most closely resemble their Finnish peers, although there are also strong similarities to both German Pfandbriefe and Swedish Sakerstallda Obligationer. It has been a long journey to reach this stage, with the initial plans having been proposed back in early 2000. Nevertheless, Norway is a welcome entrant to this market.

 

Investment grade credit

Having come back fully from the uncomfortable correction back in late February, investment grade (IG) spreads have done more than merely recover and have gone beyond to reach new lows for this current cycle. Although this may be slightly less impressive than high yield, which reached new all time spread lows (see below), the performance has left some investors suspecting that valuations may now be rather stretched.

The worriers argue that fundamentals for IG are deteriorating. Corporate net debt did rise over the course of 2006 but increases in profits and operating cash flows meant that leverage remained pretty stable. Merger and acquisition (M&A) activity is increasing and the worry, for credit investors, is that it rises to such an extent that profits and operating cash flows do not increase at the same speed and hence leverage has to rise as well.

The technical picture, conversely, remains very supportive for credit. Demand for yield still seems pretty insatiable and more and more investors are turning to derivatives for at least some form of credit exposure as government bond yields look set to remain in the low single digits. However, while the market has bounced back, it appears that although the average investor still seems unwilling to cut back credit exposure down to underweight, sentiment is definitely slightly more subdued and is erring on the cautious.

 

High yield

The recent, almost meteoric, rise in European equities since the market correction at the end of February did not go unnoticed by the high yield (HY) sector. In fact HY in Europe has done so well that spread compression within the sector has taken the spread-to-worst to an all-time low. Since mid-March European credit spreads have tightened by around 50 bps, significantly outperforming the US where HY compressed by 36bps.

Recently released Q1 2007 corporate HY default rates have remained low on both sides of the Atlantic. Rating agency Fitch reports US default rates trending even lower through the quarter, apparently immune to fallout from the sharp market corrections. Even more noteworthy is that Fitch’s trailing 12-month HY default rates are markedly lower than the long term average rate, despite a concentration of bonds rated CCC and lower. In Europe that trailing rate has risen to 0.9% from 0.6% at the end of 2006, with record quarter issuance totalling approximately €10.2 bn.

 

Emerging markets

Emerging markets (EM) have generally been enjoying the global uptick in risk appetite, as investors have put aside some of the more local worries. In Turkey, for example, investors seem to be reasonably comfortable ignoring the considerable political risks facing the country and spreads remained steady, despite the considerable increase in market volatility. With huge demonstrations on the streets and confusion surrounding the crucial presidential elections, the political situation will remain extremely tense for the next weeks and months.

However, some bad news is unignorable. Venezuela’s President Chavez jolted investors when he announced he was organising cancellation of Venevuela’s affiliation to the IMF. According to Venezuela’s external bond programmes’ prospectuses, leaving the IMF is considered a technical default, permitting bondholders to force the issuer to repay in advance - acceleration. Overall this is undesirable because most of Venezuela’s external bonds are trading above par, but those few bonds currently trading below par were marked up closer to that 100 level. Investors are not rushing to force early redemptions but it seems unlikely that much new investment will be attracted at present.

 

Credit derivatives

Fitch, the ratings agency, has recently published its initial observations on the constant proportion debt obligations (CPDO). The agency has been asked to rate some of them and, while acknowledging that these instruments can be profitable, has decreed that the first generation of CPDOs do not merit either ‘AAA’ or ‘AA’ ratings.

The agency points out that like other recent innovations in structured credit, the performance of the issued debt obligations is very dependent on changes in credit spreads and their mark-to-market impact. This form of risk is significantly different from the more conventional credit risk, defined by default rates and recovery, which takes secondary rank in a CPDO instrument.

Fitch’s assessment work has been carried out upon the first generation of the CPDOs and the agency is suggesting hopefully that the derivatives market will remain true to its constantly inventive form, and will already be at work upon on the next generation of instruments which will seek to address and rectify these perceived weaknesses in early CPDOs.

Topics