The crunch continues

Yield curve/duration

The credit crunch is now manifesting itself in the form of the massive writedowns by scores of financial institutions. The focus has moved from sub-prime to collateralised debt obligations of asset backed securities (CDOs of ABSs) to asset backed commercial paper (ABCP) as the disease spreads to the wider global financial sector. Just what lurks on banks’ balance sheets remains the key focus.

That Lehman Brothers, one of the world’s largest banks, is bankrupt is astonishing. Equally shocking is the news of Merrill Lynch being taken over. There will surely be more deleveraging and more breathtaking writedowns. Liquidity within the banking system remains poor and unpredictable, and that all-important mutual confidence between the banks is still seriously compromised, as significantly elevated interbank offered rates indicate.

The US Treasury may well have done a huge deal of good, with its plans for nationalising and recapitalising the government sponsored mortgage enterprises (GSEs), to rein back the US housing market from its downward spin, and the post-GSE announcement rallies were pretty powerful. However, US real estate remains in deep trouble and there are still so many problems that it is too early to be predicting the end of credit crunch pain.

Covered bonds

Many investors in the jumbo covered bond (CB) market are wondering now whether wider spreads and higher volatility are here to stay. Certainly there has been no turnaround in the trend towards higher spreads in the primary market, in fact it seems to have speeded up. There is little evidence that the secondary market will do anything but follow this spread widening trend.

The ECB announced that it is to raise the haircuts (levied on assets deposited at the bank as collateral) on senior bank bonds and ABS. It has become apparent that there was an increasing trend of ‘riskier’ assets being deposited as collateral by the banking community and, although the ECB has not admitted any concern, the increase in haircuts does go some way to redressing particular trend.

ECB raised the haircuts on multi-cedulas, which are considered ABS, and also on structured CBs, categorised as bank bonds. CB participants had mixed reactions: most of  market is unaffected, but any ‘excuse’ for the market to widen the intra-market differentials does add to the sense of unease that the market will never recover its lofty past status.

Investment grade credit

While the US Fed’s rescue plan of Freddie Mac and Fannie Mae may mark the bottom in the US housing market, there seems little evidence that risk appetites will be turning up just yet. The financial distress remains far too widespread and painful. Those systemic risks are now coupled with worsening economic conditions, especially within Europe. The pressures on European corporates are increasing. There are little slivers of good news, with inflation pressures declining as energy prices have fallen substantially from their highs, as has the gold price. But with central banks seemingly ‘on hold’ for now, the near term outlook for government bonds seems mixed, at best as issuance worries start to seep in.

Entering into this phase of slowing growth especially in Europe, it is logical to expect diverging performances between non-cyclicals and cyclicals. Furthermore, the gap between companies with good quality balance sheets and those with ‘problems’ will assuredly widen. Although IG companies have, as a group, entered this downturn in remarkably good shape, the need for cash will arise perhaps when investors might demand the most differentiation of risk premia. Though spreads are very wide, extremely careful stock picking will remain essential.

High yield

While there may be exceptions to test the rule, the outlook for high yield (HY) everywhere is not good. Events in the US continue to dominate all credit markets, including HY. Of course at over 840 bps over US Treasuries, US HY - like its European and UK peers - does offer a rather fat cushion of current yield.

The default rate will rise - historically, the lag between the time of tightening credit conditions and increasing default rate is estimated at six to nine months - as everyone is predicting. It is on the up already, though from a famously low level, and yields have already priced in a significant increase in the rate. It will probably peak within the next 18 months - perhaps before spreads peak - but where it does is more perplexing.

 Investor surveys have, throughout the year, pointed to deteriorating sentiment in HY as risk appetites have shrunk. While some surveys show that, although actual risk positions are reducing or staying constant, an increasing number of investors suggest that they might add to their risk positions in the coming months.

Emerging markets

Economic data from the emerging economies points to a generalised slowing of industrial production - perhaps even China, stripping out the ‘Olympic effect’, is starting to experience something of a gentle slowdown. Headline inflation has been on the rise throughout the EM universe since mid-2006, although it may have already topped in some areas, aided by the early peak in food inflation. Although much of the EM world is absolutely in better shape than during previous US/global economic slowdowns, it is hard to imagine that their growth can be immune to external weakness; much of the EM’s growth improvements have been due to international, rather than domestic, factors.

Polish Prime Minister Donald Tusk took everyone by surprise when he announced that his government was targeting 2011 as the adoption date of the euro. This was greeted with a few raised eyebrows; it is an ambitious deadline and there remains a lot to be done, stages that will not be made any easier by the global slowdown. Also, many Poles believe that the Polish constitution needs to be amended first, a step that requires a two-thirds majority in parliament, something the present government may find the hardest of all the stages to achieve.

Credit derivatives

Although there are signs of life within certain parts of the structured credit universe - there has been a steady trickle of CLO issuance on both sides of the Atlantic - spreads have just carried on widening, even in CLOs, and continue to reach ever higher record highs.

The numbers are eye watering: in CLOs for example, AA spreads are up to 500 bps, BBB breaching 1,000 bps and BB rated topping 1,500 bps. Back in the winter of 2006, BB rated CLO paper was trading at spreads below 400 bps. As long as the troubles remain so acute within the more racy CDO world, with liquidations and SIV unwinds, it seems likely that CLO spreads will stay wide.

And while much of the global capital markets were quiet during August, there was mayhem in the ABS CDO sector as events of default (EOD) continued to accumulate rapidly. It is estimated that some 30% of ABS issuance since 2000 has suffered some EOD, while for 2006 and 2007 those numbers are 43% and 68% respectively.