Bulls vie with bears
While investors may have been just slightly sceptical about the eye-opening rise in the German Ifo index, taking it to a 15-year high, news that the European Commission composite index was also on the rise, up for the fifth consecutive month to its highest level for five years, was perhaps a more credible indication that the Euro-zone economy is in good shape.
The question of whether or not the current bear run in global bonds is coming to an end is creating a quandary for the capital markets. For the fixed income bears, their compelling arguments are: central banks are not yet at the ends of their respective tightening cycles; real rates are still not that high; and much ‘hot money’ and many leveraged players, borrowing short and investing further out the curve, are still very long.
Bond bulls, on the other hand, see the US economy slowing down markedly in the second half of the year, and they point to the fact that the high price of oil could act as a headwind on the global economy, and that global growth really will not continue its upward rise, starting with the US next quarter which they argue may start to slow significantly.
Supply has, as expected, declined during April, a feature that clearly aided the Cedulas market which had been hardest hit by the worries about interest rates and rising yields in government bonds generally. Spread volatility looks set to remain rather higher in this geographic sector.
Also, in the UK, the Financial Services Agency’s (FSA) implementation of EU compliant covered bond legislation will probably come in to effect early next year. Investors are already preparing for some increased volatility in spreads in UK covered bonds, bearing in mind the intended legislation will result in a reduced risk weighting for covered bonds from 20% down to 10%. AHBR, the troubled German mortgage bank, has announced another large buy-back operation, this time of a mortgage Pfandbriefe and three of its public sector Jumbos. Liquidity dropped sharply when the depth of the problems at AHBR first came to light, perhaps damaging the high reputation of Jumbos. In an attempt to limit the damage done to the trading reputation of Jumbo’s, the Association of German Pfandbrief Banks (VDP) has said it will set up a panel of issuers and market makers to agree standards to deal with crisis situations, and to ensure that liquidity does not dry up again as the AHBR ‘crisis’unfolded.
Investment grade credit
Investment grade has been going nowhere, in a healthy sense – not much impetus for spreads to either widen or narrow further, even as government bond yields have risen. Credit has been well supported by the ample liquidity and government bond yields still very low in historical terms. The good economics of carry trades have also provided significant support for this (and virtually all other fixed income) market(s).
Increased risks in via increased corporate have been endured
and, when deals have happened the pain has often been sharp. However, the underlying positive tone to credit markets in general has meant that overall, there has not been generalised spread widening on these events and indeed many credits that have suffered ‘blow-outs’ have quickly reverted as investors had more time to re-assess whether or not the credit ‘damage’ would be real.
If the fixed income bears start to win the argument and yield risk rises, so tensions will increase for investment grade credit. Some of the more bearish analysts are already suggesting that a worrisome degree of complacency has already crept into the credit markets and that there has been too little differentiation in performance between the really good credits and the poorer ones.
The first few months of the year saw the tough combination of high issuance and investor outflows (as measured using US mutual fund data), but it has been high yield sectors which have posted the positive returns this year.
Such has been the remarkable performance in junk bonds (ie, below investment grade) that both European and US high yield spreads have actually fallen as both the ECB and the US Fed have raised rates. In fact, US junk spreads have declined some 100 basis points as the US Federal Reserve set about nearly quadrupling the Fed Funds rate.
However, the fundamentals do remain supportive for high yield. As the analysts point out, what’s really been supporting the general tightening of credit spreads has been healthy profits.
Some analysts have suggested that another channel by which monetary policy could be – indirectly- transmitted, is via emerging markets. Gone are the days when a hike from the Central Banks could trigger chaos and waves of selling Emerging Markets (EM) so setting off a series of events: severe economic slowdowns for those EM’s; a rising US dollar (and other hard currencies); falling commodity prices and hence inflationary pressures eased.
Historically, studies suggest that volatility tends to average its highest over the course of the second quarter of the year, and with such nervousness in the developed world’s government and other liquid bond markets, it’s not surprising that many investors are quite cautious about EM government bond markets. Although EM bond spreads have tightened year-to-date, most of that out-performance has come from the very marked back up in US Treasury yields and the absolute performance of EM bonds year-to-date is only around 1.5% (in US dollar terms).
That said, however, the macro economic fundamentals of so many of the countries within the EM universe do remain strongly supportive (with the rating agencies announcing more upgrades than downgrades of EM debt) as is the strength of the global economy. Thus many participants would suggest that going outright underweight in EMs may also be too risky a strategy. Also, though individual markets have suffered some severe knocks, such as Hungary, Brazil and Mexico, these ‘crises’ have not translated to a general feeling of risk aversion in EM bond markets.
The IMF publishes a semi annual assessment of global financial markets, and in its most recent report published recently*, it devoted considerable time to examining credit derivatives and the structured credit markets. The aim of the analysis was to establish whether financial stability was being put at risk with the growing use and development of these instruments. Though perhaps a surprise to the traditionalists and other sceptics, the conclusion was that the credit derivatives market was a useful sector in that it aided in the dilution of risk, previously concentrated in the banking system, out towards a broader range of investors.
Where the report did suggest caution was in the degree of the market’s reliance upon the rating agencies and that perhaps some of the products, because they utilised a greater complexity of structure rather than of credit, that perhaps the agencies should be more succinct in their rating analyses.
*Global Financial Stability Report: Market Developments and Issues, International Monetary Fund (IMF) April 2006.