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Credit markets set for tough year ahead

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Yield curve/duration

 

Though the US housing market continues to show significant signs of weakness, prompting economists to downgrade domestic growth forecasts, the US consumer has yet again surprised us by significantly increasing their spending rather than their savings during October. And another shock came in the form of a significantly stronger jobs report, which gave US Treasuries their biggest jolt for several months.

Overall, the consensus seems to be that the US economy has slipped into below-trend GDP growth and that interest rates will be stable or could decline further. Interestingly, some analysts worry that if US rates do decline further then foreign appetite for them could also decline. According to official figures, foreign entities own a massive 43% of US Treasuries and almost a third (29%) of US corporate bonds.

Closer inspection reveals that, although the Japanese are still the biggest buyers, there has been huge growth in the holdings of UK-based investors. It has been suggested that this could be on behalf of the oil-exporting nations.

While it seems more certain that the US Federal Reserve will be on hold next year, or perhaps even getting ready to cut rates towards the latter part, the European Central Bank may well have to be rather more active.

 

Covered bonds

 

Covered bonds have continued their strong and steady trundle through the year. The Jumbo covered bond universe has grown steadily. Participants have high hopes for increased US issuer activity, after Washington Mutual became in 2006 the first ever non-European Jumbo issuer to the market. It seems fairly certain that at least four additional US issuers will come to the market in 2007.

Interestingly, although spreads have narrowed between government bonds and their respective country covered bonds, there has been a reasonably high divergence in inter-country spreads. Spanish Cedulas, for example, have been one of the underperforming sectors as large supply - in fact another record year with close to €60bn of issuance - has clearly caused some indigestion. German Pfandbrief, on the other hand, have seen limited new issuance (and even negative supply because of heavy redemptions) and subsequently Jumbo swap spreads have remained tight throughout 2006.

The Financial Services Authority plans to have new UK Covered Bond regulation and rules in force by the autumn of 2007. The new framework will raise the degree of legal supervision in the UK market which is currently mainly monitored by the rating agencies.

 

Investment grade credit

 

There is an almost unanimous forecast that the global economic environment will be less supportive through 2007, although not perhaps dangerously so.

It probably means that volatility in equity markets will be on the rise which, more often than not, translates into wider corporate spreads including investment grade (IG), though higher volatility through 2006 did not stop significant spread narrowing over the year.

While it is unlikely that there will be a dramatic gapping up of IG spreads - indeed there was only a gradual widening of spreads from late 2000 to late 2001 - today's spread levels are, for many investors, too narrow to be fully accommodating the risk factors as we move into 2007. Whether or not the macro-economic fundamentals do turn against credit markets, negative forces might be lurking further down the credit ladder which even IG just might not
withstand.

 

High yield

 

For 2007, it is the default rates which investors forecast will be the key to high yield (HY). There is a strongly held consensus view that several large defaults, occurring one after the other, would trigger a very painful sell-off in HY. However, with default rates so low globally, many would argue that the risks of large and sequential defaults are actually quite low as well during 2007.

While volatility is rising so markedly in the foreign exchanges and with it perceived forex risk, investor risk appetite is understandably diminished. Furthermore, much has been written about the effect of credit derivatives' trading on speculative grade spreads (see Credit derivatives below).

There is a growing sense of unease that the narrow spreads in HY are far less supported by economic fundamentals than investment grade credit. However, there are plenty of bulls who point out that the reason that the derivative side is trading so strongly is that demand for credit remains healthily high and does not look like it is about to evaporate.

 

Emerging markets

 

Emerging markets (EM) have had a pretty strong year, and seem to be have ended it very well. This is especially true for the eastern European markets which suffered either directly or indirectly during the frequent bouts of political/social turmoils.

Turkey has been one of the poorest performers, as relations with the EU remain extremely delicate, although even here the year ended well. The market warmly welcomed the announcement that the Turkish government would abolish the death penalty and just might sanction the opening of a seaport and an airport to Cyprus
traffic. Returns in EM debt, as in high yield, have been very pleasing, especially when compared with the paltry risk-free return available.

China's rapidly growing foreign exchange reserves - already the world's largest - exceeded US$1,000bn (€758.3bn) for the first time, a reflection of the inexorable growth in the country's trade surplus.

 

Credit derivatives

 

The CDO market has continued to grow rapidly throughout the year and, like supply, demand has remained very high. There is a strong argument suggesting that, were it not for the strength of this technical bid for credit, fundamentals ought to be pushing credit spreads wider.

There has been much talk about last year's introduction of the CPDO (Constant Proportion Debt Obligation) by ABN AMRO and what its true influence on the indices is.

This product is highly complex and like many other innovations in the credit derivatives world has been developed to satisfy the seemingly insatiable investor demand for yield. The rating agencies have assigned AAA- ratings based upon the assumption that, as the instrument is based on the index which is itself re-based every six months and any downgraded entity being replaced, the probability of an actual default in the period is miniscule.

However, like many other products, CPDOs depend upon a high degree of leverage to achieve the advertised ‘high' yields, which is fine when the thing being wound up is positive, but rather painful when negative numbers start to creep in.

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