Yield curve/duration

n exciting start to the year, with the latest US jobs number making sure that no investors get lazy and assume that they have already got the macro-trends for 2007 sussed out. The 167,000 net creation of jobs was significantly higher than most forecasts predicted and certainly highlights the contrasts within the US economy: clear weakness in housing against reasonable strength elsewhere.

While the macro-economic signals remain mixed, it is not all bad news for bonds, other recent data indicates that, while the economy seems to be stronger than previously thought, price pressures overall are not on the increase in the US. That said, the payroll number has forced many forecasters to alter their predictions of early rate cuts from the US Federal Reserve, especially as the minutes of its last meeting suggested that inflation concerns - emanating from the tight labour market - remain.

In Europe, the ECB just has to keep on track, and continue to raise rates as it did five times last year. There have been no great economic surprises, and European yield curves currently price in two rate increases in 2007, the first of which could be made during this first quarter.


Covered bonds

lhough lagging slightly behind government bonds in terms of performance, Europe’s covered bond market had a really good year with 14 new institutions issuing Jumbo covered bonds, one of which was the US-based issuer Washington Mutual. Existing issuers increased their issue volumes in 2006 from 2005. German issuance was the exception and issuance declined over the year. However, it is likely that many prospective new issuers in Germany will be ready to come to the market in 2007 having set about establishing the requisite compliance and systems after the introduction in 2005 of the Pfandbriefe Law and other banking changes. These have effectively opened up the field to a much broader spectrum of would-be pfandbrief issuers.

Credit worries are not really an issue for investors in the Jumbo market where there is an almost 90% achievement of AAA ratings. However, the messy demise of AHBR, and the ongoing selling transfer of business and of its assets, does highlight the fact that even a market like the stolid and steady Jumbo Pfandbriefe needs close monitoring.

Although more countries are putting place effective covered bond legislation, in this rapidly growing market it is vital that investors stay absolutely on top of all developments in the different legal frameworks already in existence.


Investment grade credit

he euro swap curve steadily flattened over the course of 2006, while the sterling curve began the year flat and ended it inverted. Both of these moves were within bear markets and, according to Merrill Lynch, 2006 turned out to be one of the poorest years ever for euro and sterling bonds. The Merrill Lynch EMU Broad Market Index suffered only the third full-year loss in its 21-year history.

Although bearish sentiment for government yield curves remain for now, conditions for credit remain very good: corporate profit margins are high; and gearing, though on the increase, remains within reasonable bounds. In fact profit margins are considerably higher today than they were back in 1999/2000 in the aftermath of the dot-com bubble burst induced recession. For this reason many investors remain reasonably sanguine about the prospects for credit, arguing that the downturn is already mild and that corporate balance sheets are generally significantly healthier and stronger.

There is, however, no escaping the fact that merger and acquisition activity is on the increase. The bears argue that there is currently insufficient compensation for bond holders carrying this risk and recommend only those high quality sectors such as banks, life insurers and sovereigns, those without direct LBO (leveraged buy-out) risk. And to add a further shade of gloom, studies by Merrill Lynch suggest that losses in December are very often followed by one or two months of additional losses.


High yield

ast year was a pretty good year for high yield in Europe. Cheap money, healthy appetites for risk and plenty of liquidity have all helped keep default rates very low for a very long time. Global issuer defaults fell for the fifth year in a row and, according to rating agency Moody’s, the rate in December had declined to 1.69%, down from 1.91% in December 2005.

At this stage of the economic and credit cycles, there are suggestions that perhaps rating agencies’ default rates may not be quite realistic enough and that watching rating actions may give a clearer - and less optimistic - outlook on credit market. In fact during 2006 the rating agencies have been rather busier issuing negative actions than credit upgrades, in the non-financial sector at least. Although Standard & Poor’s has a slightly more bearish forecast than Moody’s for default rates this year, it is still only a small deterioration to 3.5% by year-end. Although the default rate per se will probably not rise rapidly this year, what is already on the increase is the pick up in high yield rating activity, with more names slipping down that credit ladder.


Emerging markets

hile euro-zone credit markets had a poor year due in large part to adverse movements in the government bond markets, eastern European bonds provided some cheer. Although there was considerable political turmoil in several eastern European countries, that did not mask the attractiveness of the macro-economic fundamentals of many countries and investor appetite remained strong. It was also a particularly good year for the nascent eastern European corporate bond market.

While politics may in 2007 be calmer in several countries, Russia will be having elections in the Duma, the lower house, at the end of the year followed by the presidential election in March 2008. While few believe that there will be radical changes in the economic management - assuming that Putin’s nominee wins the election - it is likely that there could well be ripples of unease and uncertainty during 2007.

Elsewhere in the EM universe the general consensus points to continued economic expansion, albeit at a slightly slower pace than in 2006, with reasonable or falling inflation. There are exceptions, such as Venezuela with its outspoken leader Chavez, or Hungary whose budgetary ill-health looks set to continue.


Credit derivatives

redit default swap (CDS) spreads have narrowed more than the conventional swap equivalents over the course of 2006. The ‘negative basis’ trade has been one of the market’s favourite trades, especially in Europe, and has been profitably played by many over the course of 2006. Opportunities to put on this trade come about when the cost of buying credit protection, via CDS, is less than the spread (ie, risk premium) available on the same named credit’s fixed income debt. So the investor buys and holds the bond, and also uses the CDS thereby virtually eliminating the credit risk while at the same time collecting an extra slither of spread.

Although the negative basis has narrowed over 2006, it still exists and for that reason many are suggesting that bonds will outperform CDS because they represent the cheaper route to credit exposure. It is unlikely that, as long as the negative basis exists that investors will be shunning the derivative side of the trade just yet.

According to Citigroup, CDO issuance in 2006 was 80% higher than in 2005.