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Europe on slow crawl upward

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Yield curve/duration
The ECB duly raised its Refi rate to 2.5% on 2 March, a move which came as no surprise to market participants. What had more influence on the short end of the yield curve were comments from the ECB. Firstly, president Trichet said the bank was “ready to do whatever is necessary” and secondly, ECB board member Mario Draghi indicated that interest rate levels were still “very relaxed”, and that there would be possibly two more rate hikes this year. Two-year rates are now at their highest levels since 2002.
The economic fundamentals continue to slowly improve in Europe with business surveys providing positive surprises, so the overall bearish tone remains intact in the Euro-zone government bond markets. Germany announced its intention to auction the first index-linked Bund. The 10-year issue, to reach between €10-15bn after subsequent taps, will be linked to the euro-zone’s Harmonised Index of Consumer Prices, excluding tobacco.
Although Q4 2005 GDP growth in the US was revised down to 1.6%, analysts and investors instead appeared to revise up their forecasts for Q1 2006 growth rather than suspect a more generalised slowdown. The fixed income markets are getting ready for a rate hike in March, and is now pricing in the growing possibility of another one in May.

Covered bonds
A steady supply of issuance across a broad range of maturities and issuer types keeps the covered bond market ticking over comfortably. For example, Caja Madrid will be the first issuer to come to the market with a 30-year Jumbo, and it is expected to be very well received, reflecting the global investor demand for high quality, long-dated fixed income assets. Allied Irish Banks (AIB), Ireland’s second largest bank, is preparing to make its debut on the covered bond stage.

Further good news on the increasing depth and breadth of the covered bond market comes from Portugal where, after years of preparation, covered bond legislation is on the verge of being passed. Although Portuguese issuance will not reach a dominant share of the European market because of its size, it seems likely that there could be the emergence of new Jumbo issuers. Neighbouring Spain, however, looks set to increase its share of the covered market with major Cedulas issuance in 2006.

Investment grade credit
Although credit spreads have not widened markedly, and equity markets have continued to trade well, the investment grade (IG) market has been trading quite cautiously recently. The possible turning of the credit cycle and having to digest big supply with expectations of more to come were two factors on the bear front, while on the other side the ongoing bid for yield provided the support.
Also, event risk, in the form of LBO and M & A activity (which hit a multi-year high in Europe in February) and all the rumours, is on the increase. In the UK the press suggested that British Telecom was being eyed as a possible LBO candidate by private equity
companiess. Although many believe that it is an unlikely target, not least because of the company’s size and its £4bn (€5.8bn)
pension shortfall, this ‘news’ highlighted the nervous tone to
the markets.
In late February, Fitch the rating agency signalled an ‘outlook change’ on Iceland’s AA- Sovereign debt rating. This news
rattled the Icelandic corporate market, and particularly bank paper but it elicited only a muted response in the rest of the
credit world.

High yield
The spread trend in high yield has started to widen since March 2005, in contrast to the investment grade category where these has been only a modest rise from those 2004 lows. This deterioration has been more pronounced in European speculative debt than US.
Credit strategists at Dresdner Kleinwort Wasserstein point out that in an environment of M&A on the increase, and rising downgrade activity, historically high yield tends to outperform investment grade. Fallen angels (those corporates whose credit ratings have declined out of the investment grade universe) tend to have widened out, while still in BBB indices, and thus enter the high yield universe at much higher spread levels. If an entitity manages to stabilise its ratios, then the spread often narrow markedly, leading to a positive performance in the high yield universe. Good examples of this in the past were Ahold and ThyssenKrupp. Similarly M&A tends to benefit the target more than the acquirer.

Emerging market
Mexico refinanced $3bn (€2.5bn) of its foreign bonds as part of an ongoing plan to reduce the government’s net foreign currency debt. The government’s net foreign currency debt-to-GDP ratio is down to 8,3% from 13% in 2000. Brazil, Venezuela and Colombia have all recently announced plans to repurchase their respective foreign debts.
Emerging markets (EM) have continued their overall general positive performances, with positive fundamentals generally, and steady sovereign and corporate balance sheet improvement. Hardly surprising that emerging market government and corporate bonds have attracted such inflows in the global hunt for yield. The EM sovereign risk premium averaged 352bps in the first half of 2004. That has since declined to 52bps. And EMs have been taking advantage of their more favourable borrowing conditions. According to a recent report from the Bank for International Settlements (BIS), EM countries sold a record $231bn of debt in 2005, up 52% from the 2004 figure.
There are clouds on the horizon. Some of the more bearish commentators have started muttering about the possible return of the evil stagflation in the world, that economic dread of low growth but high inflation, which could send money rushing out of higher risk EM’s and back to government bonds in a hurry.

Credit derivatives
Plenty of deals in the first two months of the year (CDO funded volume €6.1bn YTD 2006) kept investors happy. Synthetic deals have also increased issuance. The synthetic arena has been dominated by investment grade corporates. There has been an increase in synthetic high yield CDOs, but not cash CDOs. Because a large proportion of high yield bonds have been trading above par, it has not been possible to put together deals because the special purpose vehicle (SPV) would be left underfunded. The use of high yield credit default swaps as an asset class mean that synthetic CDOs can be made viable.
As risks of a deterioration in the benign credit conditions increase, investors are looking to protect themselves. In addition to a exercising greater degree of manager selection, investors are also expressing interest in structures which can exploit perceived risks to credit spreads, such as LBOs. CDOs can be constructed in which potential LBO candidates have been shorted. In this type of structure a short portfolio of corporate names considered to be at risk of LBO activity is included in the overall deal, benefiting the investor if CDS spreads widen or if any of those particular entities did in the event default.

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