An uncomfortable unease is permeating all asset classes across all markets. What will the Fed chairman Bernanke do next? Go for more tightening to show the markets that he too is as tough on inflation as his hugely respected predecessor? Or will he wait, giving the US economy a bit of a breather, thus worrying bond investors that he does not really mind a bit of higher inflation?
The most recent US jobs data, at the start of June, was much weaker than most had expected - less than half the number of jobs created than expected - and bond yields dropped on that news, while doubts rose as to the certainty of the rate hike expected at the start of June. All eyes are now focused on future data which will give a clearer inflation picture.
Though bond markets have been pretty volatile, other asset classes have had an even more boisterous time of it. Global equities down 4% in May, their worst month since December 2002, the US dollar down to its lowest level versus the euro in over a year, and commodity prices all over the place. Whilst some might argue that May’s decline in equity markets is a large bout of profit taking, there is perhaps a more insidious effect present: could global liquidity be drying up?
Although buffeted by the capital market ebbs and flows, covered bonds have enjoyed a ‘quiet’ month with no significant bad news. That said, although towards the end of the month there has been markedly better sentiment in the government bond markets, investors are still fairly cautious and defensive plays, like short dated Pfandbriefe and Obligations Foncieres have become rather more expensive. New issues have got some mixed receptions in recent weeks. Heavy supply in the coming weeks in long-dated Cedulas, could well put pressure on that particular curve, in spite of declining bond yields.
Moody’s assigned an Aaa rating to the Swedish covered bond issues of SBAB subsidiary SBAC*. This issuer will be converting its old mortgage-covered benchmark bonds and the new issues will become the key instruments in its refinancing. This process will also be undergone by Nordea, Stadshypotek and others and is seen as a welcome evolution of the Swedish market into a fully fledged member of the European covered bond arena.
WestLB AG marked its comeback in the Jumbo Pfandbriefe market, taking back these duties from NRW Bank which took them over when WestLB converted to a public limited company in 2002, thereby losing its issuance status under the existing Public Sector Pfandbrief Act at that time. The Specialist Bank Principle was dropped in last year’s amendment to the German Pfandbrief Act.
* SCBC ‘Swedish Covered Bond Corporation/ AB Sveriges Sakerstallda Obligationer’
Investment grade credit
No surprise that it was the high-beta names which widened most as equity volatility surged. Credit did underperform generally as government bonds pushed higher on the weak payrolls data, and the general nervous tone remains. The consensus seems to agree there is too little yield pick-up in long dated paper (seven-10 year sector), although not many investors are yet ready to go outright underweight credit, which loses the carry benefit. Defensive positioning via credit selection and curve trades seems a better route.
The triggers for investors to reduce their risk appetites across the board do not appear to be that tangible, yet – perhaps it is just due, time to reduce a bit of risk after what amounts to a three-year ride of being ‘appropriately’ rewarded for virtually all risk taking. The combination of slower growth and rising US core CPI is not a good combination for either equity markets or credit. But whether or not the US economy does slow, the bulls argue that inflation is a lagging indicator and that, if growth has already peaked then the peak in inflation will also be near and it will not be terrifyingly high either.
The huge intraday swings in implied equity volatility have spooked the high yield (HY) market, though not caused quite as much mayhem as might have happened in the past. The linkage between rising equity volatility and higher credit spreads, though stretchable, is a well-recognised and tested relationship.
However, in today’s environment, it may be that the historically low default rates may provide more ‘protection’ to the credit risk premium from the downside of a secular increase in volatility. According to studies by US investment bank Merrill Lynch, in recent years whenever there has been a ‘big disagreement’ between credit and equity option markets it is usually the credit side which has got it right. However, there are other potential reasons to back off from credit risk, such as below 300 basis point spreads within HY, and there tends to be a seasonal pattern of “sell in May and go away”. And with the possibilities in credit derivatives, it has now become a lot easier to take a view, tactical or strategic, to short credit.
While other non-government sectors may have survived the squalls and storms with increased volatility and some losses, the pain felt in emerging markets has gone rather deeper. The global risk premium has been raised globally, and it is clear that the ‘riskiest’ assets, emerging bonds among them, should be hit first and worst.
Part of the conundrum centres around commodity prices themselves. It was extremely high commodity prices which were worrying (emerging market) investors initially, but now the anxiety for investors is that the aggressive sell-off has turned into a rout, that has huge implications for risk premia and global liquidity in general.
The big fear for investors is that we are seeing the start of a declining liquidity phase, that the central banks will be withdrawing some of the enormous amounts of money they had pumped in to the global system to fight actual deflation (in Japan) or the risks of it (the US and Europe) and that the great search for yield, in an environment of such low inflation and bond yields, is over. If that is the case then for now the greatly improved macroeconomic fundamentals witnessed across the EM universe will take second place within the asset allocation decision-making process for a while yet.
This is the second May in a row that the market has experienced high volatility; last year it was the downgrade of automakers Ford and GM. The derivatives market has traded well during these stormy times, with liquidity and spreads remaining reasonably constant throughout. Although there has been some short-lived spread widening, often it did not seem that obvious that this was due to the external events or to issuer specific news. With the consensus view suggesting that the market is at the plateau of the credit cycle, mildly defensive positioning is still recommended. The structured finance groups have already seen an increase in demand for CDO structures with defensive features to mitigate any potential downturn in the credit cycle.
Issuance in the European derivatives market overall has been slightly lower so far this year compared to the same period last, although within the figure European funded CDO issuance is actually over 40% higher while that of commercial mortgage backed securities is down 12%.