Yield curve/duration

ccording to OECD data, it seems that the G7 economies (US, Japan, Germany, UK, France, Italy and Canada) are in the midst of a slowdown, with the US ‘in the lead’ and the European economies joining the trend most recently.

With inflation fears lessening, markets have taken significant comfort from falling prices in crude oil, although not many are quite ready to conclude that the recent price falls are definitely signalling the end of the oil bull market - perhaps it just another dip in what remains a fundamental bull market.

Global government bonds enjoyed their strongest monthly performance in years, led surprisingly by Japan. Indeed Japan’s monthly performance is remarkable as the return was more than 60 basis points over the average government bond yield, a very rare occurrence. This was Japan’s biggest monthly total return since 1999, but it’s maybe a bad omen as that was the last time the global bonds suffered a full year loss. Could it be a possibility for this year too?

Analysts are now suggesting that the yield curve flattening trend may continue, and may take longer dated yields below shorter maturities as curves invert. Although there is plenty of supply coming to the markets, observers suggest there will probably not be difficult for the market to absorb it.



Covered bonds

he Dutch Finance Ministry has announced that it is to create an explicit covered bond act. The ministry had initially planned to put into effect a regulatory regime which complied with the UCITS directive (Undertakings for the Collective Investment of Transferable Securities) as is planned by the UK. This would then justify a 10% risk weighting under Basel II.

It is understood that the ministry changed its plans and put in place a covered bond act after consultations with the Dutch central bank and the banking association. The ministry has said that the initial draft should be completed in the first half of 2007 and ready for implementation later that year. ABN AMRO has already announced that it will adapt its existing bonds to comply with the new framework.

Europe’s covered bond market looks set to welcome its first US issuer. Washington Mutual is the sixth largest US banking company and the third biggest home loan originator and servicer. It will issue bonds under a newly established €20bn covered bond programme, and the bonds are expected to have triple-A ratings. If this programme is successful then other US issuers could join. However, given the highly effective US securitisation market, it remains to be seen just how appealing European issuance could be for US entities.


Investment grade credit

s government bond yields fell, IG credit outperformed. However, although corporate bond spreads retraced about half of the May to June widening during the latest rally, IG bonds rather lost out to lower rated/riskier assets. Both European IG credit and government bonds are worried by the fact that European economic growth is now bucking the global trend, and although surveys suggest that it has already peaked it is still coming in stronger than expected. This may have negative implications for inflation expectations and shorter dated bonds.

Heavy new issuance, a common feature of September, may also cause some spread widening, although so far new issues have been generally well received as investors coming back to their desks after summer have looked to the primary rather than the secondary market.

Overall the macro-economic conditions remain good. Corporate leverage is not increasing as the slower growth picture makes it harder for companies to spend their existing cash. In this benign environment with tight spreads, investors have to be more aware of event risk and thus choosing the right names becomes even more important.


High yield

lthough both euro and sterling high yield (HY) markets were outstripped by the global high yield returns, this had more to do with absolute interest rate movements in government bonds, with US Treasury yields declining most. In terms of excess returns, European HY has outperformed its global peers in six out of eight months in 2006. In euro currency terms, European HY had returned just over 4% by the end of August, compared to a loss of around 1% for Global High Yield*. Ford and GM were the main contributors to August’s better performance. If we look at the recent performances of both high yield and emerging market bonds, there seems little doubt that investor risk appetite has returned for now. If the US economy, followed by the rest of the world, enjoys a soft landing then that would certainly be the most comfortable outcome for riskier assets. According to analysts at Merrill Lynch, corporate leverage is currently too low to produce a painful default wave. However, it is argued that the conditions for a secular rise in leverage by 2008 are coming in to place, accompanied by the usual health warnings on balance sheets for bond investors.

*Index performance data refer to Merrill Lynch High Yield indices.

Emerging markets

s with high yield, emerging markets (EMs) have enjoyed a good run as investor focus turns away from inflation worries and looks towards the prospect of fewer G7 Central Bank rate hikes as a slower global growth picture evolves.

The Socialist Republic of Vietnam joins the World Trade Organisation (WTO) later this year, which may augur well for the country’s debt market. At the moment the country has a BB rating from S&P but observers suggest that an upgrade may well be on the cards, with accession to the WTO and with it an increased credibility.

Within emerging Europe, of the new EU member states only Slovenia had met all five requirements, including membership of ERM-2 as of July 2006. In fact the EU Council had decided to allow Slovenia to join the Euro area in June. Cyprus, the Czech Republic and Poland all managed to meet four of the five but Cyprus has not been in the ERM-2 long enough and the other two are not participating in the ERM. It appears that the political will in many of these countries is flagging, especially in Hungary for example, and that bond markets may possibly be rather too optimistic on certain countries.


Credit derivatives


lobally, CDO issuance looks set to reach record levels in 2006. The European CDO market has seen very high supply so far this year and volumes are up 70% year-on year. The two main areas of growth were large cap balance sheet securitisations and leveraged loan products. The growth in the leveraged loan is seemingly fuelled by huge volumes in primary loans, aided in turn by today’s relatively high leveraged buy-out (LBO) activity. There is an interesting debate going on now about CDOs and their influence on credit spreads as the cycle turns. Some make the case that credit spreads will not widen because CDO managers will always step in to invest. The more pessimistic view, however, suggests that if the credit cycle turns then there will be a spread widening as default rates rise and downgrades damage reference portfolios. In fact CDOs may serve to increase the diverging performance between those names coping and those others in trouble.