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Margins holding up despite high-yield dip

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Yield curve/duration

Government bonds and other top quality credit have benefited from sharp rise in volatility and subsequent ‘flight-to-quality' moves. Short-dated bond yields have fallen to such an extent in Europe that the market is not pricing in more European Central Bank (ECB) rate hikes this year.

Although most investors do not believe the ECB will be toning down its hawkish rhetoric, it seems likely that, for the next few weeks at least, European and other bond markets will be tracking very closely movements in US treasuries. Historically markets have moved in more marked synchrony when there has been volatility, and risk aversion has risen markedly. Usually in a flight to quality move the US dollar, like the Swiss franc, is a direct beneficiary. However, in this recent turmoil, the US currency has depreciated sharply against the Japanese yen. For a long time
now, investors have played the carry trade, taking advantage of the low interest rates in Japan and going short the Japanese yen versus a long in a higher yielding currency. The Bank of Japan's rather surprising move to raise rates, despite the less than dynamic economic outlook, has hit these carry trades and will test investor appetite for this sort of risk taking.

Covered bonds

Moody's implementation of its new joint default analysis (JDA) - see below - is generally viewed as another pillar of support for covered bonds in those jurisdictions included so far, although it will certainly not mean automatic upgrades for covered bonds.

Despite enjoying an upgrade from Moody's as a result of the new JDA methodology, the covered bonds issued by Washington Mutual actually suffered some spread losses, and were indirect casualties of the sub-prime mortgage problems in the US. Washington Mutual has said that its cover assets do not contain such loans and that those loans accounted for only about 6% of the bank's whole portfolio. It appears that the spread widening is probably driven more by sentiment than by fact.

Better news for Washington Mutual came from the ECB which said that the US (covered bond) structure is no longer considered a collateralised debt obligation (CDO) but a true covered bond and is thereby eligible for ECB refinancing activities.

This has clear and positive implications for the placement of such bonds in the future and is supportive of further issuance. Indeed Bank of America, one of the largest financial institutions in the US, is getting ready to enter the European covered bond market.

Investment grade credit

In spite of the fallout, investment grade credit still managed to finish the month in the black, and non financial corporate spreads tightened by a couple of basis points over February, in the euro swap curve bull flattening move. The best performers were autos, building and basics with financials underperforming.

Moody's has started an extensive review of its banking ratings following the implementation of its joint default analysis (JDA) as part of its bank rating approach. In essence, JDA puts more emphasis on the support that a troubled bank could expect from the respective governments, peer groups and local governments and by
definition less on the individual's intrinsic financial strength.

Although the market fully expected some positive re-valuations, it was surprised by the size of the upgrades. Moody's has assumed differing probabilities of support in different countries and is rolling out its changed approach in a series of country groupings, and more upgrades are expected in the next wave.

High yield

The adverse moves in high yield have been quite harsh. February's losses in European high yield were the first since June 2006, so it is understandable that attempts to rationalise these moves looked to last summer's events for clues on future developments in 2007. To re-cap, credit spreads began to widen dramatically in May 2006 as bond markets worried about supply and equity markets suffered a sharp sell-off.

This year's widening appears to be much more severe than that initially witnessed in 2006, certainly equity markets had more severe falls. High yield credit spreads have widened as much over one week as they did over the course of about a month in 2006. The issues now are whether this increased volatility in stocks is indicative of equities entering the latter stages of their bull run, and whether the credit cycle has peaked.

The turn in the credit cycle is a two-stage process: first leverage increases; then operating performance starts to deteriorate and the higher leverage causes real problems.

Corporate Europe is still in good health and profit margins are not presently giving cause for concern. Leverage has risen only slightly since its trough at the end of 2005. However, if we have entered a period of higher stock market volatility, the early warning signals are on the increase.

Emerging markets

In the past, trading in the US stock market set the tone for what would happen in the Asian markets in their next trading session. However, the recent market sell-offs seem instead to have been abetted initially by events on the Chinese exchange, which then dominated next day trading in the US.

The Chinese stock market has enjoyed an almost meteoric rise over the last year, up nearly 160% from January 2006 to its peak on February 26 this year, so the possibility of some sort of a pullback had not been that remote. However, the big question is whether diminished risk appetite will be enough to damage economic fundamentals, particularly in the emerging markets.

The consensus appears to say not, arguing that macroeconomic fundamentals remain solid, and that there are not any real signs that there will be any significant weakening in Chinese demand. Another important factor for today's emerging markets is that resilience to external negative shocks has continued to grow within these economies.

Although the markets may well have entered a mini bear cycle, the overall theme is that the secular bull market in emerging markets has not been derailed and remains on course. The high correlation - over 70% - between emerging market spreads and credit spreads will certainly hold investor focus on the direction of credit spreads from here.

Credit derivatives

In the market sell-offs, credit derivatives generally underperformed cash bonds over the period, further closing the negative basis that existed for much of 2006. Negative basis is when the credit default spread is less than the cash bond spread. When the basis is negative, the cost of buying credit protection is less than the premium available to holders of that credit risk.

The huge growth in credit derivatives has enabled credit risk to be separated out into component parts. This has meant it is much easier for credit to be obtained.

As long as there is someone willing to buy that riskiest tranche of a structured product then the rest of the product can certainly be sold. Should the current ‘correction' in the credit market turn in to something more lasting, and risk appetites do indeed diminish and remain low, then there must be a worry that valuations will be less fundamentally supported.

If problems in the CDO market were to deepen, and buyers for the riskiest tranches were to disappear, then it is possible that the high -yield market could suffer.

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