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North Korea test hits Asian currencies

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Yield curve/duration

Government bond rallies seem to be well under way across the world, although volatility has certainly increased and corrections have been fast and furious. Bullish sentiment has been driven by falling oil prices, a particularly weak manufacturing activity indicator and housing data from the US which all seemed to indicate that the slowdown under way there was perhaps more significant than previously forecast. Sell-offs, on the other hand, occur in reaction news suggesting that perhaps the (US) housing slowdown will not be such a drag on the economy after all, or that employment remains surprisingly strong. Like other markets, Europe's bonds have been led by US Treasuries, despite the fact that there seems to be significantly more economy-positive news than negative. Ten-year European Government bonds posted their first quarterly gain since June 2005. Economic confidence indicators have continued to rise, to levels not seen since 2001. Indeed one of the European Commission's indices of sentiment, among both corporate executives and consumers, has risen to its highest level since February 2001. The ECB has continued to remind everyone of its strong vigilance against rising prices and market participants are prepared for an ECB rate hike some time soon.

Covered bonds

lenty of new issuers coming to Europe's Jumbo covered bond market, including Sweden's first name and another British savings bank, the Yorkshire Building Society. Later in the year it is likely that Norway and Portugal will also enter the market and that we will see other US issuers joining Washington Mutual with their own Jumbo issues. The Swedish mortgage bond market is already the fourth largest in the EU, issued by specialised mortgage banks. The 2003 Covered Bond Act and the ensuing regulations from the Swedish Financial Services Authority in 2004 will now enable any Swedish bank or credit company to issue covered bonds, Såkerstallda Obligationer (SO), subject to being granted the appropriate licence to do so. Although all these quality new issuers are very welcome in the covered bond market, some investors argue that Cedulas may suffer some widening in spreads. It is possible that investors will reduce their Spanish covered bond holdings in order to diversify their portfolios wider and into the new Swedish and US issuance. Overall, covered bonds remain well bid, with pfandbriefe in particular supported by lower supply, and high redemptions in the coming weeks.

Investment grade credit

ver the course of September (IG) credit spreads widened, although this is being seen as more of a retracing of some of the excess exuberance of July and August, rather than a change to the bear tack. That said credit spreads remain tight and, for many investors, much too expensive at this stage of the credit cycle. Event risk, in the form of shareholder-friendly corporate activity is on the increase which tends to counteract the positive effects of strong profit news. Looking further forward, the US will continue to set the tone for IG credit within Europe, even though Euro-zone stronger macro-economic fundamentals should on the surface be more supportive of European credit than the flagging US economy is for US credit. In today's world, risk appetite is globally, not locally, defined. The third quarter earnings season gets under way and may pose some risks. The consensus view appears to be that skewing portfolios towards the defensive sectors remains best bet.

High yield

igures recently published by Moody's Investor Services revealed that, in the trailing 12-month period to the end of September 2006, the global issuer (speculative grade) default rate declined to 1.46%, to its lowest level since February 1997. The rating agency forecasts that defaults should remain unchanged through until early 2007, and could then rise to 2.6% by next September.

As LBO activity hots up, there will be an increasing supply of fallen angel issuers, downgraded corporates whose ratings slipping out of the investment grade sector and down into high yield domain. Although there is generally a high volatility of returns in the shorter term, historically fallen angels have in reality performed very well compared to HY bonds generally over the longer term.

HY has remained reasonably calm in the face of the global central bank rate hikes. Autos have been a drag on the lower rated end, while telecom names have provided the good news in the triple-C group. Individual name selection has not yet become the absolute key to success (or failure avoidance) in high yield bonds. However with the general unease about recession and global economic growth, combined with the fear of growing event-risk, stock-picking will gain in importance.

Emerging markets

lthough the prospect of contagion is, according to many investors and observers, a thing of the past, there is no denying all is not well within a sizeable portion of the emerging markets (EM) world. The news that North Korea may have carried out a nuclear test hit not only the South Korean Won and Japanese yen, but shook the rest of the Asian currency markets.

In the Latin American markets, politics and general elections have been dominating several economies, not least of Brazil where there are real jitters going into the second round. Lower energy prices are also a negative for the oil exporting nations across the EM world.

Although falling commodity prices should be favourable for the energy importing eastern European economies. There is, however, political unease in many of the eastern European markets most notably those of Hungary, the Czech Republic, and Poland, where news that an aide to the Polish Prime Minister had been filmed offering bribes to buy political allegiance shocked the market.

Credit derivatives

oody's have recently announced that they have developed a new methodology for separating default probability from default severity*. The news has been well received by the investment community as it is seen as a logical progressive move to further quantify risks, particularly within the high yield sector. Moody's new approach will replace its existing notching system. Notching refers to the practice where one rating agency, assessing the assets of a securitised instrument, will automatically assign a lower rating to a collateralised security which is rated by another agency. The process has frequently been at the centre of ‘disagreements' between the rating agencies. It is also not particularly liked by investors as it sometimes appears to lack clearly defined reasoning for individual cases. Some also argue that it is anti-competitive as it forces CDO managers to pay for new ratings on the underlying assets in order to avoid receiving lower ratings.

Standard and Poor's is proposing to introduce changes to increase the weight of recovery prospects in issue ratings and to expand the global coverage of recovery weightings in general. As part of this greater focus, S & P intend to stick with its practice of notching, but to simplify the notching policy by basing it exclusively on the recovery rating which should increase transparency and consistency.

*"Loss Given Default Analytics: User's Guide to Prioritising Claims and Applying the LGD Model", Moody's Investor Services, September 2006

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