Thank goodness that's over
There is a sense of thankful relief that the third quarter is well and truly behind us, although September saw a great reversal of the flight to quality wave that so swamped the markets in July and August. As a result, government bonds have given back to the rest of the bond markets much of their spectacular gains garnered over July and August.
The US non-farm payroll data was, as ever, hugely influential on the markets and the magnitude of the upward revision, to the previously very weak August numbers, caught many on the hop resulting in quite a serious sell-off for US and other government bond markets. Though markets are functioning more smoothly, there are not many who would argue that life is completely back to normal.
The European Central Bank (ECB) recently signalled that, although it was perhaps in a wait-and-see mode, it was too early to say for sure what the effects of the disarray in the money markets was having on the real economy.
The three-month Euribor futures are pricing in no official rate moves from the ECB throughout the remainder of this year and much of 2008.
Stability is returning to most, though not all, of the covered bond (CB) market. New issues have been met with reasonable enthusiasm, aided by more generous offer premia and very careful pre-issue investor soundings. The fact that there has been supply, with the prospect of more, has helped recovery. The European Covered Bond Council (ECBC) has proposed a committee with specific responsibility for monitoring market-making issues, a development that should mean any future liquidity/dealing issues are rapidly addressed.
Certain segments of Europe’s CB market - longer maturities throughout Europe as well as Spanish, UK and Irish covered bonds specifically - remain wobbly and have yet to fully regain their poise. And within the UK market, the divergence between the good and the bad has greatly increased as the troubles at Northern Rock continue to drag certain other UK issuers lower.
Part of the UK CB market’s underperformance is linked to the troubles of Northern Rock. It may also be connected to the fact the UK has not yet enacted covered bond legislation and so covered bonds have been shunned in the same way as other ‘structured’ instruments.
Interestingly, one can make a direct comparison within the French market where both legal-based and structured bonds trade side by side, and there one sees a growing underperformance by the structured issues. It will be interesting to see whether the UK market, when its covered bond legislation is enacted by the end of this year, will be able to recover some of its summer underperformance.
Investment grade credit
Credit generally has performed well, regaining much of the lost ground against government markets in the aftermath of the Fed cut. In the scramble to cover underweight positions, cash bonds benefited further as insurance and pension funds alike were at last able to put to work some of their cash that had steadily accumulated during the July and August market freeze and, if investor surveys are to be believed, it appears that there is plenty more money waiting to enter the market.
Back in 1998 after the Russians had defaulted and Long Term Capital Management blew up, the rapid market recovery after the central bank intervention meant that the markets were back trading at virtually pre-crisis levels within weeks. Are the events of summer 2007 going to follow the same pattern? The technicals are clearly supportive: a mediocre supply pipeline within Europe’s IG market and a huge negative basis, effectively offering the delights of riskless profit via the credit derivatives market.
While central banks state openly that they believe it too soon to quantify the damage caused by the credit crunch, taking bets on the direction of GDP growth in terms of overall credit exposure would seem rather foolhardy. However, there has been significant movement between the sectors and perhaps the markets have calmed enough for those relative moves to be reversed.
First the US rate cut and then the upward revision of the US non-farm payrolls came as welcome news to most high yield markets in the developed world. That the US economy is not perhaps as weak as thought previously is seen as a fillip to high yield (HY) in particular as it keeps the spectre of a rising default rate at bay for a while longer. HY corporates are in reasonable shape and, in terms of their free cash flows, are significantly better off than in 1998.
The very fact that it is now macro-economic news that has returned to focus for HY markets, is testament to the improving conditions in the money markets, the less than awful figures from some brokers and those actions from the central banks. Nevertheless, the added uncertainties as to how real economies have been and will be affected surely argues for investors to demand greater compensation for their readiness to take on more risk.
Some emerging market (EM) assets, and most particularly EM equities, have shown remarkable resilience and even strength in the face of the most unpleasant headwinds being experienced both sides of the Atlantic over the summer. While there were jarringly sharp falls, these were quickly followed by even sharper rises.
Although EM debt has not done as well as EM stocks, they have not underperformed other non-government bond markets and rebounded impressively after the Fed rate cut, recovering significantly quicker than corporate high yield. After risk-taking became, following the Fed’s September move, a palatable option once more, the arguments for not owning EM debt quickly lost their emphasis.
However, few could honestly say they believe the strains triggered by the US sub-prime meltdown have totally evaporated. What the optimists could argue, however, is that such is the vigour of EM balance sheets that they stand a better chance than developed countries of ‘decoupling’ from the effects of a US slowdown. With uncertainty on the increase, investors will have to take greater care as differentiation between the strong and the weak grows wider.
It seems extremely unlikely that there will be any substantial recovery in issuance within credit derivatives, or indeed many other sectors, linked in anyway to sub-prime mortgages before the end of 2007, or perhaps even longer than that. This year will become the first that the CDO market, and possibly the securitisation market as a whole, has not expanded year on year.
The CDO market has, since its inception, been a ‘buy and hold’ proposition and secondary market liquidity, or rather lack of it, has never been much of an issue. Some now argue, paradoxically, these difficulties may be triggering the nascence of secondary trading in credit derivatives. Coupling the large number of forced sellers with an ongoing drought in primary issuance, investors may be driven to reconsider their preference for only buying new. Then again, there remains an acute lack of confidence in the rating agencies and pricing models and this will continue to weigh very heavily on these instruments for a long time