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Doom & Gloom

The last couple of days have seen a big re-pricing of risk in the sub-investment grade world. The iTraxx Crossover index of the most traded high yield companies has widened from a spread of below 200 bps in June, to 300 bps yesterday. This move was triggered by both Moody’s and S&P announcing the downgrades of hundreds of bonds backed by US sub-prime mortgages. The face value of the BBB-ABX index which tracks this asset class has fallen to below 50 cents in the dollar in the last couple of days, and the market fears contagion. Are some more hedge funds getting into trouble (like the Bear Stearns funds that are near collapse)? Will this cause the financial sector to withdraw liquidity and close down risk positions? Is the sub-prime problem just the tip of the iceberg, and is the US consumer about to crack?

At the moment this is largely about sentiment, rather than global economic weakness – and that brings us to the call we have to take. If this is confined to the sub-prime market in the States, losses might hit $75 bn – but this is a drop in the ocean for the financial system, and whilst some investors in sub-prime mortgage backed bonds will get carried out, the knock on to other assets is likely to be minimal. That makes those spreads of 300 bps look like a buying opportunity – every similar setback in the past few years has given investors some bargains. But after a year of below trend growth in the US, and the forthcoming hits to consumers’ incomes from both higher energy prices (oil is back up to over $75 a barrel) and, more importantly, upwards mortgage interest rate resets (October will be a painful month for US mortgage owners, see this article) there could be further bad news on the horizon. We’re happy to remain underweight in risky bond assets for the time being.


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'Covenant Lite' loan deals – a detailed note

A number of clients have asked us about ‘covenant lite’ leveraged loans. Our view is that the financial press has in some cases been misleading investors regarding what cov-lite actually means, and we thought it would be helpful if we put together a detailed note that explores some of the issues surrounding cov-lite leveraged loans for readers who are interested in learning more. Click here to download our short note on covenant lite leveraged loans.


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Risky credit starts to wobble

John Waples wrote in the Sunday Times (read article here) on a theme we have been discussing for quite some time – ever increasing activism amongst investors. He points to a number of examples. Cadbury Schweppes, ABN, Rentokil & Vodafone have all come under pressure from equity investors of late "to release value and change corporate structure or management." The message it seems is getting through loud and clear. Only this week we’ve seen ConocoPhillips and Johnson & Johnson approve $15bn & $10bn share buybacks.

Corporate bond markets are now also starting to get the message. I wrote a couple of weeks ago (see article here) about the lack of confidence in the credit markets, but the situation has since worsened. Despite Moody’s recent default report showing a drop in the global default rate to 1.38% (the lowest for 12 years), and despite there being just one default in Europe this year, the current iTraxx Crossover Index is now trading at all-time wides. In fact, the index which comprises the forty most liquid high yield credits in Europe (see here for an explanation) is currently trading 35% wider than the tightest spreads witnessed in May.


Thank you – we raised £100,000 for the Prostate Cancer Charity

Thank you very much for those of you who sponsored me and the team in last Sunday’s bike race from Greenwich to Canterbury, a ride of 120 miles along the route that the Tour de France took yesterday. I didn’t get near Robbie McEwan’s Tour de France time of 4 hours 39 minutes – I managed a more leisurely 8 hours 37 minutes. But then again Robbie didn’t get 3 punctures or have to ride through a filthy rainstorm, so it could have been much closer.

Most importantly, it looks as if we’ll break through the £100,000 mark for donations, of which over £55,000 has come in through the website (which we’re keeping open for a little while longer). Thanks again – the money raised is likely to go towards funding a couple of full time prostate cancer nurses. And enjoy the next three weeks of the Tour de France!


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UK homeowners aren't crippled, they're rolling in it

I’m quite bemused by the press reaction to yesterday’s interest rate hike in the UK. Almost every newspaper has chosen to focus on how the average homeowner is going to be crippled now that UK interest rates have gone up from 5.5% to 5.75%. The Daily Mail calls it Homeowner Misery, and has calculated that the average cost of a £125,000 mortgage is up £130 per month compared to this time last year (when UK interest rates were 4.5%).


Tight global labour market suggests inflationary pressure will rise further

The global unemployment rate is plummeting. France’s unemployment rate fell for the 24th consecutive month in May, reaching a 25 year low; Italy’s unemployment rate dropped to an all time low in the first quarter of this year, while Spain’s unemployment rate has fallen from 21% a decade ago to 8.5%. Likewise, the Japanese and German jobless rates stand at 9 and 12 year lows respectively. The UK unemployment rate stands at just 2.7%, close to post-war lows. Even in the troubled US economy, the unemployment rate has steadily fallen to 4.5%.


Northern Rock not so solid any more – question from a client

The following question was sent to us from a client last week:

The recent profits warning from Northern Rock has clearly taken the equity market by surprise in the short term, though equally many people will regard it as a victory for common sense that sooner or later they had to pay the price of such an aggressive strategy. But where does this leave sentiment in the mortgage-backed securities market and is it likely to add to difficulties in the already-spooked credit markets? Do you have any exposure to any of the higher-risk UK lenders, and why?

Over the past six months, our team (and myself in particular) have probably thought more about the UK and US housing markets than any other topic, as regular readers of this blog will probably have realised. Will the US sub prime crisis spread to the wider credit market, and if so, when (see Jim’s recent comment here)? How strong is the UK housing market and when will it start to slow?

Sentiment in the mortgage-backed securities market has weakened on the back of a sharp housing market slowdown in the US. The roots of this lie in the Federal Reserve’s decision to hold interest rates at just 1% in 2003-04 in an effort to encourage consumers to borrow and spend. The Fed’s policy initially succeeded, as the US consumer pulled the economy from the brink of recession. The US housing market was a great beneficiary as consumers took advantage of amazingly cheap credit to borrow like crazy, causing US house prices to shoot up. But the supply of new houses exploded as the construction industry adjusted to soaring demand by churning out a load of trailers and condos. So now that US interest rates stand at 5.25% and demand has started to dry up, suddenly the US economy is left with a huge overhang of inventory, and house prices are starting to fall and will continue to do so until the market returns to equilibrium.

The story is not the same in the UK, where there have been few signs of any slowdown in the UK housing market. The reason for this dichotomy lies in the very different dynamics of the US and UK housing markets. In the UK, the supply of land is limited, and a booming economy and low real interest rates simply encourage borrowing, forcing house prices up. Despite recent rate hikes, UK real interest rates are still very low, and the housing market is if anything accelerating. Northern Rock’s profit warning was not a function of a worsening UK housing market (there has been virtually no deterioration in asset quality), but was more to do with profit margins getting squeezed from rising competition (in January I discussed the changing dynamics of the UK housing market and its influence on UK interest rates here).

If the housing market meltdown is primarily a US phenomenon, why are we concerned? Just as the FTSE falters when the Dow Jones dips, UK corporate bond spreads will tend to follow the US market, which isn’t surprising given that the £1.5 trillion US corporate bond market is 50% bigger than the UK and European markets combined (and many of the issuers in the European markets are US companies).

I have therefore reflected my concerns about the US mortgage market by positioning my portfolios defensively, favouring higher rated corporate bonds. In keeping with this, I have tended to avoid the aggressive and smaller UK mortgage lenders and have no exposure to Northern Rock. Within the M&G Optimal Income Fund, I have gone the next step by buying protection on Wachovia, a bank heavily exposed to the US housing market (for more detail on what I’ve been up to in the fund and for more detail on my views, see a replay of my recent teleconference here).


Not waving, but drowning

I thought I’d quote the introduction of a piece out today by Albert Edwards, Dresdner’s Asset Allocation strategist:

Warren Buffet said "Only when the tide goes out do you discover who’s been swimming naked." As the US housing tide recedes, the skinny-dippers are racing up the beach to find their beach-towels. But this is not a crisis driven by the US sub-prime mortgage debacle. The housing slump guarantees this is a generalised mortgage crisis. Sub-prime has just been exposed first. Buy beach towels.

In other words, the sub-prime stuff matters, but won’t on its own be the reason for a more generalised flight to quality – there’s plenty of other fault lines in the global economy which are looking increasingly dangerous. The same dubious lending practises which are hitting the sub-prime market are widespread through the whole mortgage industry (including in the UK? Northern Rock’s profit warning showed that conditions here are deteriorating too), and higher US rates have made the first year on year fall in US median house prices since the Great Depression almost inevitable (Detroit house prices are down over 9% over the last year already). Whilst employment remains robust, both in the US and the UK, the consumers can just about keep heads above water. Any weakness in the jobs market could well herald a consumer recession.

As an aside Albert Edwards points keen readers to a book that was published by the World Bank in November 1996 – "Thailand’s Economic Miracle: Stable Adjustment and Sustainable Growth". Months later you will remember that the Asian economies and financial systems collapsed. He feels that the US economy is, ten years later, suffering from the same hubris that Asia inspired then, despite the fact that US growth has slowed towards "stall speed" of 2% pa.



Investors Strike Back

It would appear that the distinct lack of confidence that I alluded to yesterday, (see here) has led to one or two interesting developments in the primary markets (the market for new debt issuance). Private equity houses KKR, Clayton and Dublier & Rice were, yesterday, forced to drop their bond offering funding the acquisition of US Foodservices. Covenant weak leveraged loans have also been receiving short shrift of late. Earlier this week Arcelor Mittal were also forced to pull their bond offering “pending more stable conditions.”

These developments will be a concern, especially to those banks who will have provided bridging finance and now have their capital tied up, at least until investors can be persuaded to part with some cash.


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"Liquidity is confidence" according to Fed Governor Kevin M. Warsh and right now it feels like confidence and liquidity in financial markets is starting to ebb. Why you ask ?

Well first the evidence. Volatility has returned. As I write, volatility as measured by the Vix Index is currently at levels approaching those witnessed back in late February and early March. The world’s major equity indices are set to end the month of June in negative territory, barring a strong bounce later this week. Ten year bond yields in the UK, Europe and US have fallen back this week though they are still significantly higher than those experienced at the end of May. Further testament to the current lack of demand for risk is the cost of buying ‘protection’ through the iTraxx credit default swap indices (see here). Prices have increased by around 15-20% since the start of the month.

Last week Bear Stearns hit the headlines with the near collapse of their High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leveraged Fund (try saying that after a few drinks). Essentially the funds had made leveraged bets on US sub-prime borrowers- (see here) mortgages given to individuals in the US with less than exemplary credit scores. Rising delinquencies amongst sub-prime borrowers have, unsurprisingly, resulted in a re-pricing of those securities backed by sub-prime mortgages. In some instances the re-pricing has been nothing short of extreme. A number of market participants, Bear Stearns being the highest profile example, (though Cheyne Capital, UBS and other investors are also alleged to have racked up significant losses) have struggled in the aftermath. Under pressure to meet margin calls and repay investors Bear Stearns and the like were forced to liquidate somewhat opaque and illiquid securities with, arguably, wider consequences for financial markets (both Richard & David have commented recently on this). The velocity with which confidence and liquidity can be withdrawn has become all to apparent.

It’s also worth mentioning that a few of us met yesterday with a senior strategist at RBS. He thinks we have a global inflationary problem on our hands (partly a result of the growth in the BRICs – Brazil, Russia, India & China). As a result he sees a Fed unable to cut rates in the face of continued US housing woes, higher bonds yields and increased volatility; all of which don’t bode well for leveraged investors and if he’s right will have significant implications for investor’s confidence. Richard gave this some attention recently (see here).

It is exactly these intertwined issues of potentially higher bond yields, further distress in the US housing market and record leverage amongst investors that has the financial markets spooked. Both Richard and I remain cautious on credit as we look for higher interest rates in the UK and Europe and have positioned our funds accordingly.


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