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Tuesday 19 March 2024
The credit rating agency Moodys this week released the initial output from its widespread review of the banking sector. Whilst the expected outcome had been for a number of banks to benefit from upgrades to their ratings, the market was taken aback by the initial set of rating revisions. The process is set to take place over seven weeks and will cover approximately 1,000 deposit taking banks in over 90 countries.

 

The initial release on the 26th February saw banks in the Nordic region receive upgrades by as many as four or five notches, some to Moodys’ highest rating of Aaa, ranking them alongside sovereign bond issuers such as the UK, Germany and the US. Moodys’ rationale is predicated upon its new Joint Default Analysis (JDA) approach. Moodys claim that “banks will receive national government support, as well as other major forms of external support such as parental support and support from regional and local governments and cooperative and mutualist groups” which have led to the rethink.

The reaction to the upgrades has been twofold. Firstly as you’d expect, those banks so far benefiting from upgrades have seen the value of their bonds rise in response. Secondly, Moodys have come in for a great deal of criticism. Many investors have questioned the lack of transparency in the new process. It had previously been believed that Moodys were already factoring in state and/or parental support. Investors have questioned for example whether a country such as Iceland (with a population similar in size to Hull, and an economy based around cod) has the ability to support banks which has liabilities three times the nation’s Gross Domestic Product. The new process has also made it far more difficult to distinguish between banks on a credit fundamental basis given the added parental/governmental factor.

The ongoing process is expected to lead to further upgrades, further confusion and no doubt further criticism. One disgruntled bond trader has created this clip. Warning – may only be funny to bond geeks.

 

Private Equity (PE) funds have been in the news for all sorts of reasons recently. On the one hand these ‘locusts’ are under attack from unions, but on the other they are praised by the head of the CBI. While there may be changes to their regulation or disclosure requirements, one thing is certain: the amount of money they have raised and continue to raise will make them a significant influence on equity and corporate bond markets over the next few years.

PE funds raised $432bn last year globally, according to Private Equity Intelligence, which gives them firepower of around $2 trillion if they used 4 times as much debt to buy companies. And estimates suggest they may raise more in 2007, possibly $500bn. We should expect more Leveraged Buy-Outs (LBOs) in 2007, after all 8 out of the 10 largest LBOs of all time happened in 2006 after less money was raised in 2005.

What does this mean for corporate bond investors? Well bondholders of potential targets, likely to be investment grade, should make sure they are protected with covenants so they can get their money back. There are few places to hide when even Home Depot in the US is talked about as a target. High Yield investors are likely to see more issuance to fund the LBOs but should make sure that the PE fund hasn’t overpaid (multiples are rising as shareholders become less willing to be bought out cheaply).

But the more significant effect may be for corporate Europe to take on more debt and fall down the credit spectrum. Companies such as Portugal Telecom, currently being courted by Sonaecom, are offering special dividends funded by debt to fend off a takeover and so you could see their ratings fall to junk even if they are not taken over. This would bring the ratings of European companies more in line with US companies that have typically had more debt. Maybe one of the reasons for European companies having less debt than their US counterparts was a less established capital market for junk rated companies in Europe, but that fear should have eroded with the maturity of both the European High Yield and Leveraged Loan markets that are more able to finance lower rated companies.

Not since I began working in the City in the mid 1980s can I remember seeing an economic data release come out so many billions higher than market expectations. Yesterday morning, it was announced that so-called M4 lending, which is the amount of money in loans that is pumped out by banks, jumped to a new record of £31.7bn in January. A survey of economists had predicted a figure of £11.8bn – that’s a difference of £19.9bn! To put this figure in perspective, M4 lending in January was larger than in the whole of 1994. Yesterday the Bank of England also announced that M4 money supply growth, which is the broadest measure of UK money supply including notes and coin in circulation and bank deposits, rose 13% from a year earlier, ahead of the 12.7% survey prediction and only slightly below the 16 year high of 14.4% that was reached last autumn.

Gilts were marginally damaged by these figures, but why did the bond market not sell off by more? Two answers spring to mind – firstly, complacency; and secondly, the focus on money supply is nowhere near as strong now as it was a couple of decades ago, when the government used to target the money supply in an effort to control inflation.

There is no doubt that in the long run, increases in money growth are more often than not associated with increases in inflation. One of Milton Friedman‘s two most famous quotes was that “inflation is always and everywhere a monetary phenomenon” (the other quote being “there is no such a thing as a free lunch”, which is something I don’t entirely agree with!).

The Bank of England recognises this link between money supply and inflation, since contained within the last inflation report were the words “strong money growth may be associated with greater spending on goods and services, or upward pressure on asset prices, posing an upside risk to inflation. To the extent that people recognise this, strong money growth may also prompt them to raise their expectations of future inflation”.

But the extent to which money supply growth causes inflation is the subject of an economic debate that has been raging for centuries. I don’t want to go into this here, although it is definitely worth mentioning that the money supply clearly plays a role in Mervyn King’s mind. In “No inflation, no money – the role of money in the economy” , a paper he wrote while Deputy Governor of the Bank of England in 2002, he concludes:
“My own belief is that the absence of money in the standard models which economists use will cause problems in future, and that there will be profitable developments from future research into the way in which money affects risk premia and economic behaviour more generally. Money, I conjecture, will regain an important place in the conversation of economists.”

If the Governor of the Bank of England cares about money lending and money supply growth, then so do I. Yesterday’s data releases reinforce my view that the Bank of England will have to hike rates twice more, and possibly by more than that.

US sub-prime mortgages, those mortgages targeted at consumers with impaired or low credit ratings, have been the talk of the bond markets last week. The sub-prime market has grown significantly in the last few years spurred on by favourable circumstances including a falling unemployment rate, generally rising house prices and ever more accommodative lending practices. That willingness amongst lenders to re-finance existing sub-prime mortgages, often on increasingly favourable terms, meant that even those homeowners who found themselves in real financial difficulty were often able to re-finance. However, that situation has now changed. With existing and new home sales down significantly year on year in 2006 rapid house price appreciation is no longer a source of ready funds for distressed homeowners. Given the general wider strength of the US economy the increase in delinquencies to levels not seen since mid 2003 is a cause for concern. The most recent data has sub-prime loan delinquencies (loans 60 or more days past due or in foreclosure) running at around 12.5%.
Whilst the uptick in delinquencies has been only too apparent in the ABX indices (the riskiest portion rated by Moodys & S&P fell from a price of 96 at the start of the year to 87 on the 15th February, these indices essentially reference sub-prime mortgage debt) the wider impact on the bond markets has been limited. The reason for this is the belief that the issues that are currently plaguing the sub-prime mortgage market are not a symptom of a wider consumer credit problem, that growth remains fairly strong and that the banks involved can fairly comfortably swallow the associated losses. True, delinquency rates on other types of consumer lending are low by historical standards and the larger sub-prime lenders such as Wells Fargo, HSBC, New Century & Countrywide can afford to swallow the associated losses (as you’d expect their equity performance has suffered) concerns remain. Principally I believe there is an obvious danger in assuming that the liquidity this market has enjoyed will be an ever present. Sub-prime mortgages typically enjoy a ‘low’ fixed rate for a couple of years and then jump to levels of around 13%. Should borrowers find in a few years time that they are unable to re-finance (tighter lending standards on the back of this recent scare ?) we could well see delinquencies rise significantly and I’m not so sure the wider bond markets could remain quite so sanguine.

 

The latest Bank of England Inflation Report shows that the MPC believes that one more rate hike (to 5.5%) should be enough to send CPI back down below the target (2%) by the 2009 horizon date. We know this because the Bank shows where it projects rates to be on the basis of both unchanged rates (5.25% – CPI slightly higher than target), and market expectations of rates (a hike to 5.5% by mid 2007 and then probably on hold, which results in CPI slightly below target). The Bank did state though that there is “greater-than-usual” uncertainty about their forecasts – not only thanks to energy prices, but also wages and inflation expectations. The Bank’s measure of inflation expectations has edged up lately – it’s worth remembering Paul Tucker’s comment about November’s rate hike – “I concluded that it was essential for the MPC to act in a way that was most likely to keep inflation expectations anchored”.
On a different, but related note, I found this quote in a recent UBS presentation fascinating: Professor Kenneth Rogoff of Harvard said that “as long as the central bank targets inflation in the overall price level, which it can over sufficiently long horizons, cheap goods from China simply imply that other goods must become more expensive. From this perspective, one might say that China is exporting inflation to other sectors of the economy”. In other words central banks have kept rates too low – the collapse in goods prices driven by China sent inflation rates down (for example in the UK, deflation in clothing and footwear was at one time running at 6% per year), but this was an exogenous shock, and out of the control of central bankers. In order not to have overall inflation rates fall below the bottom of their targets they had to generate higher inflation in the remainder of the inflation basket, for example in domestic services, by cutting rates. As they cut rates they stimulated already robust domestic demand, made mortgage finance substantially cheaper, and we can see the consequences in housing markets today.
A triple-C rating (CCC) is known as “the hooks” in junk bond parlance. Sounds a bit better than Moodys who define them: “…to be of poor standing and are subject to very high credit risk”. Despite that definition they have been doing very well over the last couple of years and yesterday the average spread on European bonds rated CCC & below reached 359 basis points, the lowest on record. To put this in perspective, CCC spreads reached a peak of 3845 basis points on 1st October 2001 (yes, that’s a 38.45% excess yield over government bonds). It’s the same story in the US, where spreads on bonds rated CCC & below now stand at 452 basis points, also a record low. This is important because US spread history for the poorest rated bonds goes back to 1988, whereas European high yield data is only available from 1998.

Are CCC rated bonds compensating us enough for default risk? Based on historical default rates, the answer is a resounding “no”. Moody’s most recent annual default study looks at global default data from 1920-2005, and on a five year moving average, the historical global default rate for CCC rated bonds is a rather worrying 29.7%. So, if you bought a CCC rated bond now, based on an historical default rate, there is almost a 1 in 3 chance that the bond you bought would default over a five year period.

It’s all very well looking at historical averages, but are we in an “historically average” credit environment right now? Again, definitely not. The global economy had one of its strongest years ever in 2006, which goes a long way to explaining why defaults have remained so low. In Europe, following the default of Schefenacker, only 2 out of 155 companies’ bonds are trading at distressed levels (ie yielding 10% more than government bonds) indicating that they are likely to default soon.

Even though balance sheets are generally very healthy and the credit environment is very supportive, it is difficult to be bullish on something that is the most expensive it has ever been. In my funds I am being cautious on triple-Cs. Where I do hold them it is because they have short maturities or we think that they are likely to be refinanced. I’m not hooked

Defaults are few and far between in the European High Yield market at the moment but we have another today as Schefenacker, a German auto supplier that makes mirrors and lights, has announced a financial restructuring. Holders of the €200m bond issued in February 2004 have been offered 5% of the equity.

This should serve as a reminder to the current jubilant credit market that companies can go bust, although I suspect that it will be seen as part of the auto industry malaise that the rest of the market is insulated from. It should also question recovery rates. Schefenacker bonds are trading at around 10% which is much lower than the “normal” 40% assumption that is the perceived wisdom. With more loans and second lien loans ranking ahead of the bonds, we should expect recovery rates to be lower over the next credit cycle.

 

No rate hikes from either the Bank of England or the European Central Bank today, in line with the market’s expectations. The MPC will have seen January’s inflation data (out next week), so it’s therefore unlikely (though not impossible) that CPI rose above December’s 3% level and into the territory where Mervyn King has to write a letter to the Chancellor. In fact today’s news that British Gas is cutting both gas (-17%) and electricity (-11%) prices as of March makes the outlook for UK inflation a little more benign. Together these items account for 3% of the Consumer Price Index, and if competitors follow suit, the impact of the price falls will be to take around 0.4% off the inflation rate. In addition, with the IDS wage data for January’s pay settlements having been revised down from the early estimate of 4% to 3.5%, the MPC will be a little more relaxed that a wage inflation spiral in not underway. The ECB however have had no such comfort, with the German metal workers union demanding 6.5%, and the Italian banking union 10%.

In the UK then we’re waiting to see some sustained weakness in housing before we call a peak in rates (mortgage approvals have fallen, but the HBOS house price index rose again today), but it might not be that far away. In the Eurozone however rates will need to go up at least a couple more times – wage growth is a threat, money supply is extremely strong, and economic growth continues to surprise to the upside. So we expect the ECB to be at, or above, 4% later this year.

 

Friday’s statement from a group of private equity houses that they were “in the preliminary stages of assessing” a possible offer for Sainsbury saw its shares rally 17% and the CDS market jump from spreads in the mid 27 bps out to 75 bps. CDS (credit default swaps) reflect the cost of ‘insuring’ against an issuer defaulting on its debt – the higher the risk of credit deterioration, the higher the premium.

During the first half of 2005 Sainsbury’s CDS contracts traded in a range of 90 bps to 130 bps reflecting the rather poor performance the company was experiencing in a demanding sector. The second half of the year saw a gradual tightening in spreads reflecting an improving credit profile as management began to show signs of turning things around. By the end of the year Sainsbury CDS was trading at around 57 bps, largely in line with its peers.

 

However, by the end of February 2006 Sainsbury’s CDS had collapsed from the high 50s to the mid 20s and eventually settled in around the high teens a month later. The driver for this move is a technicality in the CDS market. If a credit event takes place, the ‘insured’ party has an obligation to deliver qualifying bonds or loans, and in exchange receives his/her payout from the protection seller (in the same way that if you crash your car, the insurer pays out, but then owns the wreck). The issue in February 2006 was that Sainsbury announced they intended to re-finance their outstanding debt in a move which included buying back their outstanding bonds. This meant that if a credit event was to occur then a protection buyer would be unlikely to be able to fulfil his/her part of the bargain – thus making the value of insurance dramatically lower. (The reason the CDS didn’t trade to zero will become apparent.)

So why is Sainsbury’s CDS currently trading around 90 bps? If private equity were to get their hands on Sainsbury, far from a certainty, then they would be very likely to lever up the balance sheet (by issuing loans and bonds) thus increasing the probability of a default. In theory this should see the CDS trade above the highs of 2005. The reason why the CDS hasn’t yet reached new highs is twofold: firstly we don’t know what the ultimate fate for Sainsbury will be, but crucially we don’t know whether any debt issued would ‘qualify’ as deliverable under the existing CDS contracts. In theory the CDS price should be a function of weighted sum of the various potential outcomes for Sainsbury and that is very much open to interpretation and guesswork. I imagine we will yet see some more volatility in Sainsbury CDS.

 

Friday’s Wall Street Journal lead on Putin’s response to Iran’s suggestion that the gas-producing nations set up a cartel similar to that run by the oil producing nations. Russia and Iran have the world’s largest proven gas reserves, with a world share of over 40%. Given that Europe gets a quarter of its natural gas from Russia this is a concern for inflation – the natural gas price is already the single biggest contributor to Eurozone inflation. According to the latest Economist however (see here) such a cartel is unlikely to be effective for various reasons – most importantly the long term nature of gas supply contracts. Nevertheless the "protectionism alarm" is ringing more and more frequently here.

 

Month: February 2007

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