Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.
Logo of Bond Vigilantes
Tuesday 19 March 2024

The iTraxx Crossover Index broke above 450 basis points on Friday, even though Q2 US growth figures were above consensus and headline corporate earnings figures have been reasonably strong of late. European CCC rated bonds have returned -6% since spreads reached all time lows at the end of May.
We’ve covered many of the key issues previously, but in short, a slowing US housing market has led to the US subprime mortgage crisis, CDO blowups, hedge fund bankruptcies and mass credit rating downgrades, although we view this as more a symptom of worsening credit conditions rather than the cause itself.

From a technical angle, a wobble in the leveraged loans markets has exacerbated problems for the corporate bond markets. It’s been known for a while that there was going to have to be a huge amount of leveraged loan issuance to fund all the LBOs that are taking place (some estimates put the forward calendar as high as $300bn), but this huge supply has been met by an untimely flight to quality. Daimler Chrysler had to pull a $12bn leveraged loan issue last Wednesday, and investment banks have decided to keep £5bn of the £8.5bn Alliance Boots deal on their books until markets have become more attractive. If liquidity in the leveraged loan market continues to dry up, then leveraged loan issuers will probably start issuing into the much smaller high yield corporate bond market in an effort to raise new finance, putting further pressure on high yield corporate bonds.

So is now a good time to take on a lot of credit risk? This is probably a good time to refer back to some of our favourite long-term ‘big picture’ charts. Jim wrote a piece on the predictive powers of the US yield curve in May, showing that a flat (and particularly a downward sloping yield curve) is a good indicator of wide spreads 18 months later. As the chart to the left shows (click on image to enlarge), the US yield curve is still inverted (as shown by the spread between US 10 year Treasuries and US base rates, right hand axis), and current levels normally equate to BBB rated corporate bond spreads (on the left hand axis) of about 200 bps. US BBB rated corporate bond spreads have widened from 116bps to 160bps in the past two months – better value, but still not enough.

Another chart we like to wheel out shows high yield bond spreads (left hand axis) relative to economic growth. High yield spreads have jumped higher, but still only to levels that you’d normally associate with US growth of 4%. The high yield market is not pricing in an economic slowdown, let alone an outside chance of recession, and this chart also suggests that spreads are too tight.

There has been little discrimination in the recent sell off and there are undoubtedly more opportunities than there were two months ago, but M&G’s bond funds remain positioned cautiously in terms of credit risk.

 

Our economist, Steven Andrew and I visited the Washington Fed and New York Fed last week. Here are Steven’s quick and dirty comments on what we learned from them – written on his Blackberry at Newark airport, so he asks you to be gentle on the terse style.

The Fed in Washington
Largely upbeat (they’re never anything else). Not genuinely fearing inflation – current communication on this is designed to anchor inflation expectations (seen by Bernanke as top priority – he is far more keen on communicating than Greenspan was, to the extent that he’s introducing a quarterly ‘inflation report’ type thing (it won’t be called that). I haven’t heard this reported in the media yet but Bernanke has definitely charged the Fed staff with setting it up. Bernanke’s arrival apparently has led to lots more work compared to Greenspan’s days. Now seen as a committee of textbook wielding economists (oh dear).

Other changes under Bernanke
More focus on core CPI, more willing to talk about regulating consumer credit (maybe just a sign of the times).

Housing
from his testimony this week, Bernanke is clearly no longer happy to declare sub-prime as ‘contained’. The Fed staff we spoke to were naturally reluctant to add much – but said they’d worry more if the risk was still on the banks’ books (rather than in hedge funds and CDOs). Curiously, in my view, there is some optimism that rising equity markets can offset the declining housing market in the ‘wealth effect’ stakes – this from the guy who wrote (with Greenspan) the seminal piece on housing wealth effects concluding that it was many times more powerful than that from equities. Still, I guess the useful thing about these Fed meetings is spotting the bits that don’t add up as the areas most likely to be of concern to the Fed, so this is almost certainly one of them.

Jobs
Mixed views on this. Why is employment so strong given the collapse in housebuilding? Laying off illegals is seen as having prevented a sharper fall in residential construction jobs, as is some shift to non-residential construction. (Brokers views on this were either ’employment weakness is coming with a lag’ or ‘the statistics are lousy, it’s already happening’).

The Fed is largely untroubled by the employment picture: happy to see the service sector payroll expanding although in truth it’s mostly government, healthcare and hotels (hotel employment and indeed pricing are both very robust, perhaps due to more foreign visitors taking advantage of the weak dollar, and more Americans staying in the country as the same weak dollar makes it too dear to travel abroad). I suspect they’re more troubled than they’re letting on.

The Fed in New York was most bullish. Gloom and doomsters are ‘hobgoblins’ trying to unearth obscure nuggets of bad news. They were dismissive of housing wealth effect. Consumer seen as solid despite recent weakening (because jobs are holding up). Middle America seen as frugal already, not ‘credit obsessed’. High earners are responsible for declining savings rate, so no big deal/correction to undergo.

Overall?
The Fed isn’t going anywhere until the unemployment rate starts to rise (then I think it would cut rates quite quickly). Labour market data are getting noisier without really showing any proper slippage yet. But it can’t be too far away, in my view. The over-riding focus on inflation is a red-herring/communications device, not a meaningful barrier to lower interest rates if need be.

After last week’s doom & gloom (see here) all appears significantly more rosy at the start of this week. The iTraxx Crossover index, currently trading at 285 as I type, is tighter than the 310 highs reached during last week with other areas of the market also bouncing back. Will it last? Well, this week’s plethora of data could give a good indication and potentially set the tone through the summer.

Firstly the earnings season in the US really kicks in with 80 of the S&P 500 names reporting. Of those names approximately 50 are financials, including Washington Mutual, JP Morgan, Merrill Lynch, Citigroup and Bank of America. The Q2 figures and Q3 guidance will be watched very closely for indications of just how significant an impact the current US sub prime debacle is likely to have upon earnings. Secondly Fed Governor Bernanke will give his semi annual Humphrey-Hawkins testimony to congress on Wednesday with the Fed minutes to be released the following day. Finally there is a whole raft of inflation, confidence, manufacturing & housing related data set to be released both in Europe, China & the US.

I personally, can see a scenario whereby the pending earnings data surprises to the upside and enables credit markets to rally in the short term. However, for the many reasons we have laid out in this blog I continue to be happy with maintaining a short risk position in credit.

 

CDOs (Collateralised Debt Obligations) are being hailed in some quarters as the next split cap catastrophe. As a result of the US sub prime mortgage crisis, some CDOs that are heavily exposed to the US subprime mortgage crisis have fallen dramatically in value and hedge funds that have a big exposure to these CDOs are on the brink of collapse. There are legitimate concerns with some aspects of the CDO market and perhaps the biggest one is that there isn’t a hell of a lot of confidence that the ratings agencies are on the ball (see my previous comment). Mervyn King touched on this subject at a recent speech too (as reported by Richard here). However, a lot of fear and confusion about CDOs comes from a lack of understanding of what they actually are.

A CDO is essentially just like an asset backed security (ABS). The assets that form the collateral for ABS deals are usually pools of credit card loans or car loans, but they could theoretically be anything that throws out a cash stream. David Bowie sold the rights to his songs for $55m in 1997 by issuing a Bowie bond, while Calvin Klein once issued a bond linked to future sales of its perfume products.

In a basic CDO, the collateral is a diverse portfolio of corporate bonds, high yield bonds, asset backed securities, mortgage backed securities and/or leveraged loans. The cash flows from this portfolio are then repackaged into different tranches, each with different risk and return characteristics and these tranches are sold to investors. Cash flows are received by the investors in the lowest risk tranche first, while the highest risk tranche receives cash flows last.

The highest rated tranche forms about 70% of the structure of a CDO and carries an AAA rating because it is the first in the queue and there would have to be a huge number of defaults in the underlying portfolio (about 30%) before any of the AAA rated investors start getting hit. Credit ratings of the tranches deteriorate as you go further down the queue, reflecting the fact that there’s less of a buffer, and right at the bottom is an unrated ‘equity’ tranche which is first in the firing line if things go wrong. Investors in the equity tranche stand to make fantastic returns as long as nothing defaults in the underlying portfolio, but as soon as anything does go bust then these investors start getting hit. And that’s exactly what’s happening now in the US.

Some CDOs have been heavily invested in mortgage backed securities, which themselves were backed by pools of subprime mortgages. These mortgage backed securities may have once been rated BBB, but now that so many US sub prime borrowers are defaulting, the credit ratings of these mortgage backed securities have plummeted. Many investors in CDO equity tranches are hedge funds, who were attracted to the prospect of returns of over 20% per year. Unfortunately, it seems that some investors in CDO equity tranches have also been pension funds, whose gullible trustees clearly didn’t have clue what they were getting into and have failed in their fiduciary duty.

Are all CDOs bad? As long as the underlying collateral is of sound quality, then they’re not bad at all. So called ‘CDO squared’ products, which are CDOs invested in other CDOs (this stuff really is a bit like split caps) are potentially poisonous, but they’re really not that common. CDOs in which the collateral is leveraged loans (these are Collateralised Loan Obligations, or CLOs) are actually very attractive right now and Richard has bought some for the M&G Optimal Income Fund.

In any area that has seen such phenomenal growth, there are likely to be some cases of abuse of the system, but that doesn’t absolve sophisticated investors of not reading the small print, or understanding the investment they are buying. It should also not deflect from how CDOs can offer attractive investment opportunities.

At the risk of finding something radioactive in my sushi, the escalating tension between Russia and the UK makes me nervous about the amount of issuance of capital (both equity and bonds) out of the former Soviet republics. Credit risk is not just about ability to repay a debt, but also about willingness to repay and it should take into the account to ability to take legal action to recover money due. And the yields on offer aren’t even that attractive at the moment – for example, Russian government credit risk trades at just 45 bps in 5 year CDS and Gazprom at 65 bps. Would it have been appeasement to have turned a blind eye to the failure of Russia to extradite one of its nationals to face trial in the UK, or would it have just been realpolitik? After all, if it leads to a trade war with Russia, I feel like the UK is in a similar position to the East Africans armed with spears when faced with the British army’s Maxim gun in the 1893 war. To paraphrase Hilaire Belloc’s famous jingle of the time:

Whatever happens, they have got
The oil and gas, and we have not.

 

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.

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.

 

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 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.

The index has traditionally been positively correlated to the equity markets, however for now at least, this relationship has been cast aside. The path of least resistance continues to be spread widening and with a large pipeline of deals to come to market (especially in the US) the jitters, it seems, are set to continue.

 

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!

 

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%).

Homeowner misery? Are UK homeowners really being squeezed that much? The best way to look at this is to work out the average monthly mortgage payment as a percentage of the average homeowner’s income. According to the Council of Mortgage Lenders, interest payments formed 17.3% of average income at the end of May, which is only a fraction above the historical average. Compare this to Q2 1990, when UK interest rates stood at 15% and mortgage payments formed 27.1% of average income (click on chart to enlarge).

And what’s an extra £160 per month when the price of the average UK house has risen 11.1% over the past 12 months? Assuming that the price of an average house is now £215,000, the average homeowner has seen the value of his or her property increase by nearly £25,000 in one year, and by more than £100,000 since the beginning of 2002. Surely homeowners are happy, not miserable? Homeowner misery is when prices collapse like the early 1990s. If you accept the press’s argument, homeowners should have been delirious in the early 1990s, because mortgage payments plummeted by over 50% as interest rates were slashed to offset the housing Armageddon.

The UK bond market is now pricing in interest rates to peak at 6.25% at the beginning of 2008, but if the Bank of England is serious about slowing the UK housing market, it could well have to put rates up by much more than investors are anticipating.

 

Month: July 2007

Get Bond Vigilantes updates straight to your inbox

Sign up to the BV Mailing List