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.