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Caveat emptor

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Spreads may be widening in anticipation of the new issuance season starting this month, but the worsening macro data suggests bond managers can also expect to see an increase in defaults. Some are rightly nervous of cyclical credits and high yield, with Moody’s increasing its global high yield default rate to 2.5 percent in July from 2.1 percent in June.

 

Yet Luke Hickmore, an investment director at SWIP, says there may be a longer time lag before the defaults come through than in the past, because of the increased use of cheap financing with no covenants: “Triple C-rated bonds usually last three or four years before they blow up. In the 1970s or 1980s you might have had three or four bonds in this grade that defaulted in that time span, but now there are 300 companies in the triple C grade, so default rates will increase.”

 

The popularity of ‘covenant light’ may stave off defaults until mid-to-late 2009, when economic conditions are tougher and companies are trying to refinance, but Hickmore is expecting a default rate of 10 percent for the end of next year. He also expects to see more problems amongst US regional banks, especially those with only one business, such as commercial real estate: “Those won’t get rescued by anybody. It will be the same if they only have a small number of deposits.”

 

He points out that the Federal Deposit Insurance Company has already used up a quarter to a third of its total resources through banks failing in the US, so the premiums the banks pay to the FDIC will have to go up next year. “Next year you could easily see an aggressive move by the Federal government to close down some of these ailing banks,” he adds.

 

Rising defaults

Difficulties are also apparent in certain segments of high yield, with 11 defaults of Moody’s rated issuers in July, the first double-digit monthly tally for five years. All but two of these were US issuers, the exceptions being Canada’s Ainsworth Lumber Company and the French wine and spirits group Belvedere SA. Moody’s is forecasting that the global default rate will rise to 6.3 percent over the next 12 months, and go as high as 10 percent if there is a protracted US recession.

 

But defaults are likely to be lower in Europe than the US, where high yield issuance is more cyclical and consumer-oriented, so some managers are willing to venture into lower grades. James Gledhill, head of fixed interest at New Star Asset Management, believes the market is discounting too great an increase in defaults: “The ITraxx Crossover is at about 550 now, which suggests that about 18 out of its 50 members will default over the 5-year index, which I don’t think is true,” he says.

 

“The maximum bang for your buck is to be had by investing in things that trade very wide that other people think will default, so we have a few of those, but in general we are trying to invest a bit back from that in things that trade a bit tighter. It is difficult to argue that it will recover quickly – but you are being paid to wait and there is lower volatility than in equities.” Other managers, such as BlackRock’s Owen Murfin, and Pimco’s Luke Spajic, say they are staying north of Triple B, particularly in cyclicals, which will suffer more as the economy slides into recession.

 

“The asset class has been shaken to its core,” says Spajic, head of pan-European credit portfolio management at Pimco. “Things are cheap for a reason, and you need to read the tea leaves a bit and understand what has gone wrong.” Pimco remains very defensively positioned, and is accumulating credit slowly. Whilst the new issuance season may provide fresh pickings, secondary trading remains very illiquid.

 

Hickmore adds: “Even if you’ve got a position in what used to be a triple A insurance-wrapped bond, such as Telereal [a subsidiary of BT] – which has downgraded to double A because its monoline was downgraded – the price hasn’t moved because no-one has been able to sell any. Everyone who wants them has already got them.”

 

Hamstrung market

The secondary market is still hamstrung by a lack of capacity – over the last year there have been no new entrants to the market, whilst a lot of traders have left post-credit crunch. Banks and brokers are still trying to deleverage and aren’t prepared to house the risk. “So there are few people who are buying, other than the distressed debt buyers who are bottom fishing,” says Adam Cordery, head of European credit strategies at Schroders.

 

The new issuance season is expected to bring some new names to the European market, with a big issuance backlog, particularly in the banking sector. This year some 75 to 80 percent of new issuance has come from this segment, and September is expected to be no different. But the close of August also saw corporates such as France Telecom, Eon and Daimler come to the euro-denominated bond markets, as treasurers have started to worry that conditions are likely to get worse before they get better, and that banks won’t be in a position to help them, the later they leave it.

 

This is something of a turnaround, as for a good part of this year issuers have been going to the dollar market instead. “There has been a lot of support for new issues in dollars and they have been able to get decent sizes away,” explains Hickmore. “So you’ve seen Deutsche Telekom, M&S and Cadbury’s do dollars because it’s cheaper and they can get the size they want. But we think that is becoming quite exhausted and now the balance is swinging back to the UK and Europe.”

 

If you want to read more about how credit managers are positioning themselves against a backdrop of wider spreads and rising defaults, please visit:

http://www.thomsonimnews.com/story.asp?storycode=45999 

 



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