There are a few signals that indicate a certain amount of confidence has returned, namely a decrease in volatility, a slowdown in subprime-related write-downs, stability in corporate bonds and an increase in liquidity.
The recent spread widening across the curve is expected to retrace as the scale of subprime risk becomes much clearer. The re-pricing of credit risk should gradually allow the markets to remain calm and result in tightening spreads. Thus, the stability in the market can only happen if liquidity returns.
Has the drop in the dollar changed your appetite for euro-denominated paper?
Most central banks and some sovereign wealth funds have been diversifying or re-balancing their reserves in favour of the euro. However, there are several factors that need to be considered: the economy, credit spreads and currency strength. The economic momentum in the eurozone has clearly slowed with the growth rate falling from 0.7% in the third quarter of 2007 to 0.4% in the fourth quarter. But inflation is set to remain well over the 2% mark and these concerns put downward pressure on prices at the long end of the curve. The European Central Bank is likely to leave rates unchanged.
In terms of credits, spread widening is greater at the front end of the curve due to the increase in risk-aversion. This increased risk-aversion has turned into a liquidity crisis, further compounding the financial market concerns and implying higher euro/dollar volatility. So, although the euro has appreciated, appetite for euro-denominated paper will not be apparent until liquidity returns to the system.
Are you keen to see more issuance from European borrowers? What type of paper appeals to you?
Under the current climate, issuers will generally shun the market. Lack of liquidity tends to distort pricing. I expect volatility to continue and corporate issuance to remain markedly slow. In the covered bond arena, most of the new issues are likely to offer tightening potential, especially since issuers are obliged to pay a sufficiently attractive issue premium to entice investors. Generally, investors still prefer to be in cash and their focus will be more on issuer quality and credit-worthiness. Consequently, better-rated companies will benefit from the anticipated spread tightening.
What are your current hesitations about buying European names?
The US subprime crisis, together with the interaction between weakening credit markets and the deteriorating economy, has caused credit spreads to widen. The extent and pace of spread-widening has been primarily related to the unwinding of leverage in the global credit markets. The European market has suffered relatively more from a lack of permanent capital than the US. While in the US subprime exposure has more or less been quantified, the magnitude of subprime exposure in the European market still remains unclear.
How is investor appetite for covered bonds holding up?
Covered bonds are traditionally considered very secure credit products, thus investors active in this sector are generally comfortable with the marginal amount of credit risk in exchange for the yield pick-up. However, volatility in the US and Europe has posed new challenges for the covered bond market and the current liquidity crisis is likely to prove a testing time judging by the weakness in the covered bond secondary pricing, particularly at the longer end of the curve.
Furthermore, legislation is mostly new or revised and therefore largely untested. Bonds that should continue to trade wider include structured covered bonds from the US, UK and Netherlands, namely those issuing countries that do not have specific covered-bond legislation. Thus, while the liquidity crisis continues, the shorter-dated public sector backed covered bonds look more attractive in relative terms.
What options do issuers rated lower than triple-A have in terms of attracting investor interest? What bells and whistles can they add to appeal to Asian buyers?
Besides offering higher yields and wider spreads, there is little issuers can do but sit and wait. Until there is some kind of stabilisation in credit spreads, and demand returns to the sector, investors will not be interested in buying risky assets. On a more positive note, some credit stability has been seen in the CDS market over the last month. Though far from recovered, spreads are at least better than their worst levels.
Now that US interest rates are dropping, are you likely to be more interested in paper with longer tenors?
No. The liquidity crisis has led to an increase in risk-aversion so the focus has been towards the short end of the curve and this approach has proven to be successful. This shift is more apparent of late as investors are generally moving away from corporate bonds to triple-A rated paper (supranationals, for example) and buying more shorter-duration paper.
However, a change in risk-perception may cause the inherent risk of the longer maturities to be traded more appropriately again. The yields may rise more moderately in the coming months, and cause the curve to flatten again. It will then make sense to look at the longer tenors.
What is impeding secondary market trading in credits?
The increased risk aversion is preventing the secondary market from functioning properly because investors cannot identify where subprime related losses are. So, issuers have to pay up and issue at wider levels to attract the more risk-averse investors. The wider levels are drawing out the investors, who are waiting for stability in spreads and signs that things are improving before re-entering the secondary market.
