The US corporate bond market has hit a new milestone as the credit crunch spreads the pain across the economy.
By various measures, the premiums demanded by investors to take on the additional risk of lending to an investment-grade company rather than the US Treasury have reached their highest levels ever, surpassing even the peak scaled in March when the collapse of Bear Stearns stoked the fear of a systemic financial crisis.
After a brief reprieve, the selling in cash corporate bonds has accelerated through the slow summer months.
Mounting credit-related losses in the financial system, which have reached $500bn for US banks, have curtailed the ability of Wall Street dealers to hold inventories of corporate debt.
At the same time, investors around the world are requiring high interest rates to buy the bonds of the financial companies themselves, a situation that could worsen with funding needs this autumn.
Broad exposure to Fannie Mae and Freddie Mac paper has not helped.
“It’s a fear of credit,” says Dan Fuss, vice-chairman at investment manager Loomis Sayles. “Dealers are far less willing to hold inventories because they don’t trust their hedges anymore and lack risk capital.”
The weakness in cash bonds has outpaced activity in credit derivatives based on corporate credit, where dealers buy credit default swaps when the chance of default or distress is rising. Even as spreads on cash bonds soar to new highs, the price of credit default swaps has remained well inside the March highs.
This contrast highlights the links between cash bonds and credit derivatives and for many investors, the better liquidity in derivatives makes them a more accurate barometer for credit.
“I prefer the derivatives market as it provides a real time picture of sentiment for credit,” says Michael Kastner, portfolio manager at SterlingStamos. “The cash bond market is very disorderly.”
In recent weeks, dealers have been quoting some cash bonds with a difference of 75 basis points between the bid and offer prices, a spread typically reserved for illiquid or distressed debt.
Lehman Brothers’ US credit index last week hit a high of 270bp over Treasuries, the widest ever level based on data that goes back to the early 1990s. In March the index peaked at 268bp.
In contrast, while the CDS index for US investment-grade credit derivatives has recently moved wider, trading around 145bp, it is well inside the high of 200bp seen in March. One important factor behind the selling pressure in March was the liquidation of credit positions held by hedge funds.
Now that leverage has been reduced, the CDS index is lagging the move seen in cash bonds, say traders.
A similar situation exists in Europe. For example, spreads for single A European companies raising money in euros hit 215bp over government bonds last week, a record high since the late 1990s when data was first collected, according to Lehman Brothers.
In contrast, the flagship iTraxx Europe index, which covers the 125 most traded investment grade companies in the European CDS market, is trading around 100bp compared with record highs around 110bp in the middle of March.
Other factors such as the use of interest rate swaps in hedging interest rate risk and the funding of credit trades via the repurchase market are also playing a pivotal role in driving the current discrepancy between cash and derivative credit trades.
Sharply rising funding costs, reflected in wider interest rate swaps over Treasuries, have pressured cash spreads for corporates, mortgages and other fixed income assets.
The wide level of swap spreads reflects concerns over bank balance sheets and funding through the repurchase market. This funding squeeze has exacerbated the difference between cash and derivatives for corporate bonds, known as the “basis”.
This measure is currently negative as the cost of buying credit protection is less than cash bond spreads.
While the basis is at an extreme level, this arbitrage opportunity, expressed by buying cash bonds and buying credit protection, remains a hostage to the credit squeeze and volatile markets.
“Ultimately you will get paid for buying the basis, but you need enough capital in order to withstand the volatility of holding the position,” says Ira Jersey, director of fixed income at Credit Suisse.
Kevin Murphy, a managing director at Putnam, says that while dealers, wary of adding assets to their balance sheets, are not actively buying corporates there is also the expectation that a slowing economy will cause corporate defaults to rise and pressure spreads.
“The longer it takes banks and the financial industry to sort themselves out, the longer it will take to free up credit lines and the longer the default cycle will be,” Mr Murphy says.
According to Moody’s Investors Service, the corporate default rate could reach 10 per cent in the next year should the US face a protracted recession.
The default cycle is expected to weigh more heavily on speculative-grade companies, where issuance volumes have plunged this year. With the availability of credit from banks drying up, vulnerable junk-rated companies face tough times.
Standard & Poor’s says that its Distress Ratio, a measure of how many credits have option-adjusted spreads greater than 1,000bp over Treasuries, is at its highest level since March 2003. So far this year the ratio has risen nearly 19 per cent since December.
By Michael Mackenzie and Nicole Bullock |
