Saturday, October 30, 2010

Credit Report | Credit Strategy Highlights

Micro and macro in harmony lifts sentiment

The way 3Q earnings season is unfolding so far is giving sentiment another push and yesterday credit markets started a new attempt to break early August spread lows, as macroeconomic data were also supportive, pushing aside concerns over foreclosures in the US and mixed results from financials.

In Europe, German PMIs were strong (manufacturing 56.1 vs. 54.6, services 56.6 vs. 54.9) and in the US, the Philadelphia Fed index rose for the first time in three months as measures of employment and sales increased. Weekly initial jobless claims were slightly lower, but continue to hold at a level that points to minimal improvement of the labor market, limiting the upside potential for growth and, most important, for the housing market. At least the index of leading economic indicators increased 0.3 percent in September, signaling that the recovery will extend into 2011, making further quantitative easing by the US central bank likely. Comments by regional Fed president Bullard support this assumption, as he favors purchases of about USD 100bn in between FOMC meetings.

Long-end issuance keeps pushes out modified duration

As of late, companies increasingly are opting to buy back outstanding debt in exchange for new issues and lure investors with premiums on the redemptions. The issuance comes without immediate necessity to refinance and is sparked by two obvious incentives for corporate treasurers: lowering refinancing costs through ultra-low government yields even if spreads are not anywhere near the pre-crisis frenzy levels, and extending maturities. Liquidity is cheap and corporations amass cash for maturities of coming years, opportunistically loading on debt as they regard the burden to be more manageable than facing potential uncertain capital markets down the road. As long as yields remain compressed, the strategy of additional debt is mitigated and does not even have to weigh negatively on rating factors.

However, it shifts risks from companies to the credit investor. Spreads may still look healthy to many, but risk is building in indices. With most issues coming to market in the 7Y to 10Y bucket, modified duration of iBoxx indices keeps rising. While the upward trend has been fostered predominantly by tightening spreads in 2009, long-dated issuance does the job this year. Since 1Q09, modified duration in the iBoxx non-financial index is up 6% (from 4.1 to 4.35), and in the iBoxx financial it is up even 15% (4 after 3.5). This is still far from the highs of 2005, when indices experienced modified durations of around five years, but the long-end issuance accelerated the trend most recently.

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