Weekly Credit Strategy Update : Liquidity dries out as 2010 comes to an end

Summary
Liquidity in the credit market is becoming scarcer.
The primary market is closed – likely to remain so for the rest of the year.

Market comment
Liquidity dries out as 2010 comes to an end

Liquidity was thin during the week as investor focus was on locking in performance for 2010. Consequently, we do not expect too much trading activity for the rest of the year.

Despite the poor liquidity, spreads went a bit tighter during the week. Investors did not dwell on last Friday’s disappointing US unemployment numbers for long and the week started out with improved risk appetite and a relatively good performance in the credit markets. However, for the rest of the week the markets traded flat while struggling to find a direction. Compared with last week, iTraxx Europe is currently unchanged while iTraxx Crossover is trading 12bp tighter.

PIIGS remain on the radar as EU countries face disagreements

A week after the Irish bailout, disagreements between the EU countries remains an issue. The German chancellor, Angela Merkel, rejected a proposal by Italy and Luxembourg to allow the European Union to issue joint euro-zone bonds (E-bonds). Furthermore, a proposal to increase the size of the EU bailout fund was also rejected. The latter proposal was put forth by the Belgian finance minister following rising yields and wider CDS on Belgian government bonds.

Fitch also downgraded Ireland from ‘A+’ (negative outlook) to ‘BBB+’ (stable outlook) at the end of the week. We expect the situation with EU sovereign debt to remain a key focus for credit investors as there is no quick fix to the problems.

Apax in talks to buy ISS in what would be the biggest post-crisis buyout

According to the international media, Apax Partners is now in exclusive discussions to buy ISS Holding. The private equity fund has two months to arrange financing for the rumored USD8.5bn offer. ISS’ current owners, Goldman Sachs Capital Partners and EQT, continue to run a multi-track sales process, which includes considering an IPO.

In terms of exposure to the various ISS bonds, embedded options are of significant importance. We remain positive on ISS Holding 2016 bonds due to limited downside in event of a secondary buyout and attractive upside in an IPO, while we are negative on ISS Financing 2014 bonds.

The primary market
Chinese bond issuance on the rise
Chinese bonds seem to be gaining traction as global issuers are looking to diversify their funding sources. Following issues from Caterpillar in November (CNY 1,000m) and McDonald’s in October (CNY 200m), BP is now considering issuing Renminbi bonds which are expected to dwarf the previous issues in size.

Issuers turn to the dollar market before year-end
Although some corporate issuers showed an interest in issuing bonds before the end of the year, demand from investors has decreased substantially and is not expected to pick up again until 2011. With the European primary market being more or less closed, most issuers turned to the US market for USD-denominated bonds (see table below). This follows a statement from Ben Bernanke that he does not rule out an expansion of the quantitative easing programme and the fact that the US Congress has finally come to terms on the new tax reform.
www.danskebank.com/
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Credit Strategy Highlights: The European sovereign debt crisis continues to impact market sentiment

The European sovereign debt 
crisis continues to impact
market sentiment



The fact that the sovereign debt crisis still has the potential to disturb risky asset markets  should not come as a surprise. Although the most immediate threats for systemic stability were mitigated by the Greek rescue package and the EFSF (and of course by austerity measures), the underlying problem will continue to smolder over a long period of time.

Investors are disturbed by two factors. First, even if structural issues can be resolved, such as cutting the primary deficit of Greece to zero (and more and more people recognize that Greece is moving to achieve this), the legacy problem (a huge debt burden) remains, and will weigh on economic growth as the cost of debt servicing contributes a significant amount to the overall deficit. Some investors argue that this situation (a balanced primary budget together with a significant legacy burden for Greece's real economy) might provide an incentive for a debt restructuring further down the road.

However, while this risk seems to be priced in already (GGBs continue to trade substantially below par), the second factor might be more important for the current performance: the risk of a self-fulfilling prophecy. Rising risk aversion might push governmental borrowing costs so high that it becomes difficult to refinance in private markets, which would argue for tapping the EFSF. Note that Irish government bond yields climbed to 7.1%, the highest level since the inception of the eurozone. Despite the argument that (German) taxpayers shouldn't bear all the costs (which
probably everybody subscribes to), politicians need to recognize that in credit markets insolvency and illiquidity are closely related. The post-Lehman developments have demonstrated forcefully how destructive a systemic bank run can be and how costly it is to stop it. You don't want this to happen in the trillion EUR sovereign debt market, as the risk is high that even the ultimate bailout-provider – Germany – lacks the financial flexibility to credibly stop such a process.

This highlights the dilemma of politicians: in order to avoid moral hazard and future credit bubbles one needs to credibly signal that private investors would have to bear default losses if they make unwise credit decisions (recall the simple truth that capitalism without losses is like religion without hell). The resulting risk awareness of investors should help to bring borrowing costs to levels that make an uneconomic debt burden unlikely (note that the fact that Greece could borrow such an amount was also driven by the fact that the funds were provided too cheaply). On the other hand, spiking risk aversion could set off the above mentioned vicious cycle of a liquidity crunch. Some investors might argue that a credit spread of several hundred bp to German Bunds should be enough of a incentive to deleverage sovereign balance sheets. Politicians would probably reply that they need to use the window of opportunity to push through necessary reforms (also to regain credibility before their voters). The tensions in this economic-political interface will probably continue to produce headline risk.

Today's data releases


As mentioned several times, this week's focus will be on the US midterm elections, the FOMC meeting and the US labor market report (the latter, however, appears to be of minor importance given that the crucial announcements regarding QE2 will come before Friday). Today, the eurozone will have PMI manufacturing releases (Italy, France, Germany and the eurozone itself).
http://www.unicreditmib.eu/
Full report: Credit Strategy Highlights

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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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