| Spreads are widening, but it might not be over |
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| 5.06.2005 | |
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After a period of remarkably tight spreads, it might all be over – or not yet, according to various observers of the fixed income market. In many sectors of the credit market, widening spreads are now finding their 2004 level back. "Whilst credit fundamentals remain on the stronger side, continuing negative news flow emanating from the larger US automakers, Ford and General Motors, continues to put pressure on investment grade credit spreads", says Richard White, a fixed income portfolio manager at Credit Suisse Asset Management. Standard & Poor's reported that credit fundamentals remain positive globally as more entities continue to join the ranks of those poised to benefit from potential upgrades than at the beginning of the year. For John Lonski, Chief economist at Moody's, "misguided" trading strategies are to be blamed for unsustainable spread level of speculative grade bonds. "Not too long ago, high yield bonds were unequivocally overvalued on a fundamental basis", he says, pointing to the record low spread of 271 basis points of the speculative-grade composite's yield spread over Treasuries reached in March. This was put to an abrupt end by the developments in the automotive industry in May. By May 17th, the same spread went all the way up to 455 basis points, and then relaxed to 434 points. The view is partially shared by Richard White, who thinks that the 2004 bull run in the credit market has clearly been a bubble in formation far into 2005. "The correction is often sharp and it can also be short. After the last two months, we are not out of the woods yet – but there are many sectors where value is to be found", he says. However, he says that the correction might also have positive effect as a widening spread mean that investors will be better compensated for the risk they take, which could lead to an increase of the investor base, according to Richard White. Merrill Lynch Master II Index Spread over 10-Year U.S. Treasury  Source: Merrill Lynch & Co. Inc., Fitch Ratings For Patrick Artus, Chief economist of IXIS CIB, even if there is still much cash available, those reserves might as well dry out very quickly and create a liquidity mismatch for some investors. The flattening interest rate curve in the US as well as the Federal Reserve rate hikes to come make much more expensive the carry trades used by many funds. "This could affect their performance, in turn encouraging more selling by final investors, and ultimately lead to the selling of more assets by investment funds", he says. Heavy losses could be incurred in some cases as illiquid assets would have to be sold at a discount to meet the final investors' demand. Alternative vehicles would not be as much affected by such a liquidity mismatch, according to Patrick Artus. For instance, funds of private equity or property have illiquid assets, but are fairly illiquid even for the end investor - who is aware of it when first investing. Hedge funds, which are increasingly popular among pension funds, do not usually offer much liquidity – redemption periods, usually very long, are specified in a contract, and their assets are usually fairly liquid, such as CDO tranches, CDS, derivatives, bonds, shares. Funds of hedge funds are more susceptible to be victim of a liquidity mismatch as they offer shorter redemption periods and are often marketed to a larger public than hedge funds. Yet, as pointed out by Moody's researchers, this sudden widening of the yield spreads still falls short of what happened in the last quarter of 1998, when it went from 378 basis points in July 1998 to a 599-point average for August-December 1998 in the wake of the Russian and LTCM crisis. The market has yet to fall apart under the pressure of relentless widening spread: up to now, companies are remaining on average financially healthy and are expected to remain so. J.L. |
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