Not a good week for bulls

The iTraxx Crossover Index broke above 450 basis points on Friday, even though Q2 US growth figures were above consensus and headline corporate earnings figures have been reasonably strong of late. European CCC rated bonds have returned -6% since spreads reached all time lows at the end of May.
We’ve covered many of the key issues previously, but in short, a slowing US housing market has led to the US subprime mortgage crisis, CDO blowups, hedge fund bankruptcies and mass credit rating downgrades, although we view this as more a symptom of worsening credit conditions rather than the cause itself.

From a technical angle, a wobble in the leveraged loans markets has exacerbated problems for the corporate bond markets. It’s been known for a while that there was going to have to be a huge amount of leveraged loan issuance to fund all the LBOs that are taking place (some estimates put the forward calendar as high as $300bn), but this huge supply has been met by an untimely flight to quality. Daimler Chrysler had to pull a $12bn leveraged loan issue last Wednesday, and investment banks have decided to keep £5bn of the £8.5bn Alliance Boots deal on their books until markets have become more attractive. If liquidity in the leveraged loan market continues to dry up, then leveraged loan issuers will probably start issuing into the much smaller high yield corporate bond market in an effort to raise new finance, putting further pressure on high yield corporate bonds.

So is now a good time to take on a lot of credit risk? This is probably a good time to refer back to some of our favourite long-term ‘big picture’ charts. Jim wrote a piece on the predictive powers of the US yield curve in May, showing that a flat (and particularly a downward sloping yield curve) is a good indicator of wide spreads 18 months later. As the chart to the left shows (click on image to enlarge), the US yield curve is still inverted (as shown by the spread between US 10 year Treasuries and US base rates, right hand axis), and current levels normally equate to BBB rated corporate bond spreads (on the left hand axis) of about 200 bps. US BBB rated corporate bond spreads have widened from 116bps to 160bps in the past two months – better value, but still not enough.

Another chart we like to wheel out shows high yield bond spreads (left hand axis) relative to economic growth. High yield spreads have jumped higher, but still only to levels that you’d normally associate with US growth of 4%. The high yield market is not pricing in an economic slowdown, let alone an outside chance of recession, and this chart also suggests that spreads are too tight.

There has been little discrimination in the recent sell off and there are undoubtedly more opportunities than there were two months ago, but M&G’s bond funds remain positioned cautiously in terms of credit risk.