Credit market report

Credit markets were directionless last week as investors came to terms with the increasing likelihood that monetary easing across the Western world may have peaked. It is apparent that ECB policymakers feel that the LTROs and similar initiatives have achieved their aim of averting a systemic crisis in Euroland. Indeed, Italy and Spain seem to have decoupled from Greece, Portugal and Ireland and debt markets have re-opened for first and second tier European banks. However, there has been increasing debate about possible unintended issues resulting from these unconventional policy measures. In particular, there have been concerns regarding the ECB’s LTRO exit strategy in three years’ time and potential collateral pressure for banks taking part in the LTRO if the value of the collateral posted were to drop further.

As for the UK, the combination of fiscal austerity and ultra loose monetary policy has been successful so far in keeping government borrowing costs at all time lows, but the value of incremental large scale asset purchases is now increasingly being questioned in an environment where traditional monetary policy transmission mechanisms are broken and where the Bank of England (BoE) own roughly a third of the UK’s stock of government debt. Quantitative easing (QE) is also being blamed for putting pressure on corporates by inflating pension shortfalls or punishing savers and purchasers of a retirement annuity.

Turning to the US, at first sight, the introduction of an additional third round of QE would likely be more acceptable than in Europe. However Bernanke’s perception that the economy is improving fundamentally in combination with a desire to avoid asset bubbles seems to have pushed Fed discussions towards sterilised intervention as opposed to outright QE going forward.

Given the debates on both side of the Atlantic regarding the benefits of further liquidity injections, it is no surprise that markets have taken a breather, and markets ended last week pricing in successful conclusion of the Greek PSI debt swap combined with an ISDA-sanctioned Greek CDS default event and the subsequent partial disbursement of the €130bn promised as part of the second bailout.

The focus for investors has shifted to the real economy’s potential for growth as the next prop for market progress. 2011 ended with real GDP falling in Europe and Japan and activity slowing in China. The US was virtually alone in seeing accelerating economic growth. However, at the start of 2012, there are grounds for optimism. Despite pressure from the rising oil price, the underlying inflation trend is down, towards long-term levels ranging between 2-3% in Western economies. The elimination of European tail risks has provided grounds for a recovery in economic activity and trade. In the US, economic indicators on balance are positive but employment conditions and the housing market showing signs of stabilisation.
Nevertheless, exiting a contraction (Euroland) or sustaining a growth rate of 3% (US) while pushing through fiscal consolidation and reform programmes are challenges. Coupled with China’s lowered GDP growth projection of 7.5% and Japan’s interminable battle with deflation and rising government debt, it is clear that the task facing governments globally remains significant as is the potential for policy mistakes.

Looking forwards, with the European Fiscal Compact now signed (to be implemented into national law by the end of 2013), the firewall around Spain and Italy needs to be fortified. This will likely involve merging the EFSF and the ESM as a prelude to larger IMF commitments. In addition, the now AA+ rated EFSF, which is still largely an unfunded vehicle backed by guarantees, should come to the primary market in a show of strength to build up a full curve of bonds. Meanwhile credit debt can offer attractive risk adjusted return opportunities and certainly looks attractive relative to government debt.

In contrast to European governments, European corporates are fundamentally better positioned than in 2008/09: balance sheets are strong with debt maturity profiles extended and refinancing risk lowered. Costs have been reduced and margins improved whilst working capital processes have been made more efficient. Banks too have embarked on a multi-year de-risking process which will see them regulated more closely and recapitalised with stronger liquidity profiles.

In addition, unlike government debt where safe haven yields are at all time lows, credit valuation levels can be seen as attractive. Spread implied default rates remain high, indicating that credit investors are being overcompensated for the actual amount of default risk they are taking. There are also grounds for arguing that the technical picture is supportive. As a result of limited issuance needs, investors are getting more money returned to them from redemptions, calls and coupons payments than they can invest in primary issuance. This supports valuations particularly in the context of YTD net inflows of 5% to European investment grade credit funds and 8% to European High Yield funds.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla