Wednesday, September 16, 2009

`There’s no free lunch in credit anymore’

So say Deutsche Bank credit analysts Jim Reid and Nick Burns.

They’re looking into credit markets in a note out on Wednesday, and specifically whether the markets have normalised since the start of the credit crisis and the collapse of Lehman Brothers one year ago.

As they note, 2009 has so far been a stellar year for credit. That might be surprising to some people, but not to these analysts, who say that:

Given that we started from ‘once in a Century’ valuations, this rally is not difficult to understand.

In fact, corporate bonds (USD, non-financial investment-grade) have now returned about 2 per cent more than US Treasuries over the past two years, as highlighted in the below chart. At their worst point, after Lehman’s collapse, they were underperforming by about 20 per cent. What a difference a year makes.

Total return for credit, equities, USTs during the crisis - Deutsche Bank

On the non-financial side, you can see that, having somewhat overshot the fall in US GDP in the third and fourth quarter of 2008, spreads have now risen dramatically. US BBB spreads are now broadly back in line with the economic growth that Deutsche forecasts will come through in the first half of 2010.

US GDP growth vs US BBB spreads - Deutsche Bank

And what about financial credit — the hardest hit in the Autumn of 2008? That’s a bit trickier, DB says.

The credit crisis basically saw a complete breakdown in the `normal’ relationship between non-financial and financial spreads (figure 10, below — the light blue line). And despite financials tightening in recent months, that relationship is still in negative territory.

In LT2 or subordinated bonds, the lower-ranking stuff in financials’ capital structure, that dislocation is even more pronounced (figure 12). And in the hybrid market (figure 15), everything’s proving to be more complex given recent issues concerning `burden-sharing’ for bondholders of bailed-out banks.

EUR non-financial vs financial senior spreads

EUR nonfinancial and LT2 spreads - Deutsche Bank

UT2 and T1 average price in EUR, GBP, USD - Deutsche Bank

In short, on financial credit — Reid and Burns say:

So overall looking at financial credit we would have to say there is further to go before markets are back to normal relative to non-financials and that the further you move down the capital structure the more disjointed the market remains. However if you believe that authorities continue to provide all necessary support until financial institutions can support themselves and that the ultimate goal is to keep financials in the private sector then arguably there is still much upside for financial credit, particularly as you move down the capital structure and particularly relative to the Government bond market that is essentially supporting the asset class. It might take a flight out of Government bonds (and for the risk of the state support for financials to weaken) to reverse the normalisation process in credit spreads, especially for financials.

And here’s their conclusion on the overall credit markets:

All in all we would have to conclude that credit markets have seen a substantial amount of normalising and in some instances have already completely normalised. Given that for the time being economic data is expected to continue improving we would still expect to see further spread tightening. That said the ‘free-lunch’ in credit is starting to fade. At the beginning of the year credit was so far out of line with its traditional drivers that it was likely to perform almost regardless of the economic data. However the direction of spreads from here is likely to be far more dependent on the underlying macroeconomic environment that transpires in the coming months. Indeed to get outsized returns in credit now, you have to venture into the political quagmire of the subordinated financial markets and have to buy into a high yield market that has significant re-financing risk in the years ahead. We still like the asset class on a spread basis but the days of equity like returns with credit like risks are coming to an end.

1 comment:

Best Credit Cards said...

Hi! Just want to say, thank you for adding/accepting me in your friend's list.

Best Credit Cards