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Credit notes

Conditions in credit markets have improved noticeably in recent months, with signs of stability returning. Risk assets have rallied as sentiment has recovered while economic data has taken a less negative tone with both equity market volatility and inter-bank lending rates returning to pre-Lehman levels.

While signs of stabilisation in the economy are encouraging, we think that the macro outlook remains challenging and that any recovery is likely to be restrained by a lack of credit and delevering among both consumers and banks.

Although there remains a lack of liquidity in secondary corporate bond markets, albeit significantly improved over the position around September of last year, the primary market is seeing new issues being placed easily.

Primary markets have seen record issuance, particularly for high-quality bonds. Although issuers have typically paid more than double the spread over risk-free government debt than they would have the same time last year, corporate treasurers appear willing to get deals done while there is demand.

Typically, such issues have been at a discount to the secondary market, have been oversubscribed and have traded up after issue.

Recently, more cyclical names such as Rolls-Royce and John Lewis have been able to issue bonds and deals are once again being heavily over-subscribed. A number of high-yield companies have also offered debt, including HCA, a US hospital chain, which issued US$1.5bn, the biggest high-yield issue this year.

Financials have seen a significant improvement following the extensive measures undertaken by central banks. We believe that governments are committed to maintaining the capital structure of banks and that there is strong political will to avoid nationalisation.

The results of the US bank stress testing have been made public. The Federal Reserve reported that most banks had sufficient cash reserves to cope if the recession worsened while a number of banks have already informed the market of their plans to address capital shortfalls.

Banks have also been tendering to repurchase debt and US banks are preparing to repay money received under the Tarp programme. Banks are likely to be deleveraging their balance sheets for some time. Nonetheless, strong capital market and trading activity, in addition to wide spreads and cheap financing have supported better profitability.

During April, both Goldman Sachs and JP Morgan reported earnings that beat analyst expectations and sold non-government backed debt, the first time since January that a US bank had sold dollar-denominated bonds without government backing.

With general economic conditions still challenging, defaults look set to rise, albeit from very low levels. However, a high and, in our opinion, unlikely level of defaults are already priced in while the paper of some companies considered at risk is trading as low as in the teens and twenties.

Although we do expect that default rates will increase, especially in high yield, they may take the form of consensual restructurings, equity-for-debt swaps or a general refinancing of the capital structure.

Despite the strong monetary and fiscal response and a sense in the market that we are past the most intense phase of the crisis, we remain mindful of the structural challenges that the global economy faces and would not be surprised to see some market retrenchment.

Nonetheless, we believe that credit markets continue to offer compelling value over the medium term. Spreads are exceptionally wide by historical standards and yields on large parts of the market offer equity-like returns.

In our opinion, credit remains attractive for those investors prepared to take a medium-term view.

Paul Read is co-head of fixed income at Invesco Perpetual

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