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Spread vetting

Bouts of volatility and nervousness remain in the market while financials continue towards recovery

The summer months are typically quiet for the sterling corporate bond market – and thin trading volumes and illiquidity mean the market can be prone to greater volatility. Since the seismic shifts of late 2008, this seems the permanent new reality.

The banks (as market counterparties) are still not deploying significant capital to trading platforms, hence weak liquidity and suscep-tibility to greater volatility. Risk appetite generally remains low although this is starting to build as markets rally but this can be withdrawn quickly.

The market has become more fragmented in terms of participants, with smaller dealing sizes the norm. None of this is likely to change in the foreseeable future. Volatility remains elevated and markets are likely to remain choppy.

Against that, though, a good earnings season has improved sentiment as generally comp-arisons have been easier and companies have protected margins through cost-cutting. Stronger than expected economic data in the Euro area has also been a support. Furthermore, the new banking capital requirements outlined under Basle 3 were less oner-ous than had been anticipated.

The spread on the iBoxx sterling corporate index currently sits at around 204bps over gilts. The index has produced an impressive total return of 11.3 per cent in the year to date, outper-forming gilts by just over 1 per cent. However, the rally in credit markets has stalled a little on US data which suggests a sharp slowdown in the rate of recovery.

UK gilt yields continue their march lower and at the time of writing are sitting at 2.89 per cent for 10 year. Invest-ment grade credit remains relatively attractive over the risk-free rate, given the current default numbers. That said, we are close to historic lows in terms of all-in yield for investment grade credit.

In the coming months, a significant amount of cash will be returned to investors through redemptions and coupons and while we currently expect issuance to pick up in September, this is likely to be insufficient to meet investor demand as cash will have to be rein-vested. New issuance currently remains low in both euros and sterling but is picking up as we enter September.

So, on balance, the market technicals should remain constructive into the year end but with bouts of volatility and nervousness remaining as eyes remain firmly fixed on the economic data releases.

Any slowdown in top-line growth for corporates is probably more of a story for equity investors rather than debt investors.

Substantial balance-sheet repair and refinancing has already taken place. We do not expect spreads to return to the tight levels of the credit boom, with spreads for non-financial corporate bonds at 20bps tighter than the range seen during the recession in Europe at the turn of the last decade. We currently view non-finan-cial credit as fair value, with potential for only moderate spread tightening into year end.

Financials, however, are moving through the repair phase towards recovery. The pattern for second-quarter results was one of improved profitability with higher net interest margins and lower operating costs, significantly lower impairment charges as asset quality improved and higher capital ratios.

For some of the stronger names, core tier one capital ratios have more than doubled since 2007, gross leverage has fallen by a third and liquidity buffers have improved in some cases by up to eight times.

We believe valuations are attractive on a medium-term view for institutions that are “too big to fail” and financials provide the greatest oppor-tunity for spread tightening.

Headline risks remain and financials are a high beta sector, particularly in an environment where sovereigns are the centre of attention. Again, however, much will depend on the economic data and it feels that a tougher oper-ating environment lies ahead.

We are in for a slow grind of economic repair to the economic damage caused by excessive leverage but spreads should remain constructive into the year-end.

Tim Butcher is an investment director in Swip’s fixedincome team



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