Despite the global slowdown, corporate bonds have been notably resilient and yield spreads have remained tight. This is partly because of a rapid boom in the structured credit market.
Since the turn of the year, most investment experts have bought into the general consensus that we are heading for an economic slowdown, both in Britain and globally. All other things being equal, one might expect this to result in a widening of yield spreads and, therefore, a weakening of the prices of corporate bonds.
Yet lately, corporate bond markets have continued to show a fair amount of resilience to any external factors. Credit spreads – the difference between the yield on corporate bonds and those on similarly-dated British government bonds – have shown only a little widening bias over the past six months. And any widening we have seen has come about because of the volume of bond issuance that has come onto the market since the beginning of September.
But why should credit spreads have held at such tight levels? One of the main reasons is the rapid boom in the structured credit market. Since the turn of the 21st century there has been a huge surge in the market for complex financial instruments such as collateralised debt obligations.
A study by Celent, a financial services consultant, estimates that the size of the global CDO market will rise to almost $2trn (£1.1 trn) by the end of 2006. Bond investors are now presented with a bewildering array of new products, few of which are easily understood.
In simple terms, a CDO is a structured transaction in which a special purpose vehicle is established to sell credit protection on a range of underlying assets. This basket of assets might include credit default swaps, leveraged loans and asset-backed securities.
This demand continues unabated, and we foresee a large pipeline of synthetic credit deals – levered transactions that create a strong demand for credit assets. This feature has resulted in some dislocation between bond markets – where the current economic environment makes investors nervous of credit spreads – and credit default swap markets – where there is continued strong demand for corporate bonds.
In such a low-yielding environment, issuance has moved towards more risky parts of the capital structure. The fact that credit risk is now widely spread across a diverse pool of investors via CDOs is a primary factor in keeping credit spreads tight.
Recently we have seen a big uplift in the issuance of new instruments called corporate hybrids and non-step perpetual bank deals. Most of the hype at present focuses on the Constant Proportion Debt Obligation. This esoteric structure is credited by many industry observers with having a major influence on the narrowing of European credit spreads.
CPDOs take credit exposure in the derivatives market of up to 15 times the amount invested. They involve selling credit default swap protection on corporate credits using, for example, European iTraxx index contracts. The built-in leverage magnifies the available returns – and these are proving extremely popular among risk-averse but return-hungry investors.
However, one would have to counsel caution. Some investors may be buying them without fully understanding the risks, and may be incorrectly pricing the different CDO tranches to reflect risk. The popularity of CPDOs is largely down to the fact that they have been rated AAA by the ratings agencies. However, they are far from risk-free.
The phrase “irrational exuberance” springs to mind, and it may be only a matter of time until some participants reassess their risk profiles and retreat from the market.
With the trend towards high-alpha, unconstrained,
fixed income mandates among pension fund investors, such investments are likely to grow in popularity. Happily for retail investors in the credit markets, the increasing popularity of these investments has had a beneficial knock-on effect, acting as a prime contributory factor to corporate bonds performing rather better than might have been expected of late.
Other factors are likely to weigh as much, if not more, on corporate bond yield spreads in the next few months. We expect global economies to slow. At the same time, we are experiencing an environment in which companies favour equity investors over debt investors – either by levering up the businesses through mergers and acquisitions, or by investing more heavily.
The leveraged buyout threat remains ominous, and there have been a fair number of large deals recently. In July, we saw the largest LBO ever to take place, when four private equity investors bought HCA, an American hospital company, in a deal worth more than £18bn.
For this combination of reasons, credit spreads will continue to widen throughout 2006 and into 2007 – probably by roughly 15 basis points over the next 12 months.