European and Asian equity markets performed well overnight, and according to the futures market, US stocks are set to have a good day as well. Yet the credit markets are in a state of near-panic. Some illustrative factoids and comments from the Financial Times:
“It is nothing short of ugly in credit land,” said Alan Ruskin, global strategist at RBS Greenwich Capital.
The turmoil has forced bankers to delay or cancel several billion dollars of new high-yield bond and loan deals, as investors demand better terms in the face of a $300bn pipeline of pending debt deals to fund leveraged buyouts.
However, it has caused dramatic spasms in credit derivative markets as investors have rushed to hedge against plummeting prices on less-easily traded portfolios of debt.
Credit derivative indices on both sides of the Atlantic on Monday pushed through new boundaries, beyond levels reached in the May 2005 credit “correlation crisis” that followed Ford and General Motors’ downgrades to non-investment grade. Credit derivatives provide buyers with protection against corporate default in return for an annual premium.
The cost of insuring the US investment-grade credit derivative index, or CDX, jumped 20 basis points to trade above 100bp on Monday morning. On June 18, the index was trading just above 30bp for five years of protection, and it has more than doubled over just the past week. Indices tracking the US high-yield and leveraged loan markets suffered similarly.
In Europe, the cost of insuring high-yield European corporate bonds against default leapt 60bp to more than 500bp yesterday, the biggest ever one-day move in the index. The iTraxx crossover index, which tracks 50 mostly junk-rated European corporate names and is a key barometer of credit market sentiment, has widened more than 250bp since June.
Jochen Felsenheimer, analyst at UniCredit, said that with intraday moves on the scale of fifty basis points or more, “betting on the next couple of basis points is credit roulette rather than serious investment”.
He added: “[This correction has been] triggered by a concern that goes right at the heart of the matter: the fear that liquidity might finally and suddenly be drained out of the system.”
Over the last few years, investors have had periodic bouts of anxiety that they might be living in a bubble. This was in part because asset prices benefited from the fact that liquidity was abundant, growth was strengthening across the globe and corporate and emerging market fundamentals were improving.
But now, as asset prices have swung violently lower, investors have difficulty gauging where the bottom will be.
Thus problems in the credit markets have led a severe and broad-based sell-off in other asset classes in recent days as investors have dramatically reassessed their risk appetite. According to an index of risk indicators across asset classes compiled by UBS, risk aversion is at its highest level since the terrorist attacks on New York in September 2001.
Indeed Ashish Shah, credit strategist at Lehman Brothers, likens the sell-off to the liquidity crisis that followed the collapse of Long Term Capital Management and the Russian debt default. “In 1998, as in the current market, we saw a broad-based ‘flight to quality’ and mass risk reduction,” he said. “In addition, leveraged players were forced to sell down positions in order to manage their risk exposures and meet margin requirements, much as we are seeing currently.”
Worse still, as Jim Sarni, portfolio manager at Payden & Rygel notes, the lack of demand for credit risk has come at a time of the year when activity usually ebbs. “We think this is more seasonal than systemic at this stage,” Mr Sarni said, noting that the basic fundamentals for corporate credit remained sound.
However, Mr Shah thinks the best recent historical comparison is the so-called “correlation crisis” of May 2005, which caused huge swings in the relative value of complex structured credit products backed by derivatives.
Back then large investment banks and some hedge funds were forced to take huge mark-to-market losses on their holdings of the riskiest portions of these products. This led to a sudden withdrawal of liquidity from the still young derivative indices as investors rushed to buy protection, but found few who would sell it.
The current movements in the credit markets echo this pattern. “Cash bonds and loans are next to impossible to move right now, or only with outrageous bid offers,” said one hedge fund trader.
Or as Jack Ablin, chief investment officer at Harris Private Bank said: “Derivatives are much more flexible [than cash bonds] and are used by hedge funds as a good way to get in and out of the market quickly.”
“Prices for credit are lower and it is both a valid correction, but also an over reaction on the part of some investors. The liquidity spigot is starting to run dry.”
The obvious question is “What gives?” How can investors in credit products have such a different perspective from their stock market counterparts?
The comparison to the LTCM era is the key. As nasty as the 1997-1998 credit crisis was, it had relatively little impact on the equity markets. The two main reasons why were first, there was no widespread asset price inflation, so a seize-up in the credit markets would not have immediate implications for asset prices. The only investment that was arguably a bubble at that time was emerging market equities, and they took a beating along with emerging market debt. Second, while the LTCM crisis could have produced a systemic failure, there was no resulting large scale institutional damage.
So it would seem that the equity markets are seeing the current credit contraction as a re-run of 1997-1998. But the underlying fact set is different. Not only do we now have bubbles or near bubbles in many markets, but it is not clear that Bernanke is as willing as Greenspan to increase liquidity to stem a crisis (although the bond futures markets are already betting on a rate cut by December). This Fed has a more pressing inflation problem than in the 1990s, and Bernanke is likely to capitulate at a later point than Grennspan would have.