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AmericasNovember 1 2012

Bull market waiting to turn in debt capital markets

Demand for credit has been very strong in the US this year, opening opportunities for high-yield, European and emerging market issuers. But there are risks on the horizon at home and abroad.
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Bull market waiting to turn in debt capital markets

If the doomsayers are to be believed, the US economy is on the brink of disaster. Unable to agree a fiscal consolidation package in mid-2011, Democrat and Republican parties set a formula where an automatic set of deep spending cuts and tax exemption expiries would kick in from the start of 2013. This is the so-called fiscal cliff. The idea was that policy-makers were applying pressure on themselves to come up with a less catastrophic way of reining in the budget deficit.

In the year of presidential and congressional elections, that idea has not so far worked out. Not that the debt markets appear too concerned. On the contrary, with investment-grade yields tightening so much that pension funds struggle to earn the 5% or so they need to pay out annuities, US investors have been willing to move down the credit curve and buy into less familiar names from Europe and elsewhere just to find a better rate of return.

Mark Howard, head of US credit strategy for BNP Paribas, says concerns over the US elections and the fiscal cliff had been drowned out for much of 2012. Massive central bank buying of eurozone government bonds, US Treasuries and mortgage-backed securities (MBS), and the shrinking of balance sheets by the big US government agency borrowers such as Fannie Mae and Freddie Mac, all drove every type of credit investor to take on more risk. This led to plentiful inflows to high-yield bonds, leveraged loans, structured credit such as collateralised loan obligations, and emerging market credit. But the mood is beginning to turn.

“Today, while the income investors such as insurers and pension funds still need to hit their liability-driven return target, money managers believe credit has rallied too much to offer further value, and some hedge funds are preparing to turn outright bearish,” says Mr Howard.

Reasons for optimism

Ashish Shah, head of global credit at $420bn US fund manager AllianceBernstein, believes there is still room for upside surprises. While business decision-making has been delayed by the elections and fiscal cliff, consumer sentiment has been more affected by the newsflow on the eurozone crisis.

“At the moment, the deterioration in the eurozone is if anything turning out to be less than expected. Anything resembling a resolution to the crisis could release pent-up demand, and rates would start to rise again, driving demand for risk assets,” says Mr Shah.

In addition, the stabilisation of the US housing market is a major boost, especially for non-agency MBS, says Michael Canter, director of structured assets at AllianceBernstein. There is also a broader ripple effect from the US Federal Reserve buying and reinvesting $40bn per month in MBS markets – about two-thirds of new issuance. He says the most recent programme of quantitative easing, known as QE3, has tackled one of the distorting effects of central bank buying, by building in an early roll of maturing bonds in the portfolio.

“Fed buying means that agency-wrapped mortgages are less attractive for banks, so it is starting to have the desired effect by pushing banks into commercial and industrial loans,” says Mr Canter.

Watch emerging markets

However, there are risks to US markets from well beyond its borders. Mr Shah says China is engaged in a very delicate economic balancing act, which is also occurring at a time of political transition.

“The Chinese authorities want some cooling to avoid the economy overheating. But this will have a knock-on effect for demand in specific industries. Corporate credit is now very global in nature, investors are not thinking so much about whether a company is based in Europe or the US, but about where its demand is coming from,” says Mr Shah.

Moreover, even though US investors continue to favour European corporate credit, they remain more cautious about the banking sector, which is still in the eye of the sovereign debt storm. Research by Fitch Ratings showed that US money market funds had cut allocations to eurozone bank credit by one-third in June 2012, to just 8% of their total portfolios. By contrast, allocations to Japanese banks had doubled over the preceding year, to 12% of total portfolios.

Mr Howard says that US investors with deep underweight positions in European financial institutions were beginning to increase allocations during the early part of 2012, after the advent of the European Central Bank’s Long-Term Refinancing Operations. And liability management exercises by European banks had shrunk the supply of bank paper on the market. But at current levels, he believes there could be profit-taking, and the appetite for further buying will be moderate without a sell-off in the market.

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