Negative sentiment has been fuelled by a couple of bad news reports. Bear Stearns halted redemptions in a mortgage-related hedge fund in the US, and Australia's Macquarie Bank said two of its bond funds may suffer potential losses of up to 25%.
As stocks rose yesterday, MoodyÆs darkened the mood again. The credit ratings agency placed MGIC Australia's rating on review for possible downgrade. MGIC Australia, is a wholly-owned subsidiary of Mortgage Guaranty Insurance Corporation, a leading mortgage insurer in the US.
In this environment, investors are finding it impossible to price risk. The benchmark iTraxx Crossover index, which consists of 50 mostly junk-rated credits and is an important indicator of sentiment, broke the 500 barrier on Monday û illustrating the heightened cost of insurance for the most risky assets. But it came down again substantially on Tuesday, closing at 402, while rising once again on Wednesday to 475.
Says one specialist high-yield investor: ôThis magnitude of change only happens every five to 10 years. Investors are so nervous they just don't know what to do with their money and are behaving erratically."
However, Robert Lind, head of macro research at ABN AMRO, states that these significant market moves should be viewed as a ônormalisationö, which has come about following a bullrun in credit where investors ôbought anythingö, at prices which did not adequately reflect the risk.
ôThe areas which have suffered the most significant compressions are the high-yield debt sectors in emerging markets. These markets should be perceived as very vulnerable and warrant a much greater risk premium than they have offered so far. We still need to see investors exercise considerably more discrimination in their assessment of risk.ö
Since the tight spreads over the last few years have come about by in an era of historically low interest rates in an environment of strong global growth, Lind thinks it is likely that rates will increase. This should lead to a gradual widening of spreads, although recent events û which were long overdue û reflect a process which can occasionally be quite dramatic.
In its latest credit commentary, BNP Paribas says: ôThe amplitude and velocity of spread widening in the cash bond, asset swap and CDS sectors virtually ensure the markets will overshoot. The growing sense of dread however over rising contagion risks and falling liquidity conditions hints at fear-driven trade trumping credit rating upgrades and the positive trends in economic, inflation, and interest rate data; thus we anticipate more widening in credit spreads."
However, interest rates are still far from restrictive. According to Lind, the greatest concern is whether the market is appropriately pricing in the risk of the US housing problem, which triggered the correction in the first place, and inflation, which are the two factors that could dampen global growth.
ôFundamentally, from our perspective, investors need to be cautious of corporate bonds. They are still too expensive. If they want to play the economic cycle, a better way of doing so is via the equity market, which is still well-supported in terms of valuation and growth. Obviously, we are still in an environment where the pressure on credit could continue to weigh on equities, so investors should shift from riskier areas of the equity market to safer ones.ö
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