posterous kontent

Credit, like equity, has rallied hard this year. This is understandable: credit markets, at the epicenter of this cycle, led other risk assets on the way down, so it always seemed reasonable that they would lead on the way up (Exhibit 1). More to the point, at the lows some credits appeared exceptionally cheap - effectively pricing in economic Armageddon - in a way that equities were not. That's why our credit strategists anointed 2009 as 'the year of credit', expecting handsome returns.

Our credit strategists remain broadly positive. However, the strength of the rally means that credit no longer appears a one-way bet. If there were a correction in risk assets, credit presumably would also face a setback.

Credit stress is usually a late-cycle phenomenon. This cycle, of course, is different. Sub-prime stress was the early warning of problems to come. I define sub-prime borrowers as those that can survive only so long as asset prices are rising and credit is cheap - in other words, they can run into trouble even before the real economy deteriorates. Sub-prime - mortgage and corporate - started to wobble then topple from early 2007. But, as is usual, economic deterioration causes credit losses. This cycle is very deep, so is causing substantial cycle-related (aka 'prime') credit losses.

Leading indicators suggest further significant corporate losses (Exhibit 2). According to our credit team, fundamentals continue to deteriorate, even though companies have improved liquidity positions. Leverage for the nonfinancial investment grade universe continued to move higher in the March quarter, admittedly at a slow pace. Less comforting than the pace of the ramp in leverage was the breadth of the increase. Over two-thirds of companies, the largest number in our nearly 20-year data series, had higher leverage in the March 2009 quarter compared to the same period last year. (See Greg Peters, Making The Best Of A Bad Situation, 5 June.)

In housing, the pattern of rising delinquencies, rising foreclosures and accelerating lender losses has spread from sub-prime to Alt-A products to prime mortgages. Exhibit 3 shows the losses on Alt-A mortgage products, by vintage. (Our structured credit team has expanded its coverage of non-agency residential mortgage-backed securities. It has created collateral indices for Alt-A and prime jumbo RMBS products, along the lines of the ABX indices for subprime. See Vishwanath Tirapattur, Remittance Reports: No Green Shoots, 29 May.)

Greg Peters now sees some risks for corporate credit. (What follows is taken from Thoughts Against The Grain, 29 May.) These include:

1. US rating downgrade/US$ weakness. Historically the relationship between credit pricing and the dollar has not been strong. However, sovereign/currency stress is a tail risk that could unsettle credit investors.

2. Credit markets could become more two-way as investors lock in profits. This could offset the favorable cash-flow outlook: we estimate that the funds available to be recycled in corporates through coupon payments and maturities at around nearly $600bn in high-grade corporate maturities and nearly $200bn in coupon cash flows during 2009.

3. While average valuations continue to look attractive, it's hard to find an 'average' credit. Both investment grade and high-yield markets - particularly the latter - have bifurcated: most paper has rallied, but a rump has been left behind. Exhibit 4 shows the distribution of investment grade universe. The yield on most issues is below the average, while there's a tail with much higher yields (in many cases, deservedly so).

4. The return of stress in the financial sector. This is not our base case. However, there are lingering tail risks, including: the possible return of off-balance sheet risks to the banking system; weaker macro put a question over stress-test results; weaker dollar increasing systemic risks; or failure of PPIP/TARP to clean up balance sheets. 
 

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