Bond Outlook May 21st

Rarely have so many disruptions and disquieting trends hit the world economy simultaneously. Accordingly, it is difficult to understand the relative calm of financial markets:

• The credit crisis is entering its second phase with the liquidity problems more or less solved but the full impact of the credit squeeze still to come
• The world is rapidly running out of cheap oil, while new, expensive oil and alternatives are not yet on stream
• The demand for oil and food from the Asian developing economies is growing hugely
• Switching agriculture to ethanol production has exacerbated the food shortage
• The dangers of a Mideast flare up are increasing
• The data on inflation is misleading
• The US economy is in recession

We do not intend this week to go through these various assertions, but rather to use them as a backdrop to a particular problem which we see as a major component of the second phase of the credit crisis: credit default swaps (CDSs). Early warning signs arose in April from Swiss Re, reinforced by AIG’s much greater write-downs last week on CDSs (USD 9.1 billion). Now AIG is waving a huge red flag on the topic. The insurance group is raising USD 20 billion in new equity with an implication that future losses need be prepared for now.

If these write downs on CDSs were “simply” a problem of insurance companies which have strayed away from their core business, there would be little to worry about. However, the problem is much wider, as indicated by the Basel Committee on Banking Supervision’s report: quote: “The trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world”. Likewise George Soros describes the counterparty risk in CDSs as a “Sword of Damocles”.

The Basel warning specifically mentions hedge funds. Traders in CDSs include banks, pension funds, mutual funds, insurance companies and hedge funds; it appears that the last two have ended up as the net sellers of CDS cover. At least insurance companies are subject to regulation, which means that they have had to reveal their CDS write-downs. The unregulated nature of hedge funds gives them, in contrast, plenty of opportunity to keep their exposure hidden.

The CDS market has crept up on the world while bond default rates have been historically low. It is equivalent to a huge (USD 50 + trillion is often cited) insurance market which has grown with close to no regulation and little control over the financial strength of counterparties to meet claims.

The CDS write downs by insurers are for the moment a reflection of rules applied to them (but not to many others) about marking to market. The impact of actual default has yet to be felt. Yet it will be substantial. A year ago Fitch estimated that 40% of CDS protection was for sub-investment grade bonds. That figure may well be over 50% today, including CDOs, while Moody’s is forecasting at least a 5% default rate on such bonds this year.

What does this mean for fixed-income investors? Basically they should construct their bond portfolios with properly understood and built-in risk/reward relationships. Relying on CDS protection may be to live in a fools’ paradise.

Focus

(!) Equities: six consecutive days of gain in European stock markets despite the rising oil price were broken as oil reached a new peak

(+) AUD: has broken the AUD/USD ceiling of 0.96 as the RBA implies further hikes

(–) US PPI: at 6.5% slightly less than expected at 6.7%

(+) Euro zone: 0.7% quarterly progression in Q1 vs. 0.2% in USA, and business climate quite positive

(?) Finland: April decline in unemployment (6.2% vs. 6.8% in March)

(+) Switzerland: new bond issues often offer higher yields than similar bonds in circulation and may offer possibilities for switching

(!) Iceland: the Central Bank is seeking emergency aid. Inflation is approaching 12% and the overnight rate is at 15.5%, which has not prevented the ISK losing 26% against the EUR this year

(+) positive for bonds (–) negative for bonds (!) watch out (?) begs the question