Corporate Bonds: Europe’s crisis makes US look good for now

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By:
Hamish Risk
Published on:

European regulation could favour US assets; US growth prospects better than Europe’s

Last month’s decision by Germany’s regulators to impose a ban on short selling of sovereign credit default swaps and all stocks traded in Germany could benefit the US corporate bond markets, as investors move to a jurisdiction with more regulatory certainty and as growth prospects between the regions decouple.

"There is a risk connected with how Europe handles the current sovereign credit problem. There is a danger that the European markets could shut down if market participants continue to see uncoordinated government action," says Gaël de Boissard, co-head of global securities at Credit Suisse in London. "It is harder for investors to look at the European markets with confidence; and if that’s the case, they will go elsewhere."

No immunity

US markets have not been immune to the volatility created by the European sovereign debt crisis, and corporate bond issuance markets have been hit globally. Companies worldwide issued $47 billion of debt in May, down from $183 billion in April, which is the least since December 1999, according to data from Bloomberg. Meanwhile credit spreads widened the most since October 2008 when the banking crisis was at its height, according to Bank of America Merrill Lynch’s Global Broad Market indices.

"The flight-to-quality trade that has benefited the dollar and US treasuries is unlikely to be unwound in favour of Europe, but rather in favour of riskier US dollar assets"

CreditSights

That said, as some analysts point out, the European crisis hit at a time when US equity and bond markets had rallied over the past year. The S&P 500 had rallied for 13 months and corporate bond spreads, particularly high-yield spreads, had delivered investors returns in excess of 50%. Markets priced to perfection ran straight into the European crisis buzz saw, says CreditSights, an independent credit research company. But once the panic recedes the US has much better growth prospects than Europe, it adds.

US dollar assets have already been performing their traditional role as a safe haven in times of financial market turmoil, with yields on US treasuries falling to their lowest levels this year, at the expense of high-yield debt, where according to Bank of America Merrill Lynch indices risk premiums have risen 150 basis points since touching a low for 2010 of 542bp in late April. As investors assess the prospects for the US economy, they might start switching out of the lower-yielding risk-free assets and move into the more attractive spreads in the corporate bond market, according to CreditSights.

"The flight-to-quality trade that has benefited the dollar and US treasuries is unlikely to be unwound in favour of Europe, but rather in favour of riskier US dollar assets," say CreditSights analysts Peter Petas and Glenn Reynolds. "With the tail risks of sovereign default and the euro crisis continuing to hang over the market, reserve substitution in favour of the dollar probably accelerated in May and might have further room to run."

Default and recovery

High-yield debt markets have continued to outperform equity markets since the collapse of Lehman Brothers in 2008, while the so-called ground zero of credit investing, default rates and recovery rates, have improved dramatically in 2010, so investors might well look to tip their toes back into the water.

"The world may remain a dangerous place for credit markets, but from a contingent risk standpoint it is much safer than a year ago with respect to the bank system and how that flows into investment grade and the leveraged finance sectors," say Petas and Reynolds.