Hold on tight for 2006


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Nobody in their right mind would spend the week before Christmas trawling through the credit outlooks for 2006 published by investment banks, so Euromoney has done it for you. The good times should continue to roll, but look out for some painful bumps along the way.

And at first glance it makes for comforting reading: “Spreads in Europe to remain tight,” says Lehman Brothers, while ABN Amro forecasts a benign outlook in 2006. How does this play out for fixed income, which has provided the bread and butter for many investment banks for the past five years, even though M&A and equities have returned to the fore in 2005?

Setbacks such as General Motors or Delphi did not stop the majority of banks enjoying another stellar year. Almost all have reported record profits and fixed income/credit has been at the forefront of increased earnings. Sales and trading, origination, structuring and lending business have been highly profitable businesses in investment grade, high yield and emerging markets.

But storm clouds are brewing that could make the coming 12 months even more volatile for fixed income franchises than the previous year. Watching the auto sector is like watching a car crash in slow motion. You can see it coming, you think you know what is going to happen next, but it seems impossible to stop. The leveraged structured credit sector is the most obvious area where the stresses will manifest themselves.

And rising interest rates could threaten the stream of liquidity that has boosted housing markets, although the US sector has stood up well so far after a whole year of Fed hikes.

Rising equity markets bring their own risks for credit quality as they encourage greater leverage or M&A activity. The fact that the more savvy operators are already building up their distressed debt teams tells a story. Idiosyncratic credit risk is on the rise but few banks are pulling their lines; in fact, far from it.

Banks are increasingly willing to lend cash to corporates at tighter than ever spreads. The only rationale for subsidizing credit in this manner must be cross-selling opportunities. But the leading fixed income franchises increasingly have a tough time staying ahead of the pack. Almost all the banks’ product specialists have matrix structures and revenue sharing agreements to ensure they grab their fair share of a customers’ wallet.

Banks looking to build market share, such as Royal Bank of Scotland, Bank of America, Calyon and a resurgent Bear Stearns, are increasing the competitive pressure on the more established players. The trends of increased asset growth – financed by tier 1 issuance — greater leverage, tighter loan spreads and a relaxing of loan standards continue apace. But perhaps the greatest risk come from actors such as hedge funds or financial sponsors/private equity. They enjoy the lightest regulatory touch and are highly aggressive.

Those with longer memories will recall the last time we saw excessive leverage, booming equity markets, and the rise of the unregulated, street-savvy investor. It was in the late 1990s. Let’s hope that all good things don’t have to come to an end.