Bond Outlook May 7th


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All the economic news is negative or not so bad as expected. We therefore suspect a bear trap, which may even extend to some bonds. Beware Credit Default Swaps.

Bond Outlook [by bridport & cie, May 7th 2008]

One of the inevitable results of masses of cheap liquidity is that its search for a home creates bubbles, i.e. it pushes asset prices up beyond anything that might be called underlying value or the result of matching basic supply and demand. One such bubble is commodities, and another, the resurgent stock market. That, at least, is our best explanation of rising stock markets despite a plethora of negative news (increasing losses in the financial sector, ever tighter credit, mortgage losses at Fannie Mae, many bankruptcies and the like). The “good news” is now expressed as “but not so bad as expected”, and this phrase can be applied to unemployment, GDP, consumer spending, etc. This situation has all the makings of a bear trap.

Our basic description of the economic situation remains:

  • A recession in the USA as consumers succumb to the credit squeeze and the loss of equity in their homes
  • A chronically weak USD
  • Expansion, but more restrained, in the emerging markets
  • More or less muddling through in Europe, with limited damage

All of this is rather obvious. Two items of news however are subtle indicators of what is to come: an expansion in Level III bank assets, and losses in Credit Default Swaps.

The proportion of Level III assets (those for which no market price can be estimated but internal models may be used for valuation) is growing as Level II assets are reclassified (for Level II, market prices may be deduced from recent trades or from trades of comparable assets). The proportions here are in the order of a few percent, e.g. Merrill Lynch has increased its proportion of Level III from 5% to 8%.

What does this mean? First, that more assets are just not being traded at all. Second, that the discipline of “mark to market” is greatly softened, as the internal models, it may be suspected, are extremely “kind” in their valuations. This suggests (as we wrote last week) that more write-downs are still to come, unless, that is, the whole credit market turns around and many buyers for asset backed securities emerge. Does that sound likely?

CDSs are increasing their value for holders of cover as the cost of this insurance is rising, reflecting increasing nervousness about default potential. For issuers of default cover, however, the situation is quite the reverse, as the announcements of CDS losses from Swiss Re confirm. Issuers of CDS have liabilities against the flow of premium they receive, and that liability is also subject to “mark to market”. For them it is the market price to buy back the exposure to default. Swiss Re warned of further CDS losses in 2008 already back in November when the first losses were announced, but the 2008 losses are running at much more than foreseen. As an insurance company, Swiss Re is obliged to reveal its losses from mark to market, but there must be many net issuers of CDSs keeping much quieter.

The below the surface turmoil in the CDS market is still mainly about “mark to market”. It is not yet the result of actual default. Yet “real” default is happening. S&P announced one month ago that USD 160 billion mortgage-backed bonds were in technical default. Pimco have estimated total defaults as USD 250 billion but based a modest 1.25% default rate and 50% recovery, both of which figures are probably too optimistic. There must be many CDS issuers in as much trouble as Swiss Re. Is a bear trap also awaiting lower-quality bond investors and CDS issuers?


(!) USA: 20,000 jobs lost instead of 80,000 expected, on top of 240,000 jobs lost in Q1 2008. The sectors of construction, durable goods and finance are laying off en masse (200,000 to date), but thanks to "services", particularly small part-time jobs, the statistics do not seem too bad

(?) Fannie Mae: has raised USD 6 billion in new equity. Net loss in Q1 2008 is in excess of USD 2 billion, vs a profit of nearly USD 1 billion in Q1 2007

(–) Switzerland: UBS lost CHF 6 billion in Q1 2008 and is eliminating 6,000 positions

(+) Switzerland: Inflation is lower at 2.3% annually vs 2.6% the previous month

(+) Poland: Inflation stable at 4.1% in April

(–) Turkey: Consumer prices rose 1.7% in April over March, implying an annual rate of nearly 10%

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

Recommended average maturity for bonds.

Short across the board.






As of 23.04.08





As of 02.04.08





Dr. Roy Damary