Credit Market Outlook

Financial sector stress: how much more can we expect?

Originally published in the July/August 2008 issue

We expect risk premiums to come under renewed pressure in the short to medium term, driven by the combined impact of rising inflation and continued rating downgrades, leading to further capital concerns for financials and consequent asset disposals. Moreover, the current weakening backdrop of an equity market driven by inflationary concerns is likely to compound this. That said, in the US, as the impact of the fiscal stimulus package filters through in Q3 driving stronger growth numbers, we could well see equities getting a positive impetus. This will provide some interim relief. However, looking into and beyond Q4, we see the ongoing escalating cost pressures continuing to dampen earnings' results and profit guidance, which in turn will put further pressure on equities and credit. This, coupled with continued asset write-downs/downgrades, will drive risk premiums higher.

We retain our Underweight recommendation on credit as a whole, with a more positive bias for investment grade (IG) credit, particularly IG cash bonds as opposed to CDS. In our view, IG credit is, currently, fairly priced from a fundamental standpoint, ignoring excess mark-to-market risk premium. This view is based on the potential of future ratings deterioration in light of weaker growth and higher inflation. Thus, IG main and CDX IG indices, which are trading in the ranges of 80-100bp and 100-130bp, respectively, are close to fair value. At the worst point of the fallout from the dotcom bubble, the equivalent of IG main traded at 140bp. This highlights the fact that the previous wides of this year were technically driven. If there is any further technical de-leveraging or CDO hedging pressure, IG CDS spreads could well widen out to the 150-160bp level again, but are likely then to mean revert.

Within IG credit, we have a strong Underweight recommendation on the cyclical/consumer discretionary sectors because of the impact of higher inflation and slower growth. The risk of default in IG remains low given that most IG companies do not face refinancing hurdles.

In high yield (HY), the expected deterioration in future fundamentals does not match HY risk premiums, especially given the leverage of some of the issuers and the weak capital structure of the debt profiles. Moreover, the high yield and leverage loan primary markets remain very weak, unlike that of IG credit, making it difficult to tap funding in spite of lower yields. With the increase in the cost of goods, many HY companies are starting to draw down on their loan facilities or PIKing on their toggles as working capital is being drained faster than expected owing to the higher energy and raw materials prices and weaker end markets. We expect high yield defaults rates to hit 7-8% in 2009 in the US, and 4.5% in Europe on an issuer-weighted basis. However, debt exchanges, several of which have already occurred in the US, are likely to keep the market-weighted default rate lower, at least through H1 2009. Current valuations (500bp for Xover and 640bp for CDX HY) are pricing in a 2009 default rate of circa 6% for Xover and circa 8% for CDX HY for a 40% recovery rate (bear in mind this calculation assumes that spreads are paying you for default compensation alone with no compensation for mark-to-market risk or liquidity). At the height of the2002 default cycle, Xover spreads hit 1,500bp. We do not expect high yield spreads to reach this level. However, we believe the peak for this cycle is likely to be around 700bp for Xover and 1,000bp for CDX HY. Moreover, as cost pressures rise, EBITDA is set to decline, especially for consumer-based companies and companies that are highly dependent on oil, energy and raw materials. This, in turn, will put pressure on covenants. That said, timing is key. We do not expect significant fundamental problems for the next quarter, but instead it should build up gradually in the months to come.

Ratings downgrades remain the key risk for structured products; be that synthetic CDOs, CLOs or mortgage-related structured products. Any further downgrades could well cause further liquidations from banks: off balance sheet and on balance sheet. Moreover, additional ratings downgrades will put further pressure on the monolines ratings (as witnessed with the recent MBIA1 and Ambac2 downgrades). Such downgrades could cause more headaches for banks and brokers as risk weighting of these assets on bank balance sheets would jump appreciably. As such, we see potential for further selling pressure and lower mark-to-market valuations for structured products. That said, for certain products this will create further attractive entry points for cash-rich investors to pick assets that are priced below their fundamental value.

Liquidity in secondary IG and HY bond markets will remain weak given dealers' inability to hold inventory. VAR limits have been reduced for trading books and any spike in volatility means that more assets will have to be shed. In addition, banks' capital is under pressure as risk-weighted assets weigh on bank balance sheets. As such, we expect the basis between cash spreads and CDS to remain wide, with most of the liquidity being focused on the CDS market.

We recommend the following trades/positioning:

  • Steepeners in 5s7s and 5s10s on stable investment grade companies remain attractive as core holding trades owing to high spreads, flat curves and low curve volatility. We have shown3 that such steepeners are the most efficient way to generate carry and roll-down in terms of minimising mark-to-market risk, typically showing a 60-80% improvement over selling 5yr protection outright.
  • In financials we expect credit to become more closely correlated with equity markets in H2 2008, especially for the small to mid-cap financials. We would recommend a reduction in the long financial debt-short equity trade.
  • There are many names where differing risk profiles are not being reflected in curve shapes: for example, there is no pricing differentiation between industrial non-cyclicals and cyclicals. We expect industrial non-cyclical curves to trade substantially steeper than cyclical curves.
  • We believe that the Hi-Vol Index, which consists of nearly 90% cyclicals, is likely to significantly underperform under high inflation and low-growth environments. As a result, we recommend shorting the Hi-Vol Index versus either the sub-Fin or the Main Index.
  • We recommend buying forward protection in iTraxx Main and Xover as an appealing short position, benefiting from low carry cost and complementary curve dynamics that dampen volatility.
  • For high yield names, we prefer trades with a flattening bias. On cyclical sectors such as airlines, paper/packaging and chemicals, DV01-neutral (bearish) flatteners may be attractive closer to the Q2 results period, while equal-notional (bullish) flatteners are currently appealing on some wider/steeper trading less-cyclical TMT names.
  • We expect companies that are exposed to rising inflationary pressures (ie, airlines, autos, steel, paper/packaging, US Gaming, chemical and non-food retail) to have significant scope for further underperformance.
  • We have an overweight preference for less cyclical sectors such as utilities, telecoms, energy, metal/mining and tobacco, and in HY, we recommend being in those sectors we view as counter-cyclical, namely, Telecoms and Cable.

Financial sector considerations

A broad range of financial institutions remains subject to asset quality and capital concerns, despite massive write-offs, asset dispositions, layoffs and capital raises over the past three quarters. This reflects a combination of credit, economic, regulatory and other variables that are unlikely to disappear soon. The good news is that central banks and other policy makers are well aware of these concerns, and are expected to continue to provide liquidity to ensure that systemic shocks related to financials do not occur. The bad news is that further ratings downgrades, asset dispositions and weak risk appetites by important financial intermediaries will weigh on credit, mortgage and other asset valuations over the near term. Broker balance sheet de-levering has commenced and we expect most big US banks and selected European banks to follow suit shortly (Table 1).

Two monoline insurance companies (MBIA and Ambac) have suffered downgrades from AAA to AA because they disagreed with S&P's interpretation of necessary capital. Moody's was even more aggressive, lowering these two companies to A2 and Aa3, respectively. In our opinion, less ratings-sensitive entities (ie. the banks) may also accept the greater financial/capital flexibility afforded by lower ratings (of one or two notches) because the economic cost to them is lower than issuing costly equity. The brokers, which are already rated lower than the banks, do not have the same level of ratings indifference (particularly from a counterparty confidence perspective) and are more likely to seek capital or more aggressive de-leveraging solutions (eg. asset sales at a greater loss).

The ramifications of these developments are not positive for financial credit spreads in the near term:

  • De-levering initiatives will lead to a greater supply of new issue equity and capital securities, as well as higher levels of other securities offered into the secondary markets as assets are shed at market-clearing levels.
  • Ratings downgrades for less ratings-sensitive companies. This is likely to put additional pressure on net interest margins and/or foster greater structural subordination of unsecured creditors as banks or brokers make greater use of collateralised borrowing.
  • Constrained balance sheet lending will lead to greater disintermediation of the banks and tighter credit availability for weaker borrowers. New bond supply is likely to come from (principally high yield) debtors that previously borrowed from the banks. Spreads on such public market transactions are likely to re-set secondary levels wider.

However, these painful developments combined with closer regulatory oversight and support should lead to a well fortified financial sector, which bodes well for longer-term credit market conditions.

Implications for US financial institutions

Although it appears that the majority of losses associated with the sub-prime mortgage debacle may have been recognised (US$200 billion in the US so far), fairly recent deterioration in other consumer and commercial finance receivables signals the very beginning of the loss cycle for these asset classes. As delinquencies rise further, higher loan loss provisions will be one of several earnings-related challenges that lenders, monoline insurers and ABS/MBS investors will face over the coming months.

In addition, revenue opportunities will continue to be constrained by tighter, protectionist lending standards and the potential for lower net interest income as a result of asset reduction initiatives (ie. de-leveraging) and greater levels of low-yielding liquidity pool investments. The spectre of higher inflation may add some much-needed relief by virtue of a steeper yield curve, but this has yet to materialise in any meaningful fashion. Lastly, another round of downsizing and related severance costs appears necessary in Q3 or Q4, if existing infrastructure does not match revenue opportunities.

Consequently, questions about the adequacy of capital will become more pervasive as the cycle unfolds. In addition, more disciplined regulatory regimes and/or more conservative interpretations of accounting policies may also require another call for greater capital. Although equity capital has been plentiful to date, the cost of ensuing capital raises are likely to become successively more expensive and/or dilutive, as rating agency or regulatory thresholds for the most cost-efficient (hybrid) forms of equity reach their limit. In such an environment, financial institutions will weigh the economic cost of raising new capital versus the cost of suffering a ratings downgrade (and the prospect of diminished counterparty confidence).

Given this fundamental perspective, we believe that the creditworthiness of many US financial institutions will decline in the coming months to varying degrees, depending on the level of credit deterioration in their lending/investment portfolios (including hedges) and their appetite for more expensive equity capital. Within this context, credit selection is very important and as such, we are reluctant to make very broad comments. With that said, however, we believe that the money centre banks and brokers will outperform the regional banks. Specialty finance companies no longer trade as a sector, but as a collection of idiosyncratic credits. From a cyclical perspective, commercial finance companies should outperform their consumer finance peers in H2 2008.

Implications for European financial institutions

We think capital adequacy will remain an important theme for European banks in a weakening macro economic environment, as downwards rating migration and lower recovery rates will lead to higher risk-weighted assets under Basel 2. In 2009 and beyond, we also expect some regulatory hardening. The Basel committee has already highlighted plans to increase risk weights against complex structured credit (CDOs in particular), but we also think the regulatory spotlight will shift from the banking book to the trading book and thus the biggest changes will affect those European banks with sizeable investment banking operations. Recent events have highlighted inadequacies in the regulatory regime for allocating capital against trading assets and in particular the limitations of using VAR methodology (such as correlation assumptions) to model the tail risk and thus unexpected loss.

In light of higher capital requirements, we think the need to bolster capital is likely to continue to dampen lending appetite over the course of the next 12 months. We also think the ability to tap equity markets for capital remains an important component of banks' intrinsic creditworthiness and we expect credit to become more closely correlated with equity markets in H2 2008. The heightened volatility of UK bank stocks in recent weeks has led some market participants to question the appetite of the equity market to underwrite losses and the risk of a negative pricing dynamic.

In general, however, we would expect capital to be available to the leading banks in each country at the right price, but we remain more selective on mid-cap/smaller names with less robust business models, including those that were big users of securitisation as a funding tool.


  1. 1. MBIA was downgraded to AA watch negative by S&P and A2 outlook negative by Moody's.
  2. 2. Ambac was downgraded to AA watch negative by S&P and Aa3 outlook negative by Moody's.
  3. 3. Buy 5s7s: Same carry, less vol, European Alpha Anticipator, 16 May 2008.