Weapons of Mass Destruction - The Great
Leverage Unwind

These are uncertain times for the credit markets. Banks in particular have seen their shares stabilise but their costs of borrowing in the bond market rise. Are credit markets turning into the new Weapons of Mass Destruction? A bond issued by a previously-suspected holder of WMD (IRAQ) has rallied over the last six months and now yields only slightly more than a Tier-1 subordinated bond issued by HBOS! (See chart below).

The new Weapons of Mass Destruction are not SCUDS but CDO's, CLO's, SIVS and CPDO's. The fear of these instruments is as damaging as the reality.

The surge in CDO issuance from the end of 2004 through to the beginning of 2007 drove credit spreads and bond yields to ridiculously low levels. Since then there has been an accelerating reversal in this trend.

Credit spreads have widened dramatically since July last year, with investment-grade issues being the worst casualties. Investment-grade credit spreads are now significantly wider than they were during the last spike in defaults at the end of the dotcom boom. The current levels of spreads of both high-yield and investment-grade bonds imply some interesting outcomes for the level of (high-yield) defaults over the next year. High-yield bonds currently yield 7.3% more than government bonds, which implies that defaults should rise to 8% (still below previous peaks in 1991 and 2002). However, more concerning is that investment-grade bonds, with yields of 1.6% more than government bonds, currently imply the default rate should rise to over 20%, nearly twice that of the levels seen in 1991 and 2002.

What is causing this strange pricing? One of the reasons is the great leverage unwind. Owing to rating and spread changes, CDO, CLO, SIV and CPDO positions are being unwound, releasing previously locked-away paper into the market where buyers have had their resources curtailed and markets have been forced to move to a new clearing level. With a general reduction in liquidity, this has to be a level that is extreme. This unwind is greater in the investment-grade area as many of these issues were used in structures during the great leverage wind-up. Investment-grade has probably reached its clearing level, but high-yield may have further to go.

The fate of the monoline insurers is also overhanging the credit markets, with a monoline downgrade forcing further liquidation of positions held by banks. Splitting the monoline businesses into two would fix the dislocation in the US municipal market, but it would undermine another part of the balance sheets of the banks. A solution that involves the banks in shoring up the capital of the monoline insurers looks sensible, but do the banks have the capital or the time to put a deal together? For the sake of the credit market, let's hope so.

Once the dust has settled, investment-grade issues will stand out as being cheap and a renewed focus on reducing debt and replenishing capital by the issuers will drive the market higher. But, in the short term, this leverage unwind will keep prices depressed and volatility high.

The US central bank is alive to these problems and is cutting rates and maintaining liquidity. The European and UK authorities are a bit behind the curve. The cost of borrowing in the bond market for an investment-grade company issuing in sterling has risen from 4.7% at the end of 2005 to 6.25% now (Merrill Lynch Non-Gilt Sterling Index). The gilt market has risen 0.3% in yield terms during the same period. The non-discretionary side of recent CPI releases also highlights another increase in costs for companies. Inflation is a concern to some market participants, but when you delve into the numbers they highlight a worrying trend. In very few cases is the increase in headline inflation feeding through to wage increases. As a result, most of the increased cost of energy, food and taxes is reducing the disposable income of consumers and reducing the profit margins of companies. While economic growth is strong these issues can be ignored but, as we slip towards recession, it will become a bigger issue. The widening in spreads seen in the last few months more than compensates for these concerns.