High Grade Strategy
We turned tactically bearish on HG spreads this week due to low bond yields and several developing risks including 1) the fiscal challenges for Greece and other European countries, 2) uncertainty about the path of mortgage bond spreads after Fed buying is complete and 3) uncertainty on Financial industry regulation. On all three issues the JPMorgan view is an outcome likely to be benign for HG credit investors. But risk/reward on spreads seems skewed to the bearish side after the strong rally since Dec 1 and the overweight position of many investors. Medium term we remain bullish on improving credit fundamentals which are evident in the current earnings season.
Credit Derivatives
CDX and CDS underperformed bonds in the recent sell-off, as expected. This has pushed CDS-Bond basis less negative and CDX.IG basis to +5bp, the top end of its recent range. Option volatility has increased more in the short end as investors reflect the near term risks discussed above.
Features
Structured Credit after the Crisis: The note analyses the diversity of structured products traded and the drivers of differences in product performance. It represents the first of a series which will analyze the performance of CSOs over the last few years. Our key conclusion: The performance of the underlying credits in the portfolio rather than the attachment point on the capital structure was the key performance driver.
CDS infrastructure update:
The CDS infrastructure continues to improve. Over the last months, select single name CDS have been cleared through the ICE clearinghouse, and client clearing is now available at both ICE and the CME.
Risk 1: Greece and the risk of sovereign defaults in Europe
Our economist for Europe, David Mackie, published a note this week laying out the case that the challenge facing Greece and the other small European countries is liquidity, not solvency, and therefore the default risk is very low (“Reflections on fiscal stress in the Euro area: liquidity and solvency,” published on January 27, 2010). The extent of fiscal cuts necessary is large, but not too large to be unrealistic, and other countries such as the Scandinavians and Turkey have achieved similar adjustments when required in past crises. Liquidity issues can be resolved with loans from the International Monetary Fund (IMF) as well as from the EU (the balance of payments assistance program), European Investment Bank (EIB), European Bank for Reconstruction and Development (EBRD), and World Bank, as Latvia, Hungary, and Romania have each received recently. This assistance does not nullify the need to make the painful fiscal adjustments, however, so it comes down to the willingness of the Greek government and population to accept the fiscal program. The fiscal adjustment the government has proposed is aggressive enough to meet the challenge, in our view. The next steps to watch are its passage through parliament, the reaction from the population, and the actual fiscal data as they are reported each month. It will take several months to assess whether sufficient progress is being made.
The fiscal challenges in Greece also exist in other European sovereigns, as well as in developed markets and the US municipal bond markets. The difference so far is in the extent that markets are charging more for the risk in some of these smaller European sovereigns while access to low-cost funding remains available for the large European countries and US munis. Further pressure in Greece will highlight that fiscal challenges are widespread in the US and Europe.
The link between further uncertainty in Greece and HG bond market spreads is potentially through a flight to quality that pushes UST yields lower; a weaker euro versus the dollar, which harms US exports and corporate earnings reported in dollars; and general risk aversion, which raises spreads for all products.
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