Credit markets resilient to extraneous events in Japan and MENA

Credit markets prove surprisingly resilient in March, despite Japanese earthquake, ongoing tension in the Middle East and concern over Portugal’s debt problems

Credit markets generally held remarkably firm last month in response to the natural disaster in Japan and continuing conflict in the Middle East and North Africa (MENA).

European investment grade and crossover spreads in particular stood up strongly. The investment grade credit derivatives index iTraxx Europe Main stood only two basis points wider on March 16 versus March 10, the day before the Japanese earthquake and tsunami, while the US investment grade CDX index widened 4.5bp. Although the European iTraxx Crossover index widened by close to 40bp, touching 420bp, it had retraced to below 380bp by March 21.

“The market is mature enough to absorb what the implications will be [of the Japanese earthquake and tsunami]. There will be rebuilding of infrastructure and energy markets. Japanese equities have recovered, though clearly not fully, and European equities rebounded back,” says Dinesh Pawar, head of credit flow trading at Aviva Investors in London. “What has proved most interesting is the resilience of the credit market.”

According to traders, European credit spreads were buoyed after an EU summit on March 11, when new bailout measures for the Eurozone were tabled. Japanese spreads, understandably, experienced severe volatility. The iTraxx Japan index closed at 152bp at the wides on March 15, versus 98bp on March 10. Liquidity disappeared, with iTraxx Japan market-makers demanding 15bp bid/ask spreads, compared with 1bp under normal trading conditions.

Five-year credit protection in Tokyo Electric Power Company, owner of the damaged Fukushima nuclear plant, traded above 400bp on March 15, having been around 40bp prior to the disaster. Five-year credit default swaps in Japanese banks such as Sumitomo Mitsui and Bank of Tokyo-Mitsubishi almost doubled, to the 110bp range. European reinsurers such as Munich Re, and US insurers including AIG were also caught up in the volatility.

High yield bounce-back

While there was evidence of initial risk-cutting in high yield markets, they quickly recovered. The US high yield cash market was half a point lower in price terms on March 16 versus March 9. European high yield bonds fell on average by about four points during the volatility, before recovering by about two points.

“Given the backdrop, it’s an incredible performance for high yield bonds to fall by about four points and for Crossover to trade out by 40bp, and the moment the worst is over ratchet straight back in to the tight end of the trading range,” says Simon Thorp, head of fixed income at Liontrust Asset Management in London. “It shows that people have a belief that although it will be a bumpy ride, economic recovery is in place. It also points to the fact that liquidity is burning a hole in people’s pockets. At the moment the markets are pretty gung-ho.

He adds: “High yield bonds have recovered by a couple of points. There is still a coupon effect, so high yield indexes are about flat for the month so far [to March 25].”

Adds Craig Abouchar, portfolio manager at Castle Hill Asset Management in London: “High yield is ignoring most of the macro risks at this point, though the US market has been a bit softer. There have been some outflows in US high yield and deals have been pulled on the loan side, in particular aggressive loan repricings.”

US high yield bond funds experienced two weeks of consecutive outflows between March 9 and 23, according to data provider Lipper. Outflows totalled $1.271 billion, and followed 14 straight weeks of net inflows.

Meanwhile, volatility dampened the US high yield primary market and created a hiatus in European high yield new issuance. However, European primary issuance picked up strongly from March 21.

“There has been a tremendous issue calendar in Europe,” says Abouchar. “We’ve seen good sized deals that have met with a fairly decent reception, with deals trading up. The secondary market has been fairly well behaved.”

However, European investment grade primary issuance (particularly non-financial) has been subdued. “At times we have seen very thin markets. But that isn’t due to sensitivity to Japan or MENA,” says Pawar. “We’ve seen a drop in new issuance, which has an impact on overall liquidity. People are less willing to move portfolios given the lack of deals in the pipeline.”

Despite the scenes of devastation in Japan, and continuing volatility in oil prices, European traders consider sovereign risk to have more potential to destabilise the market. “It’s the big bear out there,” says a trader at a European dealer in London. “However, corporate credit has been strong. We’ve even seen some corporate names from the peripheral countries outperforming.”

Portugal woes

Although European credit was buoyed by last month’s EU summit, the collapse of the Portuguese government, along with the prospect of Portugal needing to restructure its sovereign debt, acted as a counterweight.

“The recent collapse of Portugal’s government continues to hang like a cloud over markets, and any news flow is reflected swiftly in financial spreads,” says Pawar. “However, we are seeing a decoupling. Sovereign spreads are affected, but corporate credit remains resilient in names that have well-diversified balance sheets and those that have delevered since the start of the credit crisis.”

Meanwhile, initial enthusiasm over the EU summit dwindled, as details of the bailout package were passed on to governments for agreement. “The markets were surprised by [the summit],” says Thorp. “It looked like policymakers were ahead of the curve. Since then, most of what had been agreed has been watered down or delayed. It’s been the usual disappointment. But the market has been so strong that it has shaken the disappointment off.”

Subordinated bank debt benefited in particular from the summit meeting. For example, Allied Irish and Banco Espirito sub debt traded in sharply afterwards.

Thorp says European financials spreads have generally been well supported. “Broadly, financials have held up remarkably well, performing better than corporates,” he says. “That is a change compared with the last two periods of softening [when Greece then Ireland were the focus]. There has been good demand for financials, with sensible buying into any weakness. We’ve seen a rotation trade [into financials] for the first time in the last six to seven months. People believe the banking sector probably represents better value.”

Cutting of financials inventory among dealers has been one factor supporting spreads. “Dealers’ inventories are pretty flat, so when bank paper comes off a few points they will be buyers rather than the other way round,” he adds.

Banco Espirito paper has been one area of focus, including for Liontrust. “We’ve been long Banco Espirito versus the Portuguese sovereign as a hedge,” says Thorp. “The trade has massively outperformed. There have been lazy shorts in place on that kind of bank name. Now people think spreads represent good value. Shorts have had most of the best of it, while longs are thinking it is time to rotate out of the safer Iberian names and pick up some banking paper.”

However, peripheral European bank names also continue to attract caution. “We want to stay away from some financial names in the medium term. It’s impossible to understand the risks,” says Pawar at Aviva Investors.