01/08/2007

Opportunities In Credit

Despite the recent concerns in the credit markets, driven primarily by the fallout from the deteriorating US sub-prime mortgage market and indigestion from a very large pipeline of leveraged loan financing, the longer term outlook for corporate bonds remains relatively positive, according to research published today by leading investment house, Standard Life Investments.

In the latest edition of Global Insight, its monthly investment view, Standard Life Investments assesses the fundamental drivers of the corporate bond markets, including the business cycle, risk appetite, liquidity and corporate credit. It concludes that the recent sell-off presents an investment opportunity. Although defaults will rise they should still be lower than historical averages.

Richard Batty, Global Investment Strategist at Standard Life Investments, said:

"Recent weakness in the corporate bond market has raised investor concerns that the fall-out from the sell-off in the US sub-prime mortgage market will affect many more names than Bear Sterns or UBS, the two companies that have seen substantial losses in some of their hedge funds. While in the short-term other firms will reveal losses, and credit spreads could well widen further, our assessment is that on more meaningful medium term investment horizons, the back-up in spreads presents an investment opportunity.

"Our research shows that as long as the macro economic cycle remains relatively benign, then the historical relationship between cyclical indicators in the US such as business surveys or measures of risk appetite suggests that riskier corporate bonds such as high yield should out perform investment grade and Treasury bonds.

"Clearly there are risks, especially from pressures in the US regarding the extent to which the economic, consumer and housing cycles remain subdued and how that impacts on the credit derivative, mortgage backed securities and general credit markets. Related to this is the extent to which the current low default rate starts to pick-up.

"There are a number of key triggers we need to see unfolding to cause a significant rise in defaults beyond what we have already experienced during the last year. The first is credit quality. The rating agencies currently expect default rates to rise from historically low levels, but to remain below relative to average defaults we have seen through the course of recent cycles. Secondly, the impact of the economy will be an important driver of defaults. Our analysis indicates risks mount as and when US economic growth falls below 1.5% a year on a sustainable basis. This compares to 2.8% pa consensus estimates for 2008 after 2.1% pa expected in 2007. Additionally, a material rise in the unemployment rate would be needed.

"Liquidity is not as plentiful compared to, say, six months ago as some banks have been affected by the recent tightening in US lending conditions, and not just for sub-prime mortgage holders. If there were a number of large LBO problems impacting bank balance sheets or risk appetite generally this would also cause defaults to rise. A number of high profile credit derivative exposed names getting into trouble, leading to tranche downgrades and large scale unwinding of leveraged positions, would be a further concern.

"Putting these risks into context, our analysis - based on forecasts of a period of positive if sub-trend economic activity - suggests corporate bond defaults will rise to around 5% but remain below the peak of 10% seen in the early 2000’s."