European credit, already reeling from the worst sell-off since credit default swaps took off earlier this decade, is likely to fall further as complicated products unravel and corporate creditworthiness deteriorates.Last Wednesday the cost of insuring debt from big European blue-chips against default, as measured by the 5-year iTraxx Europe index, hit 136 basis points - a record high for the four-year old index, and up from just 50 basis points at the start of 2008.
But analysts say after years of falling credit spreads, driven by the creation of hundreds of billions of euros of structured products, the market has gone into reverse.
That technical pressure means, many analysts say, that credit spreads are now wider than is justified by fundamental factors - the risk of corporate defaults. But the problem is judging the right time to step in, with no clear indication spreads will reverse soon.
“At first glance, credit looks extremely wide versus fundamentals,” said Willem Sels, credit strategist at Dresdner Kleinwort. He said that was perhaps partly on expectations that fundamentals will get worse.
“But in the current climate, fundamentals do not need to deteriorate for spreads to widen,” Sels said in a note. “When markets drop, they create a self-enforcing negative spiral. We believe spreads will spike much further beyond fair value in this cycle than in the past.”
Higher, and more volatile, credit spreads have all but shut the corporate bond market, making it difficult or prohibitively expensive for European companies to raise new debt funding.
Worries about monoline bond insurers have driven the sell-off, coupled with fears of unwinding of structured products such as collateralized debt obligations (CDOs) and constant proportion debt obligations (CPDOs) as they hit key triggers.
In a vicious circle, that forces holders to unwind positions by buying protection, pushing index spreads wider still.
Those triggers for CPDOs, analysts at Barclays Capital say, are around 140 to 150 basis points on the iTraxx Europe.
“We are exactly mirroring the impulsive stage (around 2004) of the bull market as intense credit structuring led to moves that dominated considerations of fundamentals,” said William Porter at Credit Suisse.
“Now the market is widening despite general consensus that spreads have run ahead of fundamentals and certainly of defaults.”
Simon Ballard, global credit strategist at ABN AMRO Asset Management, said last week had been “the worst week on record for high grade credit.”
“Every time you think all the bad news is out there, something else pops out,” he said.
Spreads on the mostly junk-rated Crossover index - at 580 basis points - and the Europe index are factoring in “Armageddon,” Ballard said. He said fair value was 65 to 70 basis points for the Europe index, and 450 basis points for the Crossover.
US junk bond defaults stood at a 25-year low in January, at 1.09%, according to rating agency Standard and Poor's, but S&P reckons they will leap to 4.6% over the next 12 months.
And Bob Janjuah, a credit strategist at RBS, reckons defaults could go much higher – 12% in the United States and 7% in Europe.
“Anyone that says that credit is oversold on technicals and cheap on fundamentals ... yes, but for five years it was overbought on technicals,” Janjuah said.
“You cannot ignore the technicals. Behind the technicals are fears that fundamentals are getting worse as well.” (Reuters)