Credit market forgets fundamentals

Fri Jan 18, 2013 5:53am EST

* Investors, bankers warn market overlooking fundamentals

* Recession risk still looms in periphery

* Downgrade potential underestimated by market

By Josie Cox and Aimee Donnellan

LONDON, Jan 18 (IFR) - Contracting spreads, bumper books, negative premiums and record-low coupons - it all sounds like the glory days for credit. But the fundamentals underneath are shaky, and many say it's just a matter of time before reality catches up to the market.

In the opening weeks of 2013, a host of murky peripheral credits have accessed the bond market with ease, selling longer-dated deals as investors desperately search for yield.

Since the beginning of 2012, the iTraxx Main has contracted by approximately one-third, while spreads on some corporate bonds have snapped tighter by as much as 50%. The Senior Financials index has tightened by almost half, as has the iTraxx SovX Western Europe index.

In all, the market feels like its too good to be true, said Patrick Wuytens, head of high grade syndicate at ING in Brussels.

"It's like we're driving downhill in a car at high speed, but we haven't noticed that the car's out of fuel," Wuytens said. "As soon as we stop going downhill we could be in for a nasty shock."

He said the problem is that the market is filtering out the glum headlines and only concentrating on the good news.

A number of investors share this view, saying that little has changed in the economies of peripheral countries to warrant the spread contraction seen in recent months.

"The rally is being driven by a hunger for yield because it is so difficult for investors to buy assets that give them attractive returns," said a Germany-based portfolio manager at one of the largest fixed-income investment houses in the world.

"No one wants to miss the boat, so we expect this contraction to continue despite the fact that the underlying fundamentals are not improving."

OMINOUS SIGNS

Iberian and Italian banks have capitalized on investor willingness to ignore the ominous headwinds they face.

The International Monetary Fund expects Spain to remain in recession through much of 2013 while Italy, having recorded a 0.2% economic contraction last year according to government figures, is predicted to decline 0.7% this year.

According to Fabrice Jaudi, vice president at S&P Capital IQ, yields have fallen significantly in the past three months despite the fact that market risk has not - and that the underlying problems in peripheral economies remain. He defines market risk by the risk of losses arising from movements in market prices.

Just last month, Spain's service sector recorded its 18th month of declining activity. Nonetheless, Iberian debt has been snapped up in primary markets.

Spain's Telefonica and Gas Natural, both rated Baa2/BBB/BBB+, priced 10-year euro transactions at subscription levels of over 600%.

The 10-year spreads on the Spanish sovereign are bid at 5.1% - they last dipped below these levels in March 2012 and are down from a high of 7.6% in July.

BES, Portugal's second largest private bank by assets, meanwhile has attracted a EUR3bn order book for its EUR500m five-year deal.

This week, second-tier issuers from Italy like Credito Valtellinese and Banco Popolar di Milano, rated Baa3/BB+/BBB-, were also able to place deals, and Spanish Kutxabank, absent from the market since 2011, has hired banks to sell a four-year covered bond.

"Sooner or later, we'll all wake up and smell the coffee," said Wuytens. "The question is just what could or will trigger that."

DOWNGRADE RISKS

Bankers are speculating about what form this wake-up call might take, and several have referred to the corporate earnings season and the risk of rating cuts.

Aluminium producer Alcoa Inc, whose results traditionally mark the unofficial beginning of the season, this month said that it was optimistic about 2013 but still very conscious of a looming U.S. budget confrontation.

Meanwhile Germany's SAP - the world's biggest business software maker - reported fourth-quarter revenue that missed expectations this week.

One day earlier, compatriot Deutsche Post said it expected that 2013 would "not be easy" as a weak global economy continues to weigh on demand for express delivery and other logistics services.

Fitch strategists, in a report published this week, predict that EMEA corporate downgrades would outnumber upgrades in 2013.

Other headlines that could derail the rally and provide a rude awakening include macroeconomic woes in the U.S. and sovereign downgrades - either stateside or in core or peripheral Europe.

On Tuesday, Fitch said that the US faces a "material risk" of losing its triple-A status if there is a repeat of the wrangling seen in 2011 over raising the country's self-imposed debt ceiling. The agency also said that Spain would continue to face downgrade risks - even if it does not ask for a bailout.

High-yield market participants are already concerned that in the event of a Spanish downgrade, with heavyweight issuers such as Gas Natural, Iberdrola, Repsol and Telefonica subsequently junked, the market could be grossly knocked off balance.

This could result in a shock reminiscent of the dislocation caused when Ford and General Motors lost their investment-grade status in 2005. (Reporting By Josie Cox, Aimee Donnellan; editing by Alex Chambers, Marc Carnegie.)