Credit Market Bottom Nowhere In Sight

by: J.D. Steinhilber

Last week was another volatile one, when the S&P 500 managed to rally 1.4% despite fresh evidence of breakdowns and risk avoidance in credit markets. The latest corner of the credit markets to be infected by the contagion is the $350 billion "auction rate securities" market, which froze up last week amid the continuing buyer�s strike that is accompanying the unwinding of the credit bubble.

Auction rate securities are short-term debt instruments principally used by municipal bond issuers and leveraged closed-end funds. As a result of the drying up of the auction rate markets, short-term borrowing costs for such issuers spiked last week. Leveraged closed-end funds typically enlarge their portfolios by 30-40% through the use of auction-rate debt, and use the positive spread between borrowing costs and portfolio returns to boost distributions to shareholders. The sudden spike in funding costs and lack of demand for auction rate securities threatens to eliminate that positive spread and precipitate a de-leveraging process that could lead funds to liquidate a portion of their portfolios in an already weak market.

No doubt this situation will create opportunities for intrepid closed-end fund investors to acquire funds at large discounts to stated net asset values. The situation also highlights the challenges faced by the Federal Reserve in resolving the credit crisis. While the Fed has slashed the Fed Funds rate by 225 basis points over the past six months, credit markets have gotten progressively tighter.

Credit spreads (i.e. the yield premium to Treasuries) have exploded for high yield bonds, to 634 basis points from a low of 192 basis points early last summer. Spreads on high quality debt securities have also spiked to recession levels. Spreads on investment grade corporate bonds, as well as mortgage-backed securities issued by Fannie Mae (FNM) and Freddie Mac (FRE) (which carry an implicit government guarantee), are at or near their highest levels of the past 20 years.

Such wide spreads on a variety of debt asset classes has prompted us to take a close look at whether we are being presented with an attractive buying opportunity. Thus far, we have had trouble mustering much enthusiasm for two reasons. First, spreads may be attractive but absolute yields remain unimpressive. This is a function of what we consider excessive valuations in the Treasury market, where yields generally fall short of compensating an investor for inflation. (In recent weeks, long bond yields have started to tick higher, so perhaps Treasury investors have begun to take notice of the fact that commodity indexes continue to set records and that the government has resorted to the most blatant form of inflation - literally printing money out of thin air to fund rebate checks.)

The second reason why we are hesitant to bottom-fish in "spread" fixed income asset classes is our view that this credit contraction has much further to run. The cyclical rise in corporate bond default rates has barely begun and with home prices still in decline the ultimate size of mortgage related losses (including for the government sponsored entities) remains very much an open question.

Given the dysfunctional and highly risk-averse state of the credit markets, stocks have been holding up reasonably well since the panic lows of January 21-22. However, in assessing the roughly 8% recovery in the S&P 500 from those lows, we must consider that (1) stocks had become extremely oversold amid extreme bearish sentiment at that time, setting the stage for a relief rally; and (2) the Fed has just delivered the most aggressive, concentrated easing in its history, and its reflationary efforts have been assisted by the government's stimulus and bailout package. Viewed in this context, the stock market recovery has been rather meek.

The S&P 500 needs to break above 1400 (its late January peak) to signal an improved technical backdrop. Such a move would break the down-trending pattern of lower highs and lower lows that has been in effect since the mid-October peak in stock prices. If the market is going to stage this sort of rally in the short-term, it appears it will do so without the support of retail investors, whose redemptions from equity mutual funds and ETFs are running at the highest level since the bear market of 2001-2002. Year-to-date through February 13, investors have redeemed over $60 billion from equity funds.

These funds have principally been shifted into money market funds, despite falling money market yields. This behaviour reflects the risk aversion and pessimistic sentiment that currently prevails owing to falling home and stock prices, soaring food and energy cost, and a deteriorating employment market.