Concern over slowing US economic growth, increased borrowing to fund mergers and acquisitions and investor risk aversion are likely to push credit spreads wider in coming months, said analysts on Friday.
Investors who believe the credit markets are yet to feel the pain seen in equities in recent weeks might consider putting on steepening trades on the iTraxx or CDX credit default swap indexes to mitigate the impact of any sell off, analysts said.
"If you think spreads will go wider it makes sense to buy 10-year protection and sell five-year," said Saul Doctor, an analyst at J.P. Morgan. "You would expect the longer end to under perform, while at the short end you benefit from better appreciation over time."
The spread on the 10-year iTraxx Europe index has widened 3 basis points in the past month to 56.3 basis points, while the five-year portion traded 2.5 basis points wider at 34.3 basis points. The lack of divergence suggests the benefits of the trade are still to come.
Longer-dated fixed rate securities sell off faster than shorter-dated assets in a slowdown because a longer maturity increases the probability of default over the time of the contract. "We are expecting further spread widening in the second part of the year," said Hans Peter Lorenzen, a strategist at BNP Paribas. "A housing slowdown in the US is a possibility, and there is risk from mergers and higher borrowing."
Mergers and acquisitions surged in the first part of the year, hitting a five-year high in the first quarter and storing up a mountain of borrowing that is expected to hit the markets in the next six months.
Bankers are split on the outlook for US interest rates, a key indicator of the economic outlook, with some predicting the Federal Reserve may not lift its key rate much beyond the current 5 percent, while others see a rise to as high as 6 percent.
"That shows the divergence of views about where the economy is heading," Lorenzen said. Higher interest rates hurt bonds because they erode the value of their fixed returns.
Cash bonds have underperformed credit derivatives in recent weeks. The iBoxx index of European corporate bonds was at 50.5 basis points early on Friday, compared with a tight level in April of 41.5 basis points. Equity markets across Europe have fallen as much as 10 percent since the beginning of May.
The iTraxx series 5 indexes, meanwhile, are trading at about the same level as they were at launch in March, having been boosted by hedging of complex portfolios known as collateralised debt obligations.
"The key question now is whether credit is going to catch up and sell off," said J.P. Morgan's Doctor. Equities rallies in recent days were not matched in the credit markets, suggesting a decoupling may have already begun. Still, not all bankers are pessimistic about the outlook for credit, and do not buy into concerns over the outlook for the US economy.
"We are actually quite constructive on credit, and think the inflation and interest rate scare in the US probably won't materialise," said Gregorios Venizelos, a structured credit strategist at ABN Amro. "We wouldn't recommend a steepening trade because even if you pick up a couple of basis points, you might lose out if longer-dated securities start to rally."
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