C.M.O. 2.11.2009

Credit Market Overview

During the most of 2006 and the beginning of 2007 the demand for fixed income securities was such that investors were forced out the maturity and credit curves, sometimes simultaneously, to achieve whatever incremental yield they could obtain.

The CDS market saw a ratcheting in of spreads during this period, which would normally be good for equities but at times the stock price of the company in question declined along with spreads as well as bond and stock investors did not appear to be in synch.

Something similar is happening in the credit markets at the moment but this time for a different reason; CDS spreads for a good portion of the names in the CEC universe have come in since late January but the stocks have not rallied and in fact, most had a quite horrible day on Tuesday.

Every cross-asset relationship goes through periods when it works and other times when the answer to that question is “not so much”. This is one of those N.S.M. times but beyond the simple observation the question “why” needs to be asked.

Part of the answer comes from something I have written about often recently, the relative “cheapness” of corporate paper on a spread basis. That CSCO could issue $4BN in debt this past Monday, made up of $2BN of 10-year notes at 200bps over Treasuries and $2BN of 30-year paper at 225 bps over is testament to the demand for quality corporate paper. My CDS pricing source does not list 30-year CDS but the 10-year spread for CSCO was 96.3bps on Monday. This still shows some hesitancy by investors to use balance sheet space but that is a story for a different day.

CSCO is rated A1 by Moody’s and A+ by S&P and I think its safe to assume for the sake of this argument that since CSCO is not some CDO^2 that the two rating agencies have this one right. Additionally there have been $78.3BN worth of investment grade bonds issued in 2009 that were not supported by a government guarantee. (More evidence of demand)

The other part of the answer comes from looking at where spreads were and why they were there. Back on December 2nd of 2008 HPQ issued $2BN worth of 5-year paper but needed to pay a spread of 460bps over Treasuries to attract buyers. HPQ is rated A2/A so while slightly less credit worthy than CSCO the shorter maturity probably evens the rating difference out and we see that there was much more fear and less demand back in December. (The 5-year CDS spread for HPQ was 107.7bps at the time.)

Using these two debt issues as examples we can see that some of the fear has come out of the market and as that has happened the demand for paper has increased.

Stocks on the other hand are not enjoying the same resurgence. Many well known investors have been quoted in the media as saying that the stock market won’t come around until the credit market does, this makes sense given where the two asset classes reside on the balance sheet. The demand for paper is encouraging but the difference between CDS spreads and where corporations have to issue still shows some problems there.

People have also said that the “financials led us into this mess and they will have to lead us out”. I am not here to say whether those people are right or wrong but with the likes of BAC down 19.30%, C down 15.19% and WFC down 14.22% yesterday if they are correct we have some work to do.

Enjoy the week.

Jim Delaney

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