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Credit Market Analysis - The credit cycle turns (III): the outlook for credit spreads
Credit Market Analysis 30 August 2007
The credit cycle turns (III): the outlook for credit spreads
In the previous Credit Market Analysis, we showed that the UK insolvency rate is forecast to rise in the next two years, even if global economic growth remains strong, as we expect. In addition, the rise in capital gearing means that the UK corporate sector has become more vulnerable to external shocks and hence the risks to the insolvency rate forecast are to the upside. In this comment, we analyse the prospects for UK corporate credit spreads following the repricing of risk that we have seen in recent months and given our expectations of rising insolvency rates.
Credit spreads have increased significantly...
UK investment-grade (IG) and high-yield (HY) cash corporate bond spreads relative government bonds have widened sharply this year, as chart a shows. This suggests that the cost of raising capital in the debt markets for both IG and below IG companies has increased, while investors require extra premium for holding corporate bonds. Credit default swaps have also risen significantly, reflecting increased demand for credit derivatives to hedge against defaults, though more recently they have fallen from their peaks, see chart b.
...but still remain tight on a historical basis
The widening of credit spreads in recent months in our view is a positive development. This is because spreads had been too low in recent years, reflecting the abundance of liquidity and low interest rates, which led to gross underpricing of risk. Chart c shows HG and HY corporate spreads from a longer-term perspective. It shows that HY spreads remain below the long-term average, despite the recent increases. IG spreads, however, are slightly above their long-term average, reflecting wider spreads for financial corporations exposed to the US subprime mortgage market, as chart d shows. This is mirrored by sharp falls in equity prices for financial corporations. For industrial (i.e. nonfinancial) companies, IG spreads remain just below the long-term average. This implies trading opportunities may exist between financial and non-financial bonds.
High-yield spreads to widen further, but investment grade spreads may narrow
We therefore see scope for HY corporate spreads to widen further towards the long-term average of about 550bps, reflecting rising corporate insolvency rates, see chart e. For IG spreads, however, we believe that markets are pricing in a very gloomy scenario of the impact of US subprime mortgage on the financial sector and the selloff may therefore have been overdone, as chart f shows.
Hann-Ju Ho, Senior Economist
Economic Research,10 Gresham Street,
Lloyds TSB Corporate
London EC2V 7AE,
0207 626 - 1500
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