Global Investing

Bond investors’ pre-budget optimism in India

Ten-year Indian bond yields have fallen 30 basis points this year alone and many forecast the gains will extend further. It all depends on two things though — the Feb 28 budget of which great things are expected, and second, the March 19 central bank meeting. The latter potentially could see the RBI, arguably the world’s most hawkish central bank, finally turn dovish.

Barclays is advising clients to bid for quotas to buy Indian government and corporate bonds at this Wednesday’s foreigners’ quota auction (India’s securities exchange, SEBI, will auction around $12.3 billion in quotas for foreign investors to buy bonds). Analysts at the bank noted that this would be the last auction before the central bank meeting at which a quarter point rate cut is expected. Moreover the Reserve Bank of India will signal more to come, Barclays says, predicting 75 bps in total starting March.

That is likely to be driven first by recent data — inflation in January was at a three-year low while growth has slowed to a decade low.  Barclays notes:

Based on our economists’ view of a 25bp repo rate cut in Q1, and a further 50bp in Q2, we expect the bond curve to fall around 55bp in a parallel move. As such, we recommend extending duration to long end bonds….Given high carry, attractive price returns and our forecast for modest nominal appreciation of the  rupee, we expect an approximately10% dollar return (FX unhedged), and a 7% return (FX hedged) on 30-year bonds in the next six months.

But what could eventually determine the extent of policy easing is the upcoming 2013-2014 budget.

Fears of collateral drought questioned

Have fears of global shortage of high-grade collateral been exaggerated?

As the world braces for several more years of painful deleveraging from the pre-2007 credit excesses, one big fear has been that a shrinking pool of top-rated or AAA assets — due varioulsy to sovereign credit rating downgrades, deteriorating mortgage quality, Basel III banking regulations, central bank reserve accumulation and central clearing of OTC derivatives — has exaggerated the ongoing credit crunch. Along with interbank mistrust, the resulting shortage of high-quality collateral available to be pledged and re-pledged between banks and asset managers,  it has been argued, meant the overall amount of credit being generating in the system has been shrinking,  pushing up the cost and lowering the availability of borrowing in the real economy. Quantitative easing and bond buying by the world’s major central banks, some economists warned, was only exaggerating that shortage by removing the highest quality collateral from the banking system.

But economists at JPMorgan cast doubt on this. The bank claims that the universe of AAA/AA bonds is actually growing by around $1trillion per year.  While central bank reserve managers absorb the lion’s share of this in banking hard currency reserves,  JPM reckon they still take less than half of the total created and, even then, some of that top-rated debt does re-enter the system as some central bank reserve managers engage in securities lending.

Citing a recent speech by ECB Executive Board member Benoit Coere dismissing ideas of a collateral shortage in the euro zone, JPM said ECB action in primary covered bond markets and in accepting lower-rated and foreign currency collateral had helped. It added that the average amount of eligible collateral available for Eurosystem liquidity operations was 14.3 trillion euros in the second quarter of 2012 — with 2.5 trillion euros of that put forward as collateral by euro zone banks to be used in the ECB’s repo operations of 1.3 trillion.  Critically, the majority of that 2.5 trillion posted at the ECB was either illiquid collateral such as bank loans or collateral associated with peripheral issuers and thus unlikely eligible for use in private repo markets anyway, they added. This process of absorbing low quality collateral in order to free up higher-quality assets for private use has been an approach of both the ECB and Bank of England.

Emerging bond defaults on the rise, no surprise

As may be expected, the crisis has increased the risk of default by emerging market borrowers. According to estimates by ING Bank’s emerging bond guru David Spegel, the default rate on EM bonds is running at over $6 billion in the first four months of 2012, already surpassing the 2011 total of $4.3 billion. He  predicts another $1.3 billion of emerging defaults to come this year.

Spegel expects the default rate for speculative grade emerging corporates to rise to 3.25 percent by September, up from 3 percent at present.  That doesn’t look too bad, given defaults ran at 13 percent after the 2008 crisis and hit a record of over 30 percent in the 2001-2003 period. But ING data shows some $120 billion worth of corporate bonds trading at “distressed” or “stressed” levels, i.e. at spreads upwards of 700 basis points. The longer such wide spreads persist, the higher the probability of default. A worst case scenario  would see a 12.9 percent default rate by end-2012, Spegel says.

Many companies are having trouble rolling over maturing bonds (selling debt to pay off existing creditors). One reason might be the explosion in bond issuance this year. Data from Bank of America/Merrill Lynch shows bond sales by emerging borrowers, sovereign and corporate, totalled 14 billion in the first three months of the year, a quarter more than the same 2011 period.  Clearly everyone is rushing to raise cash before U.S. Treasury yields rise further. (see what we wrote on this a few months ago)

Corporate bonds in sweet spot

Anticipation is running high for the ECB’s LTRO 2.0 due on Feb 29.

The first such operation in December has largely benefited peripheral bonds even though estimates show banks used a bulk of their borrowing (seen at  just 150-190 bln euros on a net basis) to repay their debt, as the graphic below shows.

 

 

At the second LTRO, banks are expected to use the proceeds to pay down their debt further. That is a good news for non-bank corporate credit because banks — busy deleveraging — are more likely to repay existing debt than roll over and existing holders of bank debt will need to look elsewhere to allocate their assets.

“Apart from the shrinking size of (European bank bonds) some investors might want to get out of them anyway and allocate assets somewhere else… Credit spreads are pricing in a very pessimistic scenario. There’s a very good value in non-banking credit,” says Didier Saint-Georges, member of the investment committee at French asset manager Carmignac Gestion.