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December 31, 2008

Key Investment Deals for 2009

The extreme volatility in credit derivatives markets since Lehman Brothers collapsed in
September has brought sharp leaps and falls in the cost of protecting the debt all kinds
of companies.

Banks were hardest hit initially, but the gathering global gloom has hit other industries
such as mining, oil and gas, carmakers and retailers.

  • Equities are significantly over valued versus credit
  • Corporate bonds and loans are compensating investors for the downside risk if you
    ignore funding
  • CDS risk premiums on financials and large corporates are not fully pricing n the potential impact of rising sovereign default risk: this is an issue for iTraxx Europe and iTraxx Asia
  • The cash-CDS basis looks very attractive; however, it will remain negative and very
    dislocated, as long as repo funding costs remain high
  • IG (Investment grade) and HY (High Yield) corporate bond spreads staying at these levels if financial institutions continue to struggle to de-lever
  • Remain more pessimistic on European IG than US IG, given the heightened sovereign
    risk in Europe

As equity valuations fall further and bond yields trade towards zero, pension funds that are close to breaching their solvency limits will need to be looking at better yielding, high-quality, longer-dated corporate bonds to drive returns coupled with diminished supply, this could well create a positive technical for cash credit over time.

Defaults are set to climb markedly in 2009, given current unprecedented credit conditions. The potential for large variance in default projections is high: 10-20%. Based on a bottom-up analysis, expect 10%. Lending standard projections point to a baseline peak rate of 14.3% increasing into 2010.

This down cycle is looking very similar to that of the 1970s. These cycles exhibit
surprising regularity in how they play out, and the early-warning indicators that have worked over the past 40 years worked this cycle too.

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