Investors regain appetite for credit risk

Financial times – Published: July 21 2009 14:38

An important barometer of European appetite for risk in the credit market on Tuesday reached a level not seen since the collapse of Lehman Brothers last year.

The Markit iTraxx Europe, the continent’s main credit default swap index, which tracks the 125 most liquid names in the investment-grade class, fell below the 100 basis points mark for the first time since September 2008.

CDS are over-the-counter derivatives, which offer insurance against the non-payment of unsecured debt, usually corporate or sovereign bonds. The cost of cover is measured in basis points, each point being equivalent to €1,000 payable annually on €10m of debt.

The recent tightening of CDS indices comes on the back of a strong rally in European equities, which have risen for seven consecutive sessions.

Gary Jenkins, head of fixed income research at Evolution, said: “It’s a reflection of the fact that credit remains the asset class of choice. Companies are focused on cash flow generation, debt reduction and improving balance sheet strength, which is close to being the perfect backdrop for credit.”

In spite of some fears that ongoing uncertainty surrounding the economic outlook will continue to pose challenges for credit, the market is likely to take heart from the an upsurge in companies raising money via rights issues.

“Anything to put off the day of reckoning, and of course given time a lot of these companies may well be able to place themselves on a sounder footing,” Mr Jenkins said.

The index tracks the risk of default by the 125 most traded investment-grade corporates. The last time it traded below the 100 basis points mark was less than a week before Lehman collapsed.

Following the implosion of the US investment bank, the cost of insuring against the risk of default on European corporate debt shot up by almost 20 per cent in two days, before spiking at just more than 200 basis points last December.

“Lehman created the prospect of total collapse of the financial system, which was priced in after it fell, but the market is now saying ‘we are no longer looking for this complete meltdown’. Governments have done enough to prevent that,” said Willem Sels, head of credit strategy at Dresdner Kleinwort.

Another factor behind the current rally is a growing sense of optimism among investors over the possibility that the global economy will emerge from the downturn sooner than was initially expected.

However, some analysts worry that the index, which widened to as much as 207 basis points earlier this year, is close to being over-priced.

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