Renewed anxiety about the health of the US economy and large companies such as Citigroup and General Motors has led to fears in the credit markets that the worst of the crunch might not be over.

The high-grade derivatives index has widened to 138 basis points after being as low as 90bp in mid-May. The Merrill Lynch US High-Yield Master II index, the benchmark for the high-yield cash market, is showing a spread of more than 700bp over US Treasuries. In March, the high-grade derivatives index reached 193bp, according to Markit, while spreads on cash junk bonds topped 850bp.

“In the last few weeks, hopes that the financial markets had turned the corner have faded,” says Martin Fridson, chief executive of Fridson Investment Advisors, an investment management firm specialising in speculative grade debt.

The mood in the credit markets had improved considerably in the months after the near-collapse of Bear Stearns in March. Wall Street was able to unload some leveraged buy-out debt left over from the boom and write new business. At the same time, the blockbuster bankruptcy or default that investors had feared failed to materialise. However, poor economic data, concerns of further writedowns at the big banks and problems at US carmakers have rattled investors.

“A number of industries are in full-blown recessions: the housing industry, the airline industry, the auto industry and some would say the retail industry and the banking industry,” says Derrick Wulf, a portfolio manager at Dwight Asset Management.

US carmakers, which have billions of dollars of junk-rated debt, have stumbled as surging petrol prices and low demand for sports-utility vehicles hurt sales and cash flow. Long-term bonds of Ford and GM have sold off in the past week and now trade about 55-65 cents on the dollar, which are considered distressed levels. Ford is the largest member of the Merrill index. GM is in the top 10.

The spectre of stagflation does not help. Higher costs, but flat or lower sales and profits hurt a company’s ability to service and repay bonds, especially those companies that are the most hamstrung by debt.

For the rest of the year “there will be spread volatility, a few more negative headlines, a few more investment-grade issuers downgraded to junk and an increase in the default rate”, Mr Wulf says.

Through May, the default rate has doubled, but it is still historically low at 2 per cent. It is expected to surge to 5 per cent by the end of this year and to 6.3 per cent a year from now, according to Moody’s Investor Service.

(FT, 27th June 2008)

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