Credit markets lose momentum after new mortgage fears

Renewed concerns over provisioning by US mortgage lenders led to some pullback for credit as October closed, following a strong advance to mid-month.

Money centre banks and mortgage financing credits in the US such as Ally Financial and H&R Block came under significant pressure last month, due to fresh questions about the cost of repurchasing improperly documented mortgages. News that mortgage lenders are expanding moratoriums on foreclosures, amid regulatory scrutiny of flawed documents, helped trigger the sell-off.

In addition, reports emerged that end-investors including Pimco, BlackRock and Federal Home Loan Banks are looking to force repurchases or put-backs of mortgages, over fears of defective representations and warranties.

Bank of America Merrill Lynch was hit hardest by the sell-off, due to its ownership of home loans originator Countrywide. BAML five-year credit protection sold off by 50 basis points in the month, reaching a high of 205bp on October 21.

JP Morgan, Citi and Wells Fargo, which with Bank of America account for three-fifths of the mortgage exposure, moved 15bp to 30bp wider. Bonds spreads came under even greater pressure.

“Depending on the securities, spreads are up to 100bp to 150bp wider, with Bank of America hit the most,” says Philip Milburn, fixed income investment manager at Aegon Asset Management in London. “It has been on fairly low volume according to broker reports, but with not enough buyers standing in the way. There could be more widening, but we would see that as a buying opportunity.”

“Mortgage put-backs are weighing on sentiment,” says Mark Kiesel, global head of the corporate bond portfolio management group at Pimco. “Near-term, there is a fair amount of volatility. There is speculation that we could see $50 billion to $70 billion of provisioning over several years. However, JP Morgan Chase, Citi, Wells Fargo and BAML produce $140 billion of earnings, pre-provisioning. The earnings power in the industry is a huge buffer against these headwinds. Capital is organically building. The bank sector continues to show credit improvement.”

According to pessimistic estimates, the cost of mortgage put-backs could reach $120 billion. Spreads among money centre banks ended the week tighter on October 22, as the market began to downplay the impact of the losses, although further spread volatility is possible.

“We will see a higher run rate of put-backs over the next few quarters and more negative headlines,” says Milburn. “However, mortgage put-backs are not a new issue. Banks have always provisioned for them. The 2005, 2006 and 2007 vintages, when the mortgage machine was in overdrive, are the most vulnerable, but it will be manageable for banks.”

Concern over mortgage put-backs had an impact more generally on credit spreads. North American high yield cash spreads bore the brunt of the volatility, with banks as well as homebuilders leading the spread widening. US homebuilders have captive mortgage origination businesses, so also face questions over representation and warranty claims.

Barclays Capital’s US high yield cash credit index moved 10bp wider in the week ending October 22. However, the index was still 2.66 points higher month-to-date on October 25. US volatility failed to deflect the European high yield bond market, which continued to rally.

“High yield continues to perform well, though one has to accept the majority of the capital upside has gone,” says Milburn. “It is now more about total return, with capital upside eroded as a result of the rally. We have had fairly active turnover in high yield positions as we have taken profits. For example, we sold Fortescue Metals Group bonds at 123 cents in the euro. That made 15bp for our Strategic Global Bond Fund and 25bp for the High Yield Global Bond Fund.”

Expectations of an additional round of quantitative easing in the US, or QE2, drove the rally in high yield and in credit assets more generally last month. “QE2 is changing relative value in the markets as Treasury curves have compressed,” says Kiesel. “The short end [of the Treasury curve] is collapsing to 1%. Investors are moving again back into credit, where valuations are still very compelling. A shift from government bonds to credit is a natural fundamentals move.”

Asset price inflation due to further monetary expansion will underpin demand for high beta assets, according to traders. “QE2 has been helping sentiment and the high beta sector,” says a trader at a European dealer in London. “It is positive for the overall macro environment. However, there is uncertainty over the timing of QE2 and the extent of the asset repurchases, and whether we will see the same in the UK and other countries.”

A sought-after commodity

Commodity names should be among the biggest beneficiaries of further quantitative easing. “You want to be in assets that benefit from QE2. We will see inflation in some asset classes and deflation in others,” says Kiesel. “In housing there are lot of headwinds still. But we are seeing inflation in commodity sectors. One of our largest overweights is commodity names, especially in the oil, copper and iron ore sectors.”

An emphasis on emerging market credit goes hand-in-hand with that strategy. “We got aggressively into selected emerging market corporate bonds 18 months ago, particularly oil and pipeline companies, as well as metals and infrastructure credits,” Kiesel says. “You are picking up a 1% to 1.5% yield premium with these emerging market companies.”

He adds that the double-B crossover bucket has contributed to the strong performance of Pimco’s US investment grade corporate bond fund, or PIGIX.

“We have delivered 20.7% returns in PIGIX annualised over the past 24 months, through September 30, with +5.2% of alpha,” says Kiesel. “We think double-B credit will continue to outperform. There is less event risk in high yield. You want to own companies where the incentives are aligned with bondholders. LBO risk and shareholder-friendly risk are in the double-A and single-A areas.”

Pimco has been buying a lot of double-B crossover credits over the last 12 to 18 months, especially the rising stars. “We moved early on. Eighteen months ago the double-B market was yielding 8% to 12%; today it is yielding 6% to 7%. That is a significant positive move.”

Meanwhile, European financials spreads remained relatively immune to the volatility among US banks and mortgage-related credits last month. Financials along with peripheral corporates performed the strongest in the European investment grade bond market over the three weeks to October 22.

“We see opportunities in financials, but with the value slightly decreasing given the rally following the Basel III rules,” says Milburn. “We see value in high quality names and banks such as RBS and Lloyds, which have been through the turmoil and are in recovery mode.”

Aegon Asset Management’s strategic global bond fund has a 22% allocation to banks, of which 9% is in tier 1 securities. Investments in tier 1 have included UBS’s 8.622% dollar-denominated paper, which was bought by the fund 18 months ago, and was called by the bank in October. “We picked up those in the mid-40s and sold in the summer at 99 cents in the dollar,” he says.

Meanwhile, some recent analyst calls have included overweights in European high beta industrial credits, such as chemicals company Lanxess and steelmaker ArcelorMittal.

However, Milburn maintains financials offer better opportunities in the current market. “We haven’t massively emphasised those kinds of names,” he says. “We prefer to look at the better value names in the financials sector.”