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Comment: Relief for banks, but markets remain fragile

Ingrid Neitsch, a portfolio advisor with FRM Credit Alpha, says that while last month saw a return of liquidity to the credit markets, the environment remains fragile and more risk-adverse than in the first half of the year.

September saw a cautious return of liquidity to the credit markets, dampening volatility and narrowing credit spreads from their August highs. The decision by the Federal Reserve to cut interest rates by 50bps partly enabled this reversion, giving comfort to investors that the Fed was sympathetic to the market turmoil.

Against this backdrop, FRM Credit Alpha delivered an estimated gain of 0.4 per cent month-to-date up to September 21, bringing its estimated return to 7.7 per cent since its launch on April 1 this year. This follows a gain of 3.2 per cent in July and a decline of 0.9 per cent in August, both volatile months in which the credit crunch precipitated by the sub-prime crisis worsened and claimed new victims.

For September, none of the large events that threatened to derail the market proved to be major stumbling blocks. The announcement of poor third-quarter earnings from Bear Stearns, largely due to losses in the sub-prime markets, was offset by the very good earnings announcement from Goldman Sachs on the same day. The rollover of short-term asset-backed commercial paper in Europe, touted as a potential catalyst for turmoil, passed without major incident due to increased inter-bank liquidity.

In such an environment, a common theme across managers in FRM Credit Alpha was the ability to generate profits from trading the tightening of market dislocations that opened during the August turmoil. However, the market remains fragile, and certainly more risk-adverse than in the first six months of the year. There are still many issues surrounding the US housing market; the US consumer appears weak; and around USD300bn of loan issuance in the US alone is waiting in the pipeline to be placed. These and other issues have the potential to return us to the turmoil of July and August.

In addition, FRM has observed a common theme that suggests that hedge funds are gearing up for more supply than demand in coming months - the launch of 'dislocation funds'. The concept is simple, to purchase 'hung bridges' from lenders at discounted levels. The execution, however, may be more difficult. With so many players lining up to provide liquidity to the banks, the levels at which deals will be completed is unlikely to be as rich as some participants hope.

The Merrill Lynch US High Yield Master II index returned 2.4 per cent in September, implying a return of confidence to fundamentally strong assets. The cash high yield spreads are 35bps tighter, at 420bps at month-end, compared with a value of 455bps at the end of August.

Toward the end of September, the loans backing the USD26bn First Data Corp LBO deal were in the process of being sold to investors, in a deal seen as a bellwether for the health of the primary loan market. The CDS and LCDS spreads on First Data Corp tightened significantly mid-month, as it became increasingly clear that the banks would be able to offload a large portion of these loans. Recent news flow has suggested that the banks have managed to syndicate out around USD10bn of their exposure at a spread of +350bps; finally allowing the wider market to breathe a collective sigh of relief.

As with the cash markets, CDX spreads tightened significantly during September. The investment grade index tightened from 68bps at the start of the month to 62bps at month-end. Similar levels of tightening occurred in cross-over and high yield indices, in both the US and Europe. ABX indices rallied briefly on the news of the Fed rate cut, but the lower grade (BBB and BBB-) indices ended the month close to new lows. Higher grade indices showed volatile returns, but largely ended the month close to where they began.

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