Fed fails to restore creditor confidence

As far as the world's biggest bond investors are concerned, the Federal Reserve is failing to restore confidence in the US credit markets.

Pacific Investment Management Co, TIAA-CREF and Insight Investment Management say the central bank's decision to lower the overnight lending rate between banks by half a percentage point last month won't prevent the economy from slowing or corporate defaults from increasing.

Lehman Brothers Holdings Inc. strategists say last month's rally in high-yield corporate bonds, the biggest since 2003, may fizzle by year-end.

While indexes of derivatives that measure the risk of default show increasing investor confidence, the difference between the interest that banks and the US government pay for three-month loans is wider now than a month ago.

That's a sign the Fed's September 18 rate decision has yet to persuade bondholders that lower borrowing costs will stop "disruptions in financial markets'' from hurting the economy.

"The reality is the fundamentals haven't gotten any better, and, if anything, they've gotten worse,'' said Mark Kiesel, an executive vice president at Newport Beach, California-based Pimco who oversees $85 billion in corporate bonds.

About three-quarters of 30 fund managers who oversee $1.25 trillion expect a hedge fund or credit market blowup in the "near future,'' according to a survey by Jersey City, New Jersey-based research firm Ried, Thunberg & Co. dated October 1.

Former Treasury Secretary Lawrence Summers said September 27 that there is an almost even chance the economy will fall into its first recession in six years.

New York-based Goldman Sachs Group Inc., the world's most profitable securities firm, reduced its estimate of economic growth in 2008 last week by about a third, to 1.8 per cent from 2.6 per cent, because of fallout from the worst housing slump in at least 16 years.

"I'm still bearish,'' said Alex Moss, a senior credit analyst at Insight, a London-based money manager with $94 billion of fixed-income assets. "I can't see any real excuse to get involved in this market.''

More than 3 per cent of company bonds were distressed in September, triple the amount in July, Standard & Poor's said in a report last week. Bonds are considered distressed when they yield at least 10 percentage points more than comparable- maturity Treasuries.

Moody's Investors Service forecasts the US default rate will more than double to 4 per cent in the next year. New York-based S&P and Moody's are the largest credit- rating companies.

Sales of new homes tumbled 8.3 per cent in August to the lowest in more than seven years and house prices dropped the most in four decades, the Commerce Department in Washington said last week.

Consumer confidence fell to the lowest in almost two years in September, according to the Conference Board's index of confidence.

"The big picture is you're going to have a consumer that is going to be pulling back significantly,'' Pimco's Kiesel said. "The rate cuts by the Fed are unlikely to save housing.''

The Fed's September 18 reduction of its target federal funds rate to 4.75 per cent was "intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets.''

The perception of credit risk in the US, measured by the CDX North American Investment Grade Index, fell to 55.6 basis points on September 21, the lowest since July. A decline in the index signals diminishing concern that companies will default. A basis point is 0.01 percentage point.

The extra yield investors demand to own junk bonds instead of Treasuries narrowed to 420 basis points last month from a four-year high of 479 on September 10, according to data compiled by New York-based Merrill Lynch & Co.

High-yield debt, securities rated below Baa3 by Moody's and BBB- by S&P, returned 2.44 per cent last month, the best since 2003.

Companies sold about $114 billion of bonds in the US during September, a record for the month, data compiled by Bloomberg show.

Issuers that abandoned sales in June, July and August returned to the market, including Montreal-based newspaper publisher Quebecor Media Inc. and Downstream Development Authority of the Quapaw Tribe of Oklahoma.

Gains prompted Wall Street executives to declare an end to the credit-market swoon. "We are a lot closer to the bottom,'' Goldman Chief Financial Officer David Viniar said last month as the securities firm reported the third-highest earnings in its 138-year history.

Citigroup Inc. Chief Executive Officer Charles Prince said yesterday that the biggest US bank will "return to a normal earnings environment in the fourth quarter.'' The New York-based company reported third-quarter profit fell 60 per cent on $5.9 billion of credit and trading losses.

Lehman, whose fixed-income research team has been top- ranked in Institutional Investor magazine's annual survey for eight straight years, told investors last week to buy more junk bonds, with the caveat that gains may be over by year-end. The firm also has increased its recommendations on investment-grade and emerging-market debt.

"We've increased markedly our exposure to risky assets and we think a lot of the sell-off is over,'' said Joseph Di Censo, a fixed-income strategist at Lehman in New York. "We will see a rally in the spread sectors that were the most beat up.''

Former Federal Reserve Chairman Alan Greenspan said yesterday that the worst of the global credit slump may be almost over because banks are starting to buy lower-rated assets with longer maturities.

The difference between the dollar London interbank offered rate, which banks use to lend to each other, and the three-month Treasury bill yield shows a different view. The so-called TED- spread has climbed to 1.33 percentage points from 1 percentage point on August 27.

The North American CDX investment-grade index rose 5.75 basis points last week to 55.5 basis points, the biggest increase in more than a month, according to Deutsche Bank AG prices.

While banks working for New York-based Kohlberg Kravis Roberts & Co. sold $9.4 billion of loans to finance the leveraged buyout of First Data Corp. in Greenwood Village, Colorado, lenders still need to find investors for more than $300 billion of loans and bonds to fund pending takeovers.

Morgan Stanley, Lehman and Bear Stearns Cos. in New York reported lower third-quarter profits last month after writing down the values of unsold loans and losses on securities linked to subprime mortgages for people with patchy credit histories.

UBS AG, Europe's biggest bank, yesterday reported a loss for the quarter after the Zurich-based company reduced the value of mortgage-backed securities by about 4 billion Swiss francs ($3.4 billion). Credit Suisse Group, Switzerland's second- largest bank, also said profits fell.

This rally will be "pretty short-lived,'' said Richard Cheng, who co-manages $45 billion in investment-grade corporate bonds at TIAA-CREF in New York. "The economy might be slowing down and third quarter earnings releases may be a little bit difficult. We see spreads widening a little bit more.''

Sales of collateralized debt obligations, the biggest buyers of corporate loans in the first half, fell 54 per cent in August to $17 billion from July, the lowest in more than a year, according to Morgan Stanley. CDOs are created by packaging bonds, loans or credit-default swaps and using their income to pay investors interest.

The reduction in collateralized loan obligations may make it more difficult to sell the debt, according to Dan Fuss, vice chairman of Boston-based Loomis Sayles & Co. CLOs bought as much as 60 per cent of loans for LBOs this year, according to New York-based JPMorgan Chase & Co. analysts.

"The impact of the CLO freeze up is certainly not out yet,'' said Fuss, who oversees $22 billion of bonds.

More than 65 per cent of investors in mortgage-backed securities are struggling to find bids for their holdings, according to a survey of 251 institutions last month by Greenwich Associates, a Greenwich, Connecticut-based consulting firm. Among holders of CDOs, the figure is 80 per cent.

The US commercial paper market is shrinking. The amount of debt outstanding that matures in 270 days or less fell $13.6 billion the week ended September 26 to a seasonally adjusted $1.86 trillion, according to the Fed. It's down 17 percent in the past seven weeks.

"People said this subprime liquidity issue was going to go away after Labor Day,'' said Tom Quindlen, CEO of corporate lending at GE Commercial Finance in Norwalk, Connecticut, a unit of General Electric Co. that has $14 billion of assets.

"The bankers were going to return from vacation and just jump right back in,'' said Quindlen. "That's what I heard in August. Well, they get back from vacation and they're saying it's the first half of 2008. I think it's going to be longer rather than shorter.''