Markets on alert as junk bonds are mauled

By Ambrose Evans-Pritchard
Last Updated: 1:38am BST 13/07/2007

Junk bonds have suffered a second day of mauling on Asian, European and US markets as investors shun risky credit, raising the risk of contagion for stock markets.
    
Stock traders: markets on alert as junk bonds are mauled
The sudden tightness in bonds is said to be similar to conditions a month before the 1987 market crash

Europe's iTraxx Crossover index, which measures risk appetite for low-grade corporate bonds, had the sharpest rise since the index began.

Marcus Schüler, director of credit at Deutsche Bank, said the sudden rise in the cost of money for risky deals and leveraged buyouts was serious: "We've now reached a point where the worries are spreading to other parts of the capital markets and, for example, people in equities are starting to wonder about financing conditions for new deals. I've never had so many requests to add people from all areas to my distribution lists on the credit market," he said.

It is believed that, unlike the dotcom bubble in the late 1990s, the epicentre of the current one is in the credit markets, while stocks have been well-behaved. But this is highly misleading.

Morgan Stanley says the price-to-earnings ratio of smaller and mid-size stocks - such as on Europe's MSCI index of 600 stocks, or America's Russell 2000 - have been pushed to an all-time high of around 20 on the belief that they may be targets for private equity predators armed with cheap debt. The larger stocks have less of a premium because they are deemed too big for such takeovers.

Twelve deals have already been pulled over the past fortnight and a further $300bn are now in doubt. Gunnar Stangl, a bond strategist at Dresdner Kleinwort, said a "large glut" of loans with minimal covenants were now hanging over the markets and would have trouble finding buyers.

The hardening mood has meant KKR is having to accept more stringent terms and higher interest rates on the £9bn in debt refinancing for the Alliance Boots takeover.

James Carrick, a strategist at Legal & General, said we are entering "historically dangerous territory" for the markets; the sudden tightness in bonds was similar to conditions in autumn 1987, a month before the crash, and again just before the 1991 recession and the dotcom bust.

In essence, a credit crunch at the lower end of the debt markets can all too easily set off a vicious circle of slower growth and ever higher credit spreads, ultimately hitting the real economy.

The latest turbulence began when rising default rates in the US sub-prime mortgage industry (now 13.8pc) caused the near collapse of two Bear Stearns hedge funds, which exposed that up to $1,200bn (£590bn) worth of sub-prime debt packaged in securities may be falsely priced.

Deutsche Bank estimates that $90bn of investor money has already been lost since the bubble burst. The ratings agencies have since been downgrading these risky bonds, triggering further losses. Moody's has downgraded 399 sub-prime bonds from 2006-vintage, while Standard & Poor's has 612 securities on negative watch.

Federal Reserve governor Kevin Warsh said yesterday the debacle posed no serious danger to the US economy. "There are certainly losses, but they don't appear to be raising, at this point, systemic risk issues," he told Congress.