US Bond Market Outlook for 2008 and beyond –

The year 2006 was in interesting year to go by. And so 2007 seems to follow the same theme, the buccaneers of change and multitude of events that shape the financial districts of the globe. The increase in global M&A activity (most notably Leveraged Buy Outs) have led to considerable increase in the bond market liquidity and depth. The high liquidity in the markets has also helped in increasing bond market activity. With the hope that companies being LBO’ed (pronounced elbowed) will finance the deal and help in repayment of debt and service the interest liability of the deal; one interesting thing that showed up on a research paper by a prominent investment bank was that after an LBO the sponsorer of the buyout (mostly PE firms) issue more debt to increase the dividend payout for its investors. If this is really true than we have a problem. And that a big one too. Now I don’t want to sound like a harbinger of distress, but it’s only a matter of time when all the dominoes start to fall.

The benign growth in the US economy and increasing profits has reduced the spreads of junk bonds over the treasuries. And also the CDS spreads have been on the fall. Are the investors neglecting the risk?? The inverted yield curve of US tells us another story. The inverted yield curve which shows that the economy is heading into recession was a false signal. If we look at the recent trends in the CDX index, we will see that the spreads have stared to widen. And the main reason attributed to it is the recent CDOgate. The delinquencies in the mortgage and related derivatives markets have added supplementary jet fuel to the fire.

The reason for falling spreads was that reducing risks premiums and growth in the emerging economies. Yields in the USTs were very low, and what better place to reap higher yields than emerging economies growing at around 10% a fiscal. Strong fundamentals, supporting currencies and higher yields as compared to the G8 nations resulted in higher FIIs for Emerging Economies.

However, one interesting fact to note is the reverse funneling hypothesis – where by the emerging economies have been finding the increasing fiscal and budgetary deficit (twin deficit) of US. This has been the driving factor for preventing the economy in going into recession.

The FED has increased the interest rates for consecutive 17 times by 25 bips over the past 5 years. Now the economy is on short finals for a soft landing. The fall in real estates prices and depreciating dollar has led to analysts discount a fall in the fed rates that is now at 5.25%

The increased LBO activity is not going to last long. Once the liquidity in the market has dries up and the risk premium spreads starts to widen, the default rates in the junks will increase. And the markets will fall like a pack of cards. Now I don’t want to sound like a harbinger of distress, but the fact is that the economy has stretched out too thin. To collaborate this we look at the VIX index and the XO index (crossover index). The index has shown a significant growth in volatility in recent period, mainly due to sub prime delinquencies.

The demand of dollar and USTs will reduce once the petrodollars find its way into emerging economies and alternative investments. This will have a negative impact on the US economy and will have a cascading effect on the global economy. However, looking at the depreciating dollar against all the major currencies, and simultaneously the growth in E8 economies, we clearly see that dependence on US is reducing. We can’t totally ignore US economy though. It still is the cue for the global markets.

After Bank of England increased interest rates to match US with 5.25% and further to 5.75% in the last BOE meeting, over inflation and runway £, the investments have shifted from US to UK. This has again put pressure on the US yield curve. The fed has only two solutions. First wait and watch and the second is preferential reduction the interest rates in the next quarter review.