Credit-default swap spreads have been heading toward new lows after two years of relentless spread tightening, but strategists are interpreting the last two weeks of spread widening as a buying opportunity rather than the start of sustained spread widening. Roberto Fumagalli, credit strategist at Citigroup in London, said, "We see this as a buying opportunity. This is unlikely to be the beginning of the end of the cycle."
The Merrill Lynch high-grade index ended March at 50 basis points, up from 38bps on March 10. The iTraxx credit derivative indices had a rollover on March 20, in which some of the constituents changed, so a true comparison is hard, but dealers estimated it had widened by about 20% in the last two weeks.
Fumagalli takes heed from the 1994-97 credit cycle, when tightening came to an end because of a collapse in corporate profits. Although profits this year are expected to fall from the skyhigh 20% returns on equity level of the last two years, they are still forecast at around 8%, which means dividend payments will be from earnings rather than increased debt and Fumagalli thinks this is critical in keeping credit quality high and spreads tight.
Barnaby Martin, credit strategist at Merrill Lynch in London, said, "Our model suggests spreads are starting to look cheap given limited moves in equity volatility." Merrill's spread model puts high-grade spreads 7bps below current tradable levels, whereas at the end of February the model put them 5pbs above. Over the last month the VDAX, which measures implied volatility on the DAX 40, has remained around 12%. European equities have also had a positive total return over the last quarter.
Martin said swings in credit spreads are likely to be larger than in previous cycles because of the increased leverage imposed, most clearly through the buying of single-tranche collateralized debt obligations.
