Toward a double-dip recession?

Although the economic recovery in the U.S. seemed to be following its course and talks of a double-dip recession were quieting down at the beginning of the year, a slew of disappointing economic news reports prompted a sell-off that rattled financial markets this summer as uncertainty returned.

"Times have been very tumultuous," said Colleen Denzler, Senior Vice President and Head of Fixed Income Strategy at Janus Capital Group. "The economy was growing and then we hit a lull. In addition, recent events and rhetoric in Washington added to investor unease, leading the markets to a crisis of confidence." The sell-off was driven by three main factors:

• Sovereign debt problems in the European Union intensified and began to spread from countries including Greece, Portugal and Ireland to the core of the Euro-zone, particularly Italy and Spain. The European Central Bank intervened in the markets and purchased Spanish and Italian sovereign debt stemming the rise in yields, which were pressuring the region. But policy responses thus far have been insufficient to provide a long-term solution.

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After a volatile summer, opportunities abound at home and abroad

Risk increased over the summer in corporate credit as a market correction rattled spreads and brought issuance to a standstill. But with lower valuations and an increasingly global fixed income world, investors are finding new opportunities, making the corporate bond market a compelling, ever more diversified investment arena.

The investment-grade corporate bond market went through a significant repricing starting at the end of July, with spreads widening to roughly 200 basis points as of the end of August from 140 basis points at the beginning of summer. "The widening has been significant," said Colleen Denzler, Senior Vice President and Head of Fixed Income Strategy at Janus Capital Group. "Corporate credit has really underperformed in August and early September, but as a result, many investors now view this sector as being more attractive. Companies with strong balance sheets and flexibility will do well. They don't need 2.5% growth to excel. Companies that aren't as financially stable will suffer."

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But risk-taking remains subdued

Structured credit products suffered greatly during the recession of 2008 as problems with subprime real estate first spread to various types of mortgage-backed securities. This was followed by other investment vehicles in the securitization world, including collateralized loan obligations. Although many facets of the real estate market in the U.S. continue to deteriorate, structured products have come back to life.

CMBS 2.0: Revival of a market

As the CMBS market made its comeback in the past 12 months, issuers and underwriters have made sure that the structures of transactions are more conservative than at the top of the market in 2006 and 2007, for example, drastically reducing the leverage of deals as well as the power of special servicers in restructuring. As a result, issuance soared. From virtually no issuance in 2009, roughly $10 billion worth of new CMBS were issued in 2010 and predictions for 2011 called for $25 billion to $40 billion in new CMBS.

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Investors are forced to look elsewhere for yield

The 2008 financial crisis prompted a major shift in the composition of the main fixed-income index, the Barclays Capital Aggregate Bond Index, forcing investors to review their allocations.

Increased government issuance of Treasuries and government support have created more concentrated exposures than prior to the credit crisis.

U.S. Treasuries in the Barclays Capital Aggregate Index are above 30%, a historical high over the past decade, according to David Zielinski, Fixed Income Product Manager at Manulife Asset Management.

The fast pace at which the government has been issuing Treasuries to fund deficits in the U.S. and fiscal policy as well as numerous takeovers by the government during the credit crisis -- including that of Fannie Mae and Freddie Mac -- accelerated the exposure to government-held bonds in the Aggregate. Meanwhile, the growth of government debt has far outpaced the growth rate of other sectors of the bond market, including the corporate bond market. "The index became very concentrated in government issuance and isn't as diversified as it was just a few years ago," Zielinski added.

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LBO financing main driver of issuance

Although it is far from being at pre-credit crisis levels, the market for new leveraged loans is healthy and once again driven by financing for leveraged buyouts.

"LBO financing is at the forefront of activity in the leveraged loan market," wrote Thomson Reuters in a Sept. 12 credit market report. Completed LBO loan volume for the third quarter already reached $11.7 billion as of mid-September. The LBO backlog, at $9.9 billion, is also significant, potentially making the third quarter of 2011 one of the biggest LBO quarters since the third quarter of 2008, according to Thomson Reuters.

Sure, the leveraged loan market is far from its heyday during the second quarter of 2007, when issuance of LBO loans reached nearly $60 billion. Additionally, investor skittishness due to an uncertain economic backdrop and concerns regarding the European sovereign debt crisis could present potential risks for arrangers pricing deals.

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