Investors remained gripped on Thursday by lenders’ attempts to sell more than $1bn of US subprime mortgage assets seized from two stricken Bear Stearns hedge funds, driving credit markets lower amid fears of a broader repricing of risky debt securities.
If sustained, the fall-out could make it more expensive for companies to raise money at a time when billions of dollars of new bonds and loans are expected to hit the market, largely to fund the boom in merger activity.
“A repricing of risk in the credit markets is overdue and investors face a significant challenge to embrace the wave of highly leveraged, low-rated supply that is coming their way while all around them the headlines are pointing out the perils of lending to subprime credits in a rising rate environment,” said Louise Purtle, of CreditSights, the research firm. Some $15bn of high-yield debt is slated for issue in the coming weeks while a further $70bn in bonds and more than $150bn in leveraged loan supply is expected by the end of the year.
But on Thursday, risk premia for such assets climbed as uncertainty over the firesale of complex debt securities from the Bear Stearns funds tested the resilience of investor risk appetite. A US credit derivative index tracking the cost of insuring the riskiest tier of investment-grade assets against default climbed to a nine-month high while a similar index in Europe also rose.
Meanwhile, the ABX derivative index tracking bonds backed by subprime mortgages fell to a low for a fifth consecutive day to trade at 58.75 cents on the dollar as H&R Block, the largest US tax preparer, reported an $85m loss in the first quarter on its mortgage unit.
The concerns hinge on whether the large sales of seized collateral from the Bear Stearns funds, predominantly collateralised debt obligations backed by subprime mortgages, could spark problems for investors in similar assets.
CDOs, which package portfolios of debt into high-yielding securities, are rarely traded and difficult to value.
Early attempts to sell the collateral met with mixed results as prices plummeted. Lower valuations for CDO assets could prompt lenders to demand more collateral against leveraged positions in similar complex debt securities.
Ms Purtle said: “A fire- sale rarely realises anything close to the expected value of the assets and yet, in an illiquid market, it will provide a legitimate trading level that will challenge many of the marks that portfolios have been using for valuation.”
A broad market repricing of this kind could also affect valuations for CDOs backed by assets other than subprime mortgages. CDO managers have been important buyers of debt, helping to fuel the boom in leveraged buy-out activity.
Bankers say that, in the new issue market for such complex securities, some buyers are already demanding more to address their perception of increased market risk.
William O’Donnell, strategist at UBS, said investor enthusiasm for CDOs could come back to haunt them. “Lending-fuelled risk-seeking is in many ways a ponzi [pyramid] scheme in that is great for investors until it’s not – and when it’s not, the unwinds are breathtaking with their alacrity.”
