"Is this the big one?"

It is typical of the credit market to be looking the wrong way when something happens. Many investors in credit this year (and perhaps for the last three years), have been reluctant bulls invested in increasingly risky assets but with a careful eye on the state of the US economy. The recent low level of credit spreads does not compensate the investor if default rates were to return to their long-term averages. More recently, default rates have been kept very low by the prolonged economic expansion and the availability of cheap finance. If the decline in the US housing market were to cause a more widespread economic slowdown, thereby causing global default rates to pick up, then the herd of credit investors would all rush for the narrow exit door at the same time. This used to be the greatest risk to the credit bull market, until last Wednesday.

In a piece we sent out towards the end of last year entitled 'when will the good times end', we pointed out that the markets may be looking the wrong way: "The biggest risk to this cosy (goldilocks) scenario is not, perhaps, the recession scenario but one that has a rebound in growth as its central theme A rebound in growth is not factored in at the moment and may be more of a concern to the credit markets. Initially the reaction should be positive and the market shouldn't get nervous until the forecasts for rate increases start to dominate."

Over the last couple of months as the fears over the US housing market have begun to decline, the credit markets have continued to rally. Meanwhile, Government bonds have been going straight down almost continually since the 10th May. The risky bond markets such as high yield corporates and emerging market sovereigns continued to rally until all the expected rate cuts had been eliminated from the market. As investors turned towards the idea that the Federal Reserve may have to raise rates then high yield and emerging market bonds began to fall in price.

The high point for these risky markets was reached on the 1st June, which saw spreads reach historic lows. Where will things head from here?

The table shows how the sell-off over the last couple of days looks comparatively minor compared to other bull market corrections. With investors nervous, it will be interesting to see how they will react to the data as it comes out. If the US economic data continues to suggest resilience then the bond markets will need to price in rate increases by the Federal Reserve. This doesn't look particularly bullish for credit. If, on the other hand, the housing market takes a turn for the worse (following higher bond yields) then holders of high yield bonds will be worried about rising default rates again. A difficult few weeks are ahead of us.

The medium term arguments for seeking risk in volatile bond markets are still there:

A healthy correction in credit markets can be expected and may represent an opportunity. The dynamic funds had been anticipating this recent sell-off and have underweight positions in government bonds, high yield corporate bonds and emerging market sovereigns. Options can be used to gain access to the government bond markets at slightly higher yields. The credit positions will be topped up as the markets work through their annual bull market correction. We may have to wait a while longer for the big one.