Inflation is set to be a dominant theme in 2007. Will a cooling US economy and global rising rates offset higher energy and raw material increases? We have been scouring around for data and have found the Christmas Price Index. Someone with too much time on their hands has created an index that tracks the cost of the elements in the song “the 12 days of Christmas”.

The Christmas index has risen 3.1% this year which compares with the US core personal rate at 2.2% and UK CPI at 2.7%. A key factor for the higher Christmas rate is that the cost of a pear tree has rocketed 44% due to demand for ornamental trees from landscapers. The cost of 4 calling birds rose 20%.

The surprising aspects of the survey (if you exclude the fact that you can pay 10 lords to leap) was that there was no increase in the price of 5 gold rings despite higher gold prices (bad news for jewellers’ margins?) and that the internet index (the price rise if you bought the same items online) rose 3.4%, perhaps showing that there are less marketing budgets being used on the internet as it becomes more mainstream.

The impact of pension fund demand on long dated bonds is generally understood, but few realise that rising takeover activity is amplifying this effect. In order to protect people's pensions, the pension regulator is insisting that the acquiring company fully funds the takeover target's pension fund deficit. Last week, for example, both India's Tata Steel and Brazil's CSN offered to fund Corus' pension fund deficit of £138m as part of their takeover offers. CSN, for example, is BB rated and will have to borrow £4.35bn to fund the takeover, so the pension regulators' concern is understandable.

What does takeover activity and the pension fund crisis have to do with the yield curve? Well, companies have to raise finance from somewhere and, at the moment, the cheapest way of doing this is by borrowing from the debt market (ie issuing bonds). Typically highly leveraged companies such as Tata Steel and CSN have to issue short and medium dated bonds, as there isn't much demand in the market for long dated corporate bonds from such risky entities. These highly levered entities issue fixed rate bonds, so as to protect themselves from rising interest rates. Takeover activity is therefore resulting in heavy issuance of fixed rate short dated bonds, and this pushes short and medium dated bond yields up.

If the acquiring company has to take on the target's pension fund liabilities, then it has to raise additional finance by issuing more short and medium dated bonds. It then has to buy pension fund assets for the target company's pension fund, and as mentioned previously, the best assets to match with pension fund liabilities are long dated bonds. This then pushes up the prices of long dated assets and drags down yields further.

So in this way, the leverage and the pension regulations combine any takeover of a company with a pension fund deficit (which is most companies) results in the yield curve inverting even further. Yet another reason why I believe that long dated bonds will continue to outperform short and medium dated bonds, not just in the UK, but throughout much of the world.

Richard wrote on December 4th (see here) about a potential gigantic leveraged buyout (LBO) for Home Depot in the US. Since then we have seen the company's CEO describe the rumours as an 'unfortunate distraction' and issue $5bn worth of bonds. So was the bond issuance announced a mere number of days after the LBO rumours a co-incidence ? I'd suggest not.

Typically when a company looks to come to market one of the first questions they are likely to be asked is what they intend to use the proceeds for. On this occasion the company stated use of proceeds was largely the repurchase of shares. This in theory will have a two fold impact, firstly supporting the share price (simple supply & demand economics) and secondly increasing leverage (net debt increases as cash is paid out). For bond investors this is a worrying trend. Leverage typically is not a good thing. The greater the leverage the greater the debt burden and consequently the greater the chance bond investors will struggle to get their money back. As you’d expect credit spreads tend to come under pressure in such scenarios. This year we have seen a long list of companies return cash to shareholders (ITV, Vodafone & Volvo for example) through additional dividends.

Is this trend likely to continue? Well as long as private equity continues to have access to large swathes of capital (currently estimated in excess of $1 trillion) then in a word, yes. As CEOs become increasingly concerned about the potential for their beloved public companies being taken private they are likely to look to return cash to shareholders. Higher equity prices equal more satisfied shareholders and increasingly prohibitive costs for private equity.

As a team this is a trend that we have long been conscious of. We continue to seek better covenant protection on those issues that we buy which can limit downside in such scenarios. For example a "change of control" clause can see us getting our money back immediately in the event of a leveraged takeover. Given the current market environment it's definitely worth doing some legal homework in advance of buying a bond issued by an LBO target candidate.

The US mutual fund market has much more transparency than here in Europe and AMG Data produce weekly returns of flows into different types of asset classes. So far in 2006, flows into equities have beaten flows into bonds ($60bn into equities vs $42bn into bonds). However, within the bond component, investment grade funds (+$41bn) and international bonds (+$7bn) grew at the expense of government bonds (-$5bn) and High Yield (-$3bn).

So how good are retail investors at picking asset classes? At first glance mixed. Comparing flows into High Yield mutual funds in one year and total return in the following year, over the last 6 years retail investors got it right half the time. But when you consider the years only when the returns are above 5% or below -5% they get it right in three out of four years - this year however, being the one they (like many strategists) got wrong.

Whilst the bull market in credit (especially high yield) has got all the headlines over the past few years, one bond asset class has been an even more spectacular performer - emerging market debt (EMD). In mid 2002 the yield premium over US Treasury bonds for the EMBI+ emerging market bond index was a massive 11%. Today it's just 2% for an average credit quality somewhere around the BB or B level (ie junk).

You can justify this shrinking in risk premium in many ways - increased globalisation and extremely strong global GDP growth, higher global liquidity and demand for higher yield instruments, mispricing of the asset class following the Asian crisis, Russia and Argentinian defaults leaving EMD cheap. But I think we've gone too far, and that cracks are starting to show in the fundamentals for these emerging market government bonds. Last night the central bank of Thailand introduced exchange controls for international investors (the stock market was down nearly 20% at worst), and elsewhere we have seen growing unease at the regulatory and legal framework in Russia (how do you enforce property rights there?); fears about the growing influence of extreme left governments in Central America; a couple of military coups (Thailand and Fiji); and most worrying of all - the prospect of a global slowdown in 2007. EMD looks expensive given these risks - the term "priced for perfection" is overused by us, but is probably apt, unless you believe that these governments will never again renege on their obligations.

Amongst discussions we had last week, a growing concern over delinquencies within the subprime mortgage market raised its head. The $1.3 trillion subprime mortgage market, which is a bit more than a tenth of the overall US mortgage market, caters to home buyers with poor credit records or those who might have trouble paying off their mortgages.

Concern has been growing in the US as the yield demanded by lenders has risen significantly from 2.4% above money market interest rates to 3.8% above in a matter of weeks. At the same time two smaller subprime lenders, Ownit Mortgage Solutions and Sebring CapitalPartners, have folded in recent weeks. Some big subprime lenders, including H&R Block Inc.'s Option One Mortgage, are up for sale.

The overall impact on the US mortgage market is not that significant whilst liquidity remains high and general default rates remain at low levels, however, if this situation was to change - coupled with what is already a fragile housing market - then the impact could, potentially, be far greater.

Credit default swaps (CDS) , originally conceived by banks over a decade ago to enable the transfer of credit risk are set to approach $40 trillion in size by the end of 2008 according to Deutsche Bank's credit strategist John Tierney. Trading in indexes based on credit-default swaps and other variations of derivatives that allow investors to speculate on the ability of companies to repay their debt, will drive the increase.

Credit-default swaps, more than doubled to $26 trillion in the first half of 2006 from a year ago, according to the International Swaps and Derivatives Association. CDS remains one of the fastest-growing investment vehicles partly because they offer a cheaper and easier way to take a view on the direction of corporate bonds.

The growth in the market is set to be supported by demand from funds like our M&G Optimal Income fund which has the ability to invest in CDS in order to take both positive and negative views on a company's creditworthiness.

The Fed's FOMC policy statement released last night was notable for a significant downgrading of it's assessment of the US housing market. In a world where economists look for even the smallest changes of emphasis in the wording of the FOMC statement from month to month, the move from a "gradual" cooling in housing to a "substantial" one was enough to see short dated US Treasury bonds rally by 5 bps. The Fed's inflation worries persist however for the time being ("the high level of resourse utlization has the potential to sustain inflation pressures") - but my guess is that it's the outlook for growth on the downside that's worrying them more than the outlook for higher prices at the moment.

Talking of housing, in this week's copy of London's Time Out listings magazine they have a section on London lists and facts, which includes house prices in the capital over the past couple of decades. I'd known that house prices had fallen in the years after the '80s boom - but the length of the post-boom downturn surprised me. Here are the price changes in the years in question:
1986 +25%
1987 +23%
1988 +23%
1989 -9%
1990 -3%
1991 -8%
1992 -13%
1993 -0.2%
1994 +2%
1995 -1%
1996 +2%

So post 1988, London house prices fell for 5 years in a row, and even then were effectively flat for another 3 years.

This morning's inflation data was higher than expected, with the CPI measure targetted by the Monetary Policy Committee coming in at +2.7% from a year ago against +2.4% the previous month. The headline RPI measure was also very strong at +3.9%. For me, the biggest risk to further UK rate hikes remains the prospect of workers seeing this headline rate of inflation approaching 4% (it's not been there since mid 1998) and demanding higher wages in the forthcoming pay bargaining rounds. For all the MPC's focus on the CPI, the public still look to the RPI as their preferred measure - and why not? After all given that housing is a huge factor in our spending why should it be excluded from the inflation data as it is in the CPI? Income Data Services, a consultancy, have pointed out that Ford, Rolls Royce and the Air Traffic Controllers - amongst others - all have automatic pay links to the RPI rather than the CPI.

Looking at the breakdown of the inflation numbers and it's clear that a major factor has been the growth in household bills, and especially energy costs. They are up 11.1% year on year - the highest increase ever recorded. This again is a worry, not least for those on low incomes such as the elderly where this non-discretionary spending forms a much larger percentage of their "personal" inflation basket than for the average where falls in the prices of plasma screen TVs, CDs, and designer clothes can offset part of the rise in fuel bills. Even for those of us who do benefit from deflation in these other items, the regular increases in utility bills have been much more memorable, and newsworthy.

So far wage inflation has remained very well behaved. In the third quarter of this year it was running at a +3.9% rate (i.e. at the same rate as current headline inflation) - so in fact the workforce has not been able to increase its "real" take home pay, despite a small increase in productivity. If this changes, expect higher rates from the Bank of England next year. Just two things will keep the Bank from hiking again - further signs of a significant economic slowdown in the US, and a collapse in our own domestic consumption. For choice I still lean towards expecting another hike, early in 2007. But is it just me, or do the shops feel pretty empty this Christmas?

Those who have read Jim’s note of this morning will be aware that he and I spent the latter part of last week in New York. Whilst the US economy dominated many a meeting and conversation another prevalent theme and concern was the leveraged buyout or LBO. Those familiar with our views will be well aware this is something that has concerned us as a team for sometime now.

Flush with a record $172 billion in new funds this year, buyout firms have tripled the pace of their takeovers, announcing a record $616 billion of deals (the initial equity investment can be levered through borrowing many times).That compares with $265.5 billion in 2005, according to data compiled by Bloomberg. The obvious outcome is ever increasing multiples, leverage and potential downside for bond investors.

The consensus I took away from our trip was that 2007 is likely to see new records set. Whether we will see an LBO the size of Home Depot (see Richard’s note 4th December) is uncertain but far from impossible. In fact it is merely the perceived likelihood of ever more aggressive LBO’s that puts pressure on credit spreads.

Johannes Huth of private equity giant KKR’s summed it up nicely for me. "One way to respond to rising competition is by focusing on increasingly larger transactions, where only a handful of private equity firms can effectively compete."

On a different note those in the Big Apple who fancy a challenge should head to Keens Steakhouse at 72 West 36th St…. you wont be disappointed!

The high yield market is set to significantly outperform investment grade corporate bonds for the fourth consecutive year. By far the biggest driver of performance over not only this year, but the last four years, has been a plummeting default rate. Strong global economic growth has translated into profitable companies with healthy balance sheets, and as a result there have been very few companies that have missed their loan repayments. Click on the image to the left to view global high yield default rates.

Globally, the high yield default rate stands close to record lows, but it's not just the low default rate that's impressive, it's the fact that it has been so low for so long. The global high yield default rate has now been stuck below 2% for 13 consecutive months, breaking the record set in 1981-1982. The default rate is a trailing 12 month average, so I can say with a degree of certainty that this record will be extended unless something catastrophic and unexpected happens over the next month.

The picture in Europe has been particularly rosy. Since February 2005, just three companies have defaulted, out of around 140 companies in Europe with bonds rated sub-investment grade. But before everyone rushes out to buy the lowest rated, highest yielding bonds they can find, it's worth pointing out that all three of these defaults have taken place in the last six months. One company was Eurotunnel, which is restructuring, while the other two were manufacturers in car parts (GAL is a French company that supplies parts to Renault, while Dura is US-based and manufactures parts for GM and Ford). Auto parts companies have really felt the heat this year as a result of major production cutting by the big car manufacturers - in the US, there have been a number of defaults in the sector, including Delphi, GM's largest supplier.

I'm not overly concerned with the recent pick up in the default rate at the moment. There are very few companies "in distress", which is defined as a bond yielding at least 10% more than a government bond. Those that are in trouble are concentrated in the auto part sector (which I've avoided). The big risk to the market over the medium to long term is that the global economy slows sharply next year, as this would start putting pressure on those companies that are already highly leveraged or are struggling with high production costs.

Graph source: Moody’s Default Report, end November 2006

Stefan and I had a research trip to see our New York counterparties at the end of last week. Two key themes emerged. Firstly, when we were there a year ago, many of the Wall Street strategists were cautious on high yield and investment grade bonds. But after a year of strong returns from credit - and especially risky credit - capitulation appears to be the order of the day. Not one strategist was anything but positive on the asset class. There are a couple of reasons why - the high yield default rate continues to stay around 1%, and the demand for corporate bonds from structured credit vehicles like CDOs (and CPDOs, see our earlier post) remains incredibly high. This strikes me as a little complacent, after all since I was last in NY the US growth rate has collapsed. GDP growth was over 5% in the first quarter of 2006, but is likely to be running at around a 2% rate in Q4 - and according to some indicators like the ISM manufacturing survey, the industrial sector may well be approaching recession. This can't be good for credit fundamentals, and we continue to think that it's time to rotate out of riskier corporate bonds into more conservative issuers.

Secondly, the Wall Street economists on the whole think that 2007 will see a continued US slowdown rather than a recession. A couple of people we saw even thought that US rates would end the year at their current level (5.25%) or higher. There were a couple of outliers however. Both Merrill Lynch's David Rosenberg and BNP's Richard Iley see the US housing market weakness tipping US growth over a cliff next year. The US corporate savings rate is currently extremely high (companies are very cash rich and can't find opprtunities to invest in the US, which in itself is quite bearish - has the US economy gone "ex-growth"?) - what happens if the US consumer weakens further and starts to save rather than spend? As a result Rosenberg sees the Fed cutting to 3.75% by year end, and Iley to an even more punchy 3% - both moves implying that the US is getting a hard landing rather than the consensus soft landing.

Elsewhere we learned that basketball is a mediocre spectator sport, and that the New York Knicks can't buy a home win at the minute; and that the Gramercy Park Hotel's Rose Bar is the hippest place in the universe right now - even if I did have to ask Stefan who exactly any of the celebrities were (Misha Barton?)...

Life expectancy isn't just increasing, the rate of change is actually accelerating, thanks to rapid medical advancements. Great news for humankind, great news for owners of long dated bonds, but a nightmare for pension funds.

Recent research from Paternoster, a company that buys up final salary pension fund schemes, has published a report estimating that if life expectancy continues to increase at its current rate, pension funds will be in deficit of £175bn (Life expectancy - has everyone got their numbers wrong?). Even if the rate of change slows, pension fund liabilities will still exceed pension fund assets by around £75bn.

Any increase in pension fund liabilities means that companies will need to increase pension fund assets, and long dated bonds are the best assets to match with long term liabilities. The total supply of gilts maturing in at least 25 years is only £74bn, and this huge demand/supply imbalance should continue to support long dated bonds.

You might like to also take a look at Jim's recent article Longevity starts to worry the actuaries.

There are rumours in the market that private equity firms are considering bidding for US DIY giant Home Depot. Home Depot's market capitalisation is currently $78bn, so any private equity bidders would have to pay somewhere in the region of $100bn to takeover the company. To put this figure in perspective, only six companies in the FTSE 100 have a market cap of over $100bn.

A leveraged buyout (LBO) of this magnitude would send shock waves around the world. Before this year, the $25bn takeover of RJR Nabisco in 1988 was the largest the LBO the world had ever seen. But in July this year, HCA (a US health care company) was LBOd for $33bn, and last month Equity Office (owner of Worldwide Plaza in New York) was bought for $36bn. The market believes that an LBO of $100bn is unlikely, as shown by the fact the Home Depot's share price has hardly moved, but the fact that there is speculation that such a large takeover could occur is proof that an LBO of
this size is potentially on the horizon.

If it does occur, then corporate bond holders better watch out. A leveraged buyout results in a large amount of debt placed on the victim's balance sheet, and inevitably results in multiple credit rating downgrades. LBO targets have traditionally been BBB rated companies as they tend to be smaller companies than their higher rated contemporaries, and are therefore within range of private equity companies. A deal of $100bn would suddenly bring a significant part of the UK corporate bond market into play. Spreads may well then widen out across the board, because LBOs mean higher leverage, which in turn means greater default risk.