LONDON (Citywire) - Concern that fixed income markets will be hit by a decline in the U.S. sub-prime mortgage market are overblown, according to Aegon Asset Management.
Recent volatility in all parts of the fixed income market has been blamed on significant concerns about the sub-prime mortgage market in the US, where derivative instruments which reference the performance of sub-prime mortgages have fallen dramatically.
Sub-prime mortgages are not performing as well as expected because a large proportion of homeowners are in arrears on their mortgage or have defaulted on it, said Aegon. This is happening despite strong economic growth because residential property prices in the US have started to decline: in the six months to the end of 2006, the average home price fell by over 1 percent. In previous ‘hot' property markets in the US such as San Diego, California, the average home price has fallen by almost 5 percent in the six months to the end of 2006.
As a result, homeowners have no equity left in their homes, so they cannot sell them to realise the equity value and downsize to a smaller property.
"The US has woken up to the concept of negative equity," according to the assistant manager of the Aegon Ethical Corporate Bond fund, Iain Buckle.
The 95.3 million pound fund, which has Citywire AAA-rated Philip Milburn as its lead manager, is 8 percent invested in more risky high yield end of fixed income markets.
But high yield bonds will not be affected by the mortgage slump and the wider move in credit spreads seen in US investment banks is an "overreaction", he added.
"These banks are very large, diversified institutions that have been extremely profitable in recent years. There is no doubt that these institutions will have experienced losses on their sub-prime investments, but we do not think they will be material enough to threaten their credit worthiness.
"We think the concern about the impact of potential losses at investment banks is overblown."
Sub-prime mortgages make up approximately 14 percent of all mortgages in the US. Most of these are not held on the balance sheet of the lender who originated them, but are sold on to investment banks, who package and sell them on to fixed income investors in the form of Asset Backed Securities (ABS). As a result, the risk moves to the ABS investor.
These have been concerned for some time about the decline in mortgage underwriting standards and the potential impact on sub-prime mortgage performance.
This concern has been reflected in the movements of derivative instruments that reference the performance of sub-prime mortgages. The 2006-2 BBB- ABX index, which reflects the performance of sub-prime mortgages, started to fall towards the end of last year as investors became concerned about the rising delinquencies and defaults in sub-prime mortgages.
However, the index really started to tumble when, at the start of February, HSBC announced that its US mortgage finance arm, HSBC Finance (Household), had under provided for potential losses on its sub-prime mortgage lending by almost $2 billion (1 billion pounds). This announcement heightened the concern about potential defaults on sub-prime ABS bonds and the 2006-2 BBB- ABX index fell from 95 at the start of the year to 63 at the end of February as a result.
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