It was business as usual for European market dealers as a number of transactions rushed to price in the brief repose before the New Year's Eve slowdown. That said, a busy start of the year is expected, as already a number of deals have begun to populate the 2004 pipeline.

"[Last] year has been defined by the expensive consumer markets," said one market analyst. "There's been a lot of demand for consumer portfolios. In 2001, even before Sept. 11, there was a shift in focus to fundamental strategies in consumer economy - a shift away from CDOs and overwhelming demand for residential mortgages."

The analyst continued that, while spreads have tightened over the year for consumer product, the consumer economy has yet to demonstrate that it has passed through the down cycle. "Consumers are leveled, yet we are pricing products as better than perfection," he said.

According to ABN Amro, unless some unexpected event occurred during the last few days of the year, 2003 will exit with tighter spreads across the board when compared to the closing levels in 2002.

Whether the market will maintain this concentration into the New Year will depend on the direction of interest rates and the corporate spread levels. According to research from BNP Paribas, in a tight spread environment investors will shift to alternative investments, with CDOs, in particular, capturing market appeal.

"Many European regulatory regimes are becoming increasingly lax with respect to real money investors' activities in synthetic and non-synthetic CDOs," reported analysts at the bank.

"This has encouraged many to upgrade their expertise in this field, and hence consider how the instruments fit in a traditional portfolio of credit product."

According to Standard & Poor's, a strong developing pipeline for CDOs signals a busy start to 2004. The rating agency said that the single tranche leveraged loan transactions and CDOs of ABS deals are dominating pipeline development. This is driven by an increase in synthetic issuance. About 93% of all transactions rated in 2003 were synthetic, up from 85% in 2002. On the cash side, the market experienced growth in arbitrage CDOs of ABS. At least 15 new transactions are expected in 2004. On the leveraged loan side, at least 10 deals closed this year with another a few expected to have priced by the end of the year.

"The mezzanine level interest has seen people come in from all over," said one market source, adding that buyers can range from traditional triple-A to the typical CDO buyer. "The shift of focus thus far has been from corporate CDO products to CDO of ABS or CDOs of CDOs."

And with increasing pressure to clarify Basle II regulations, the implementation of the new accord looks likely to be delayed further, said market sources. According to S&P, the current ability to achieve capital or economic relief - independent of where Basle comes out on the issue - could encourage an increase in balance sheet transactions.

Rising rates pressure

consumer technicals

Strong demand technicals in consumer assets are likely to persist into the start of the year, curbed only when the effects of a rising interest rate environment is felt, said analysts. BNP believes that sectors with a greater sensitivity to interest rates will underperform next year, and those that are more sensitive to economic growth should bloom.

Consumer spreads are the most vulnerable to spread widening in such an environment. In the industrial sector, analysts did not expect spreads to come under pressure and envisaged the balance of growth shifting from consumers towards corporates as 2004 progresses. Analysts at ABN Amro chimed in similar predictions at their year-end press meeting, adding that next year would be the time to begin shifting towards corporate assets on a selective basis.

On the auto side, the effects are less uniform. According to market sources, there has already been a decoupling in performance vs. trading spreads. "Look at Ford [Motor] and Fiat: both have been trading 10 basis points wider and it's not because assets are performing badly," a researcher said. "This means that, when push comes to shove, the market doesn't believe in the way the structure functions. If they begin to see material widening investors overreact."

BNP added that that the sector should benefit from further spread compression, but added that benchmark issuers Ford and General Motors are sensitive to the rising interest rates especially with vulnerable underlying credit ratings, which are highly dependent on meeting key targets as the year develops. "Near term growth prospects supports an overweight, but investors should stay liquid and be prepared to reassess when new data becomes available," said analysts.

On the telecom side, ABN Amro expected this sector to be one of the least vulnerable to a rising rate environment, encouraged by the deleveraging trend and improved credit fundamentals that seized the sector throughout the beginning of 2003. However, any significant fluctuation could hit spreads disproportionately. This means the fundamentals for this sector could be vulnerable to deterioration in the second half of 2004.

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