Fixed-Income Market Monitor Archive

September 2008

• In the 1980's horror film, "A Nightmare on Elm Street," the villain Freddy Krueger, terrorized people in their dreams. For the bond market, this September could aptly be called "A Nightmare on Wall Street", with the snowballing financial crisis playing the role of Freddy Krueger, terrorizing market participants not only in their dreams, but also in their waking moments. Indeed, panic seems to have taken over the bond market. It could be argued that the darkest moment for the bond market occurred in the early afternoon of September 17th. That was when the yield on the 3-month T-bill was a mere 0.02%. (For the record, yes; T-bills can trade at negative yields. Just pay a dollar price above par).

  As professional investors we are supposed to remove the emotional aspect from the process and proceed with a reasonable investment strategy. Buying T-bills at 0.02% seems to be anything but a reasonable investment strategy. To my way of thinking, investing at that level reflects extreme fear -- not an unemotional, sound strategy. By putting money to "work" at those levels you are basically saying that you could not find anything better to invest in that will meet your needs. I touched on the demand for risk free assets last month, but this is taking it to a whole new level -- one that I have never seen before. Who were those buyers at 0.02%? My guess is money market fund and cash managers who likely had very little choice. I understand why some were forced to do so, but I would have a hard time explaining it to clients that we manage money for. T-bill yields did bounce back up a bit. Even though they did, if you have flexibility in your investment portfolio, then I would recommend against investing in T-bills after this recent flight to quality that has left their yields so low.

• Hank Paulson has become a financial paramedic in addition to his role as Treasury Secretary. This current crisis is bad, but it could have been worse. Paulson knows from his tenure on Wall Street the interconnectedness of the credit markets and the banking system. In coming to the rescue of several institutions he was able to "persuade" others to see things from his point of view. The fact that the economic recovery package (once known as the Troubled Asset Relief Act) did not pass on its first vote by the House should not take away from the successes he has had. The final chapter has not been written and there certainly were some big losses and there may be even more to come, but the "saves" have been even bigger.

  The month of September provided a lifetime's worth of extreme events. Fannie and Freddie received an official and explicit backstop from the Treasury, Lehman filed for bankruptcy, Merrill "merged" with BAC and AIG went from being on life support to resuscitation with the help of $85B in loan guarantees. WaMu is gone and so too is Wachovia as we knew it. I think we are fortunate that Paulson knew the importance of it all and was able to get issues resolved as quickly as they were. Delays in responding to many of these events would only have made matters worse.Today we find much of the taxable bond market in a shambles. The financial sector has been hit particularly hard and trading desks are reluctant (refusing?) to take on any new inventory. The bid-side has fallen dramatically -- even for higher quality financial institutions. Investors who can stomach the startling headlines, and are capable of handling today's risks, now have the opportunity to pick up some of the companies in this sector at significant yield premiums. The risk, of course, is that no one knows who the next Lehman or WaMu will be.

• The yields on tax-exempt municipal money market funds have recently exploded to the upside. Because of their tax-exempt status, muni money funds typically yield less than comparable taxable funds, but now many yield twice as much as taxable funds! I reviewed the 7-day yields on 30 different funds (some national, some state specific) and came up with an average yield of 5.07%. There are a couple of reasons for this, but mostly it is just the latest chapter in the credit crunch. Money fund managers want to have a greater amount of cash on hand to meet the demand for withdrawals.

  A common investment for these funds is in a product called variable rate demand notes (VRDN). VRDNs have rates that reset daily or weekly. A money manager can sell his VRDN back to the remarketing agents who are obligated to take the security back in for par value. (Many readers are now probably thinking about the auction rate market mess, but these securities have specific liquidity agreements in place where the ARS market did not). The dealers, who have their own intense needs for cash, now have them on their books and need to offer them at higher rates (sometimes at penalty rate levels) to entice buyers. In the end it is not costing them for the higher rates. It is costing the underlying issuers -- the municipalities and agencies that issue the paper.

  A couple of fund families have issued updates and information alerts stating their commitment to the $1 NAV of their money market funds. We believe them in their efforts to do so. These are extraordinary times though and very little can be taken for granted. The added yields are appealing and are sure to attract new assets. Investors who have cash on hand, and have confidence in the fund families they are invested with, should take advantage of these yields while they last because I don't think they'll last too long.

• Market review:
• Other than T-bills and the Treasury index, every major fixed-income index we follow was down in September. The TIPS index suffered its third worst monthly drubbing in its 10-year history. Not since July of 2003 have TIPS been hit as hard as they were. The dramatic sell-off in commodities has contributed to an easing of inflation fears. One way this can be seen is in a review of the break-even spreads between TIPS and nominal Treasuries. It is at its narrowest in over five years.
  
• The benchmark 10-year Treasury note gained 0.18% during the month. The year-to-date total return now stands at 4.42%. During the month the yield ranged from a high of 3.85% to a low of 3.38%. There could be a lot of supply on the horizon -- say perhaps $700B, just to grab a number out of thin air. Demand certainly seems to be there now, so the market should be able to absorb the new supply without too much disruption. I do believe that this would be staggered into the market.
  
• The Lehman Aggregate Bond index's performance was dragged down by its non-Treasury / non-government exposures. This index is broken down into more than 100 parts and the worst performer was a decline of 17.1% in long maturity issuers in the financial sector -- and these are investment-grade rated!
  
• The High Yield index's monthly drop of 7.98% is the worst in its 25-year history. The yield-to-worst on this index now stands at 13.9%. With a yield level like that it would not be surprising to see equity-like returns from this asset class in the future. Yield spreads are at or approaching "distressed" levels -- levels that are 1,000 basis points above Treasuries.
  
• As recently as the beginning of the year some market observers were discussing the de-coupling theory of the Global economy, saying the U.S. could experience a slowdown, but that other economies around the world may not. The Emerging Market index's performance seems to be supporting the other side of that argument.
  
• The Municipal bond market as a whole performed poorly in September for several reasons, but none of them seem as drastic as the problems that plagued the corporate bond market. There are a couple of issues working their way through the system now (a potential big default in Alabama and one that already occurred in California). Not to diminish the severity of these events, but the market has known about and prepared for these occurrences. In my home state of Massachusetts, the State Treasurer was on the airwaves discussing how difficult it is to borrow money (bring a new bond deal) in this environment. This is not a unique situation as there are reports of more than $10B in new deals being postponed to let the market settle down and hopefully borrow later at more favorable rates. There is a plus side to all of this for muni investors. Yield ratios (muni yields as a percentage of Treasury yields) are at levels I have never seen before. Investors can easily find yields of 5% + for high quality names in roughly ten years or so until maturity. There is a growing opinion out there that predicts that Federal taxes are going up. This could make tax-exempt munis a much sought after investment.

Christopher Keith
Fixed-Income Manager

 
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