Fixed-Income Market Monitor Archive

February 2008

• January performance seemed to be a shot straight upward for investors in Treasury and U.S. Government related debt. To be sure there were a few down days but they were dwarfed by the overall positive tone in the market. The benchmark 10-year Treasury had a monthly total return of 3.52%. This marks the best January performance since a 3.34% return in 1988. For the record, the 10-year ended 1988 with a total return of "only" 6.37%, so you know the torrid pace of January can slow to a crawl. Contributing to the performance was a confluence of events led by an active Fed, a growing uneasiness about the survivability of the bond insurers (more on them below) and additional multi-billion dollar write downs in the value of mortgage derivative products. It was a great start to the year if high quality bonds are your focus.

  During the month the Federal Reserve lowered the Fed Funds target rate twice - once at an emergency meeting and once at the scheduled January meeting a week or so later. There is talk about the Fed being "hoodwinked" into the emergency 75 basis point cut because of a lapse in timing of a Euro-zone bank's unwinding of a "rogue" trader's bets (ever notice how there are never any reports of rogue traders making money?) and notification to the Fed that that was what was causing world equity bourses to plummet. Had the Fed known, they might not have fired that bullet of a rate cut when they did. But they did and we now have had 225 basis points of rate cuts in a very short four-month span. One economist we follow is quick to point out that if the economy proves more resilient than currently expected, expect the Fed to act quickly and reverse its current posture of monetary easing. There is precedent for such a quick reversal of policy. In 1987, after the October crash, the Fed went from making several quick easings to tightening after it became evident that the impact of the crash was likely to be less harmful to the overall economy than originally feared.

• Municipal bonds and insurance: What is happening now is not a credit disaster by a muni bond issuer, though you might never know that judging by some of the things being said. This is an insurance company problem. The monoline insurers (monoline meaning a company focused on a specific business) are in dire straits because of the mortgage securities they guaranteed, not because of the municipal bonds they guaranteed. In our managed bond program we have zero exposure to the MBS/CDO instruments they insured (and that they are going to take a serious bath on). However, we do have exposure to the muni credits they guarantee.

  Undoubtedly much will be written and reported about the impact of an insurer losing its "AAA" rating and some of it will sound alarming. This is why it is crucial to understand exactly what they promise to do and when they promise to do it. Simply put, a bond insurer guarantees the principal and interest payments when due. Market values may rise and fall along the way but when you are scheduled to receive that next payment - that is what is insured. I am not saying there won't be market price disruption - there will be some until the dust settles. But if you are patient, that price disruption will smooth out and the odds are very high that on the last day you will have received all of the interest and principal you are due.

  Underlying credit ratings (what an issuer would be rated on a stand-alone, uninsured basis) have always been important but easy to ignore - until now anyway. In short, investors need to be comfortable with the issuer more than the insurance. I have no idea how all this will end up with insurers. One rater has already lowered their rating assigned to AMBAC to "AA" from "AAA." Irrationality is leading some to put a higher value on the uninsured debt of the exact same issuer of bonds with very similar characteristics that happen to be insured. That makes no sense at all!

  Municipal bond defaults are very rare but not unheard of. This has been the case in times of economic expansion and contraction. The bigger threat now is that of a recession and the stresses that municipalities, insured or not, face.

Lehman Fixed Income Index Returns Through 1/31/08
Lehman Index	Duration	Jan.		YTD		2007		2006		2005		2004
US T Bill Index	0.26	0.51	%	0.51	%	5.01	%	4.82	%	3.05	%	1.24	%
US Treasury Index	5.21	2.54		2.54		9.01		3.08		2.79		3.54
US TIPS Index	6.75	3.96		3.96		11.63		0.41		2.84		8.46
US Aggregate Bond Index	4.23	1.68		1.68		6.97		4.33		2.43		4.34
US Govt/Credit Index	5.36	1.90		1.90		7.23		3.78		2.37		4.19
US Credit Index {A2}	6.22	1.22		1.22		5.11		4.26		1.96		5.24
US High Yield Index {B1}	4.70	-1.33		-1.33		1.87		11.85		2.74		11.13
Caa Component	4.70	-4.17		-4.17		-0.13		17.66		0.64		13.80
Emerging Market ($$) {BA2}	6.80	0.59		0.59		5.21		9.96		12.27		11.89
Municipal Index	7.74	1.26		1.26		3.36		4.84		3.51		4.48
Municipal Index - 5 Year	4.09	2.49		2.49		5.15		3.34		0.95		2.72

Christopher Keith
Fixed-Income Manager