Fixed-Income Market Commentary Archive

Key Points:
• One big default and the threat of another give the bond markets something to think about in November.
• The market's response to CIT's default is muted while the Dubai threat is still unfolding.
• The markets don't like surprises or uncertainty.

In the aggregate, 2009 has been a pretty good year for the bond markets with smooth sailing and solid returns enjoyed by just about every sector. We managed to get through almost eleven full months without any major surprises in the bond market. Sure, there have been defaults along the way, the biggest in terms of media recognition being General Motors while the biggest in dollar terms was Commercial Investment Trust (CIT). But neither of these was a real surprise when the actual event occurred. I know - some people thought CIT would receive a special blessing from the Government and be saved, but that never happened. Back in the Spring though, when some of their bonds were trading between 40¢ and 50¢ on the dollar, it was a good indication that there was an elevated level of risk in the company's debt.

On November 1st CIT Group filed for chapter 11 bankruptcy protection. The New York / New Jersey based finance company's pre-packaged plan was not a total surprise as the company's troubles were fairly well documented. CIT has $60B+ in outstanding debt and obligations. Global equity markets, led by the S&P, seemed to shrug it off without much concern. The S&P posted a positive return of 3.2% in the week following the announcement.

Then we got to Thanksgiving week and the “unexpected” news out of Dubai occurred. The markets had to cope with a sovereign entity that alerted investors by saying they need to amend the terms on a rather large bill that needs to be paid off very soon. The market's reaction to these events (CIT vs. Dubai) was very different.

What happened was that on the 25th the Emirate of Dubai's Department of Finance announced they need to renegotiate and extend payment schedules on at least a portion of their $60B+ in liabilities. This news broke just before the Thanksgiving holiday and many market participants were enjoying some time off, but international markets showed a lot more concern than after CIT's announcement. The international markets responded to Dubai with a sharp sell-off in equity indices (MSCI ex-US dropped 2.7% in two days) followed by a rocky day when the U.S. returned from the holiday. Shaving a couple of percentage points from the returns of respected indices should not rate as a major event. I'm just trying to highlight the difference in reactions to the two stories.

Why did the markets sell off? I believe a big reason is the contagion factor. If this is a case of economic contagion brought about by a global recession, then what is happening in Dubai could be just the tip of the proverbial iceberg. Markets do not respond well to the unknown, and right now we do not know if this is an isolated incident, due to the aggressive nature of transforming Dubai's economy, or if Dubai is the first domino among emerging market economies to wobble. (For a fascinating look at Dubai's growth check out the “Palm Islands” project at www.thepalm.ae).

If Dubai's problems are emblematic of other emerging market economies, then that signals the potential for a much greater problem. The emerging market debt asset class has only one month of negative performance (February) this year, so a correction cannot be totally ruled out and it should not come as a surprise. As I have written in past commentaries, part of this year's run up in the credit markets is a consequence of the deliberately low interest rate environment that the Fed has orchestrated. It may or may not be the intended result, but the low interest rate environment is pushing investors searching for yield into higher-risk asset classes.

$60B is a big number, but in bond market terms it is a number that could be absorbed without major disruption. Conscientious professional investors either hedge a position and / or limit its size in their portfolios so that in a worst case scenario it does not bring down the house. Also, the Dubai World debt is fractured with several different subsidiaries of varying sizes. In the immediate aftermath of the news, there is uncertainty over which subsidiary will be impacted the most and this isn't helping. There is still a lot to discover in the weeks ahead. Who does have exposure and how significant is it?

As I write this monthly commentary the story is still fresh and playing out. The major point though, is that the markets do not like surprises. I'm sure many readers may be asking how this story could be a surprise considering the recent economic turmoil around the globe. That's a fair question as you would think that after all of the coverage and doomsday warnings around the investment world that there would be few surprises left.

For investors today, adding exposure to the Emerging Markets asset class can diversify an investment portfolio and possibly enhance risk-adjusted performance. Investing in emerging markets does not just mean investing in the equity markets of emerging economies, but also includes emerging market debt (EMD). EMD can offer exposure not only to higher yielding bonds, but also to foreign currencies and even indirectly in commodities.

While there is opportunity to increase returns, investing in emerging markets may also increase risks. Emerging market economies are often considered weaker than developed market economies and therefore less stable and more prone to shocks. My current advice to investors who may wish to take advantage of the recent sell-off is the same as when it comes to high-yield bond investing. When investing in lower quality bonds or in places where information is less reliable or harder to come by (like emerging market economies) I recommend the use of funds since there is an added degree of safety in numbers.

One beneficiary of the recent events discussed above is the Treasury market (flight-to-quality). The Treasury index that I follow (shown in our returns box below) returned 1.39% in November. This index has been struggling to get into positive territory all year. At one point it was down over 4%, but has been able to trim those losses considerably and is now down only 0.98% YTD. On a stand-alone basis the benchmark 10-year Treasury note was up 1.80% in November, but remains negative YTD at -5.11%. The yield on the 10-year closed the month of November at 3.19%.

Christopher Keith
Fixed-Income Manager