Fixed-Income Market Commentary Archive

January 2009

December Fixed-Income Review

• The books on 2008 closed on a positive tone, which is something I'm happy to be able to report. There was a point during the year when I was not so sure. Wall Street has this habit of doing things to the extreme and this past year certainly qualifies as extreme. Sticking with extremes, in the past I have referred to the fact that there are dozens of components to the Lehman Aggregate Bond Index (from now on the indices will be know as the Barclay's Indices). In 2008 there was quite a variance between the return extremes in this index. To no surprise, the twenty-year + component of the Treasury sector performed best and returned 33.7%. On the opposite end of the performance scale was the Home Equity component of the Securitized ABS sector. This investment grade rated sector lost 36.0%. Mix in the entire index components and you get a YTD total return of 5.2%.

• The turnaround in the credit markets (investment grade corporate bonds) that began in November showed absolutely no signs of abating in December. The sector returned 6.8% for the month. It was its best month of performance for all of 2008, but not enough to wipe out the cumulative losses of prior months. YTD it is down 4.9%. In the non-investment grade high yield sector the theme was the same -- a recovery of sorts. High Yield returned 7.6% for the month, but was still trounced on a YTD basis. The near 30% loss incurred during the thee-month span beginning in September was just too much to recover from. YTD it is down 26.1%. Dollar denominated emerging market debt (EMD) was also a beneficiary of the renewed sense of calm in the markets. EMD returned 8.6% for the month, but like others remained in negative territory on a YTD basis. It was down 14.7% in 2008.

• I was recently asked what I thought was the most surprising event that occurred in the bond market in 2008. Before answering the question I had to quickly think of all the events -- there were so darn many. In the end I answered that the speed at which the markets came unglued after the September 15th bankruptcy filing of Lehman Brothers had to rank at the top. The resulting freeze up in all markets (excluding Treasury), the lack of liquidity and the downward pressure on prices was just so amazing in its intensity. Even though credit markets have begun to turn around as mentioned above, the liquidity scarcity continues on many fronts. I would not want to be a seller of any large positions at this time.

  Themes that could develop in 2009

• It is never easy to make predictions and this year is no different - especially so considering the current environment. Having said that, I do look at what has occurred and assess a fair degree of probability as to what may lie ahead. The Fed and Treasury's aggressive lending facility programs, interest rate cuts and emergency loans help pave the way and the liquidity tree will bear the desired fruit of their intentions. The fearful attitude that permeated the landscape subsides.

  A recovery of sorts in the credit markets -- both investment grade and speculative grade, would not surprise me one bit. We have already seen that theme begin to develop at the investment grade level in November and December and I look for a continuation. The near lunacy that we saw in corporate bonds where it seemed that just about all bonds had their prices beaten way down should subside further. The absence of bad news, not necessarily the emergence of good news, will be the catalyst for the credit bond market turnaround in 2009. Likewise, the high yield (speculative grade sector) should see a better environment as well. Last month I reviewed the yield on the Barclay's (Lehman) High Yield index, factored in the expected default and recovery rates, and still came up with a very plausible return scenario that could see patient investors receive double-digit gains.

  In the municipal bond market I look for a lot of headline risk as municipalities will undoubtedly be faced with tighter budgets as revenues shrink. Just when the market was getting ready for a wave of possible upgrades due to a change in the ratings methodologies (to make them more uniform with how corporate credits are rated) there could instead be a wave of downgrades. The fallout from the weakened economy, lower home values, lower sales tax revenues and lower tax revenue (ordinary income and capital gains) will collectively take their toll on states, cities and towns across the country. One Standard & Poor's analyst points out that state revenues tend to lag behind what is occurring in the national economy, so when things do start to get better nationally, the states will still need more time to recover. A major source of relief could be the stimulus package that the in-coming White House administration is planning. Early talk speculates on a massive ($800B +) package to keep Americans at work with major road, bridge and other infrastructural improvements as well as upgrades to school buildings. The Obama team really wants to hit the ground running early on when they take office, so we look for quick action.

  We have always felt a fair degree of comfort from investing in tax-supported GO (General Obligation) debt and essential purpose revenue backed debt (think user fees). We do remain cautious when it comes to the "other" categories out there.

  Our graph (below) depicts the Treasury and Muni yield curves at year-end. At first glance you'd think that they are mislabeled. They are not. This is a very unusual relationship right now when you have tax-exempt munis with higher absolute yields than Treasuries. The biggest part of this can be explained by the run up in Treasury prices across the curve that has left munis cheap on a relative basis. How cheap? The muni market is seeing a lot of activity from what we refer to as cross-over buyers. They are investors who usually only look at taxable debt but now are forced to take a look at munis due to their compelling valuations.

  
  

  As far as the Treasury market is concerned, I think many investors will say "thanks" for keeping my money safe for the past three months, but now it is time to actually earn a return on my money. I suspect that many investors will look elsewhere to earn some semblance of a return on their cash and that the over-bought Treasury market will likely see rates trend higher throughout 2009 when they do. I am familiar with the old saying that says "don't fight the Fed" and right now the Fed would like to keep rates very low in an effort to influence mortgage rates lower -- long-term fixed rates that is. (Just imagine what a 30-year mortgage rate at less than 5.00% would do to help revive the housing market.) I just don't see how Treasuries can stay where they are as investor mindsets turn away from the fear that has been prevalent recently. Also, we are aware that some money market funds are taking a good hard look at what is known as TLGB debt. This is "Temporary Liquidity Guarantee Bonds" and they are issued by various banks and financial institutions. They are "AAA" rated and carry the explicit backing of the FDIC, therefore making them qualify as government backed debt and eligible for investment by many funds. Their yields are still low, but at least they can earn a full percentage point or more than you could on some short Treasuries. Another possible pressure point on the Treasury market could come from their own borrowing needs in 2009. It is expected to skyrocket. The estimate is that that it could range from $1.5 to $2 trillion. That is a lot of bonds for the market to absorb.

Christopher Keith
Fixed-Income Manager