Fixed-Income Market Commentary Archive

December 2008

November Fixed-Income Review

• Performance in the bond market was again driven by the Treasury sector and the top performer within that group belonged to the twenty-year + component, which returned 14.14% in November. The broader index as measured by the Lehman Aggregate returned 3.25%. One area of this index that sticks out to me is the investment grade corporate bond index that staged a very nice turnaround and posted a positive return of 4.07%. I say turnaround because in the prior two months combined this same sector lost 13.7%. The primary reason for the performance differential appears to be attitude. Investors began to take notice of how wide the spreads became and decided that not all of the wheels were falling off the credit sector and decided to take advantage. I wrote last month that the corporate bond market is "chock-full" of opportunity -- and it still is today.

  At the end of the day on November 20th I printed a copy of my home page on Bloomberg and tacked it to the wall in my office. This page displays the bond market summary and I took this unusual action because it was showing me something that had not occurred before -- a nine point move on the long bond (on-the-run 30-year Treasury). This equates to about a 7.4% one-day price move. Now that may be something that equity investors are becoming more and more accustomed to, but in the Treasury market it was previously unheard of. The reason for the big move included a compilation of the usual themes (fear, uncertainty, recession, rate cuts...). Then in the final week of the month long Treasuries continued their performance on news that Secretary Paulson would re-direct the efforts of the TARP to buying the securitized debt of the government sponsored enterprises. A consequence of this would lead to lower home mortgage rates, which in turn would lead to a wave of refinancing. When homeowners refinance, the duration on mortgage-backed securities is reduced on principal paybacks and benchmarked managers need to add duration to offset that move. The result is a continued rally on the long end of the curve. With all of this going on it is hard to believe that some people still think bonds are boring!

• Events in the non-investment grade (high yield) market find Moody's revising their forecast for the default rate over the next twelve months to more than 10% based on "a deep and protracted recession in the U.S." Historically, recessionary periods are harder on high yield bonds because that sector needs a stronger economy to thrive in. The weaker the economy, the weaker their overall performance. Yet recent performance in this sector seems to be predicting even more of a doomsday scenario than that. So why are we warming to the asset class?

  Because even after factoring in all of the above, our projected returns are still very attractive. The yield on the high yield index we follow here topped 22% at one interval. With a yield of 22%, an assumed default rate of 10% and possible recovery rate of 50¢ on the dollar from defaults, that still leaves us with potential returns in the neighborhood of 17%.

  Furthermore, we are aware that several corporations whose debt falls into this category are making an effort to buy back their debt in the open market to take advantage of the deep discounts where the bonds are trading. This is a significant step for these companies. There are also covenants that investment grade bonds don't usually carry that are more "bondholder friendly" in the high yield asset class. Lastly, the recent run-up in yield is reflective of the lack of liquidity. In this cycle of de-leveraging, there are plenty of sellers, but few buyers. For these reasons we think investors with an appropriate time horizon and risk tolerance can begin to gradually start taking a position in the high yield asset class.

Christopher Keith
Fixed-Income Manager