Fixed-Income Market Monitor Archive

September 2008

• What a difference a year makes ... or maybe not. It was a year ago when many of us were first introduced to the phrase "credit crunch." Back then, troubles in two "high grade" Bear Stearns hedge funds that focused on mortgage securities first came to light. In the ensuing months the wheels seemed to come off entire sectors of the fixed income markets and the flight to quality was on. The commercial paper market froze up and T-bill yields began a ride that saw wild swings in their yields. It seemed that no investors wanted to roll over maturing debt into new issues. At the time, some observers were initially claiming that any bond market related problems would be confined to the sub-prime mortgage market. We now know that was not true. The asset class of preference (requirement?) became T-bills and short Treasuries.
  
  Today we see a climate where banks are desperately trying to raise and hold onto cash. The costs to borrow in the capital markets for companies that fall under the "financial" sector heading have risen sharply. We know of one particular company, rated AA-, that recently came to market with a $3B+, 10-year offering at 8.25%! That may seem like a big number for a company that is rated that high, but this is the landscape we find ourselves in as a consequence of the continuing credit crunch. All of this is still going on even after a year of aggressive interest rate cuts by the Fed and the unusual measures taken by Chairman Bernanke to add liquidity to the system. One source estimates that Wall Street banks and brokers need to roll over in excess of $850B of maturing bonds over the next year or so. For those issuers that can find a market to accomplish this refinancing in, it will be very expensive.
  
  With some high quality debt paying 8.25%, you may find yourself asking why treasuries are still in such demand: Why would anyone buy a 10-year Treasury that yields only 3.81%? The answer is that there is a significant demand for "risk-free" assets that offer the best liquidity. The fear and repercussions of the fallout from Fannie, Freddie and the tight credit markets is that compelling. There is also fear that additional markdowns on certain securities are in the wings. After one full year, the credit crunch is not close to being over.
  
  
• The month ended with the Treasury auctioning off more than $50B in new debt (2s and 5s). That put a little bit of price pressure on the sector as the month drew to a close. During the month, nominal Treasury bonds ran neck and neck with TIPS (Treasury Inflation Protected Securities) but TIPS stumbled at the end and the Treasury index came out on top with a return of 1.25% against a TIPS index return of 0.82%. As our data box below shows, on YTD basis TIPS are still comfortably ahead. The benchmark 10-year Treasury closed the month with a yield of 3.81% and an impressive August return of 1.78%. The YTD total return is now 4.23%.
  
  
• Over the years I have been asked why I don't include "preferreds" in our bond portfolios. The answer is because even though they have bond-like characteristics, I view preferred stock as being closer to an equity security than a debt instrument. They are further down the line in the capital structure, ranking as the most junior to all but common equity. The yields are attractive for a good reason -- they carry more risk than traditional debt securities of the same firms.
  
  
• Fannie Mae and Freddie Mac preferred shares have seen their prices cut in half and more. Some now yield anywhere from 17% to 19%. The "bailout" from the U.S. government (me and you) is still being debated as to how far reaching and extensive it will be. The credit (debt) and securitized (mortgage-backed) components should be just fine and the prices of those bonds support that view. Treasury Secretary Paulson, President Bush and members of both houses of the legislature back some sort of plan supporting the two mortgage giants. They should. Combined they back around 50% of the U.S. housing market and account for upwards of 80% of all new mortgages being originated in 2008. The fate of the equity securities is much less certain and it shows in the share price of both the common and preferred. I'm sure the debate will be intense about the moral hazard with these two companies and it should be. In the interim though, the consequences of a failure are too big to endure.

Lehman Fixed Income Index Returns Through 8/31/08
Lehman Index	Duration	Aug.		YTD		Ret. '07		Ret. '06		Ret. '.05		Ret. '04
US T Bill Index	0.31	0.16	%	1.63	%	5.01	%	4.82	%	3.05	%	1.24	%
US Treasury Index	5.27	1.25		3.95		9.01		3.08		2.79		3.54
US TIPS Index	7.27	0.82		5.20		11.63		0.41		2.84		8.46
US Aggregate Bond Index	4.71	0.95		2.00		6.97		4.33		2.43		4.34
US Govt/Credit Index	5.30	0.92		1.91		7.23		3.78		2.37		4.19
US Credit Index {A2}	6.09	0.79		-0.28		5.11		4.26		1.96		5.24
US High Yield Index {B1}	4.43	0.35		-2.28		1.87		11.85		2.74		11.13
Caa Component	4.35	-0.62		-4.61		-0.13		17.66		0.64		13.80
Emerging Market ($$) {BA2}	6.47	0.48		0.94		5.21		9.96		12.27		11.89
Municipal Index	8.11	1.17		1.57		3.36		4.84		3.51		4.48
Municipal Index - 5 Year	4.14	1.35		3.92		5.15		3.34		0.95		2.72
Prepared by Christopher Keith Fixed Income Manager

Christopher Keith
Fixed-Income Manager