Market Commentary as of 9/30/08
Credit Freeze
We are unquestionably in the midst of the greatest financial debacle of our generation. With the placement of government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac into conservatorship, the nationalization of American International Group (AIG), and the bankruptcy of Lehman Brothers—the largest bankruptcy in US history—the contagion effects of the global credit crisis accelerated during the third quarter. Massive redemptions from short-term funds ensued, leading to the inability of corporate America to borrow for working capital needs. In response, corporate treasurers have tapped existing lines of credit at the very same time banks are constrained by capital needs. Secondary trading in corporate bonds is "by appointment only," with forced sellers typically executing at prices at substantially less than indicated levels.
With global credit markets frozen, there has been an outsized impact on the short-term funding environment. Sparked by concerns in the money markets, a swift flight to quality led to a sharp decline in Treasury-bill rates while trepidation concerning interbank lending continued to push the London Interbank Offered Rate (LIBOR)—the rate at which banks lend to each other—wider, suggesting that the perceived credit risk to the general economy had increased significantly. The inability of many corporate issuers to borrow on a short-term basis became a focus of policymakers attempting to alleviate the difficulties in the broader credit markets.
The Federal Reserve, the US Treasury Department, the U.S. Congress and the entire federal government have extended immense resources in an effort to ease the stress on credit markets. All of these actions are part of a larger list of government initiatives to support the credit markets. Such support is critical, as the credit market lies at the core of the turmoil that threatens dire consequences for the broader global economy. The scope of the credit crisis is global and the international community is responding with their own government interventions.
Flight to Quality
Amid this environment of turmoil, US Treasuries were the best performing asset class during the quarter, posting a 2.3% gain. Corporate bonds posted their worst quarterly return since the third quarter of 1981, losing 6.4% as liquidity in credit markets evaporated from the impact of multiple failures of major financial institutions. The 718 basis point deficit between Corporates and Treasuries during the month of September was the worst relative performance on record. By way of background, the previous record was negative 270 basis points. In terms of valuation, corporate spreads widened to 435 basis points versus comparable maturity Treasuries, compared with a previous all-time gap of positive 225 basis points. Mortgage-backed securities gained ground but underperformed duration-matched Treasuries during the third quarter, and were extremely volatile. During September, however, mortgage-backed securities were the best performing asset class, realizing 26 basis points of excess return on the back of a commitment by the Treasury to purchase new mortgage-backed security products originated by the GSEs.
While the timing of an end to the credit crunch remains unclear, corporate bond spreads are providing extremely attractive opportunities—unlike any other point in modern history. Based on the critical role that credit markets play in the world of finance and in the broader global economy, we are confident that corporate bonds will lead the eventual recovery across most asset classes. A healthy economy requires a healthy corporate bond sector. If corporate America is unable to access the capital markets for short-term borrowing to finance payrolls, inventories, etc., and cannot access the term markets as set forth below, the effect on economic growth would be significant. In our opinion, stabilization of the credit markets is necessary before other sectors of the capital markets can improve.
Despite a weaker outlook for economic growth over the period ahead, many corporations have attractive opportunities in which to invest capital. As frozen credit markets unthaw, and as companies are able to refinance, we think many corporate bonds offer attractive risk-return profiles. Overall, the investment grade corporate bond market is now yielding 8.5%. General Electric and Goldman Sachs both paid rates in excess of 10% for capital. In contrast, Treasury bonds are yielding less than 3% on average.
Mortgage pass through securities also have an important role to play going forward in offering attractive relative value for investors with yields above 5.5%. We believe the placement of both Fannie Mae and Freddie Mac into conservatorship is a positive development for the fixed-income marketplace. The two GSEs combined guarantee the debt of 43% of the Lehman Aggregate Bond Index (LAGG). The action taken by the government should improve liquidity in the financial markets over time. Credit spreads for both GSEs and mortgage pass through securities issued by Fannie and Freddie narrowed sharply on the news. Other initiatives of various government entities also reflect a commitment to mortgage pass through investors that should provide further support for mortgage valuations.
Where Do We Go From Here?
Financial markets remain severely strained, as the credit crisis has evolved into a crisis of confidence. With the credit markets at the epicenter of the financial crisis, the financial system cannot improve and the global economy cannot avert a deep recession without the stabilization of the corporate bond market. We expect corporate bonds to lead any sustained recovery and Treasury yields to rise, particularly in light of a substantial rise in public debt and assumption of risk that has shifted to the public sector following recent government actions.
Although prospects for economic growth have deteriorated as consumer spending continues to decelerate amid a weakening labor market and turbulent financial markets, we will get through this period. The economic outlook will likely weaken further as more news concerning the credit crunch is revealed and uncertainty abounds in the coming months. The entire situation remains extremely fluid and literally changes hour by hour. Rest assured, though, that we are diligently working to explore all corners of the bond market to ensure that the Fund's portfolio is structured in such a way as to capture what we see as one of the most compelling opportunities in fixed-income in some time.
Tere Alvarez Canida
President – Taplin, Canida & Habacht (TCH)
Note: Bond funds have the same interest rate, high yield, and credit risk associated with the underlying bonds in the portfolio, all of which could reduce a fund’s value. As interest rates rise, the value of a fund can decline and an investor can lose principal.
The views expressed above are for informational purposes only and is not intended as investment advice. Since the date of the commentary, economic, market conditions and the portfolio manager's views may have changed. Holdings and weightings are subject to change daily. Holdings are provided for informational purposes only and should not be construed as a recommendation to buy or sell the securities mentioned.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.