PRINTMarket Update -- In the Markets
September 21, 2007
Investor psychology is one of the most significant and unpredictable variables in the financial markets. It has become a field of study among academics and is now considered almost as important as fundamental security analysis by many successful investors. And while there is much we don't yet understand about investor psychology, there are certain aspects of human nature we must always take into careful consideration when making investment decisions.
When market volatility manifests confusion and uncertainty, disoriented investors invariably look at history to provide a frame of reference. It is basic human nature to seek out patterns of behavior, and so, as the recent liquidity crisis has unfolded, it has drawn inevitable comparisons to the last major liquidity crisis back in 1998. Not surprisingly, a number of investors have borrowed pages from the '98 playbook, when an emergency Fed rate cut marked a turning point and eventually led to a renormalization of credit markets. So when the Fed announced a 50 basis point rate cut at their most recent meeting, the herd responded in typical Pavlovian manner by buying risk assets wherever they could be found.
It can be very comforting to pursue a strategy that has proven itself once already, especially when in the company of many other professionals who seem to agree. But we would urge caution here.
There are a number of similarities between the credit crises of '98 and '07, but there is one significant difference that we find very sobering: today's events are much less isolated than they were in 1998. Then, as now, we experienced a major 'leverage unwind' triggered by large losses in one sector of the credit markets, but in 1998 those losses were not caused nor accompanied by major fundamental deterioration in the domestic economy. Payrolls were growing at an average monthly rate of more than 250,000 in 1998, unemployment was falling, and GDP grew at 4.7% in the third quarter and accelerated to 6.2% in the fourth quarter.
So let us not so blithely dismiss the negative payroll number that was released at the beginning of this month. The primary explanation of economic resilience in the face of weakening housing markets and high gas and food prices throughout the first half of this year was strong job and wage growth. Since that time, food and gas prices have remained stubbornly high, the housing market has only gotten worse, and now the labor market is softening too. These conditions have a lot of skilled economists forecasting a recession, and one 50 basis point cut in the fed funds rate won't quickly change that. The weaker dollar probably won't rescue the economy either. It will help exports, but it won't have much of an immediate impact on domestic demand.
There is also more bad news likely to come out of the credit markets. Most of the eventual loan delinquencies and foreclosures in recently-originated subprime mortgage securitizations have yet to translate into realized capital losses. Amid a huge overhang of unsold homes and a softening economy, it is hard to expect any real improvement in collateral performance over the next few months. Many of the poorly performing deals will face downgrades and principal writedowns at the lower end of the capital structure, which may lead to another round or two of forced liquidations.
Needless to say, we view the recent improvement in investor sentiment with a healthy dose of skepticism, and we certainly don't expect spreads to tighten a whole lot further anytime soon. But despite all the reasons for caution, we do feel that there are still some bonds worth buying right now.
Recent volatility in the bond markets has left a lot of investors feeling a bit battered. It has been said that time heals all wounds, and while there is definitely some truth to this saying, there is also something to be said for the healing powers of money. Combine the two and you can bounce back from a pretty sound beating quite heartily. That is to say, the accrual of spread income can cushion investors against a fair amount of mark-to-market volatility over longer time horizons. And with spreads where they are right now, that cushion is actually a pretty cozy place for investors to lay their weary heads.
Spreads on high quality assets such as AAA-rated commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS), for example, offer investors significant yield concessions over comparable Treasuries. On bonds with very limited credit risk, that incremental yield can help offset the impact of further spread volatility over longer time horizons.
To help quantify the value of this cushion, we ran a few simple breakevens on various asset classes using the Lehman Brothers Aggregate Index data from the close of business on September 18 (the day of the FOMC meeting). The average option adjusted spread (OAS) on the CMBS component of the index at the time was 127 basis points over Treasuries. That amount of spread would produce incremental income of more than 10 basis points per month. With a duration of just over five years, the CMBS Index could sustain more than 2 basis points of widening per month and still outperform comparable Treasuries. If your time horizon is one year, your breakeven spread widening is almost 25 basis points. That's a pretty large margin for error.
The ABS component of the Lehman Brothers Aggregate Index, meanwhile, has an average OAS of 161 basis points and a duration of just over three years. More spread and less duration translate into even larger breakevens, in this case over 50 basis points over the course of a year. To put that in perspective, in all of 2006 the OAS of the ABS Index stayed in a range of less than 15 basis points.
These breakevens do not address the risk of downgrades or defaults, but they are helpful in measuring the value of a nice spread cushion over various time horizons. Given the risks outlined above, it is imperative that investors tread carefully and be very selective with their purchases right now. It certainly isn't prudent to declare all spread product cheap and start buying indiscriminately, but with some thorough analysis and a sound investment process, investors should feel comfortable putting some money to work at these levels.
Market Update
RSS