Market Conditions & Dwight Portfolios
The credit crisis that has been unfolding over the past year or so has had profound and broadening impact on our world, reaching far beyond the financial markets and the securities industry to touch the lives of everyday Americans. Esoteric sectors of the bond markets have become the subject of conversation in homes and businesses across the country, and people who had never even heard of a CDO or an SIV now find themselves struggling to understand why their lives are being adversely affected by these acronyms.
The extreme price volatility witnessed in many parts of the bond market, even in those sectors traditionally considered safe and stable investment classes, has been nothing short of extraordinary. Not even agency-guaranteed mortgage-backed securities have been spared the volatility. Exposure to these sectors has resulted in substantial underperformance relative to the safe haven of U.S. Treasury debt for fixed income investors during the first quarter. However, while the mark-to-market pain has been acute, more of it is attributable to supply/demand imbalances in a liquidity-constrained market than to a massive shift in fundamental credit risk, and long-term investors will ultimately benefit from the delevering currently underway in the capital markets.
We have been overweight structured product, primarily high-grade asset-backed and commercial mortgage-backed securities, in all of our investment strategies for a number of years now. Structural protections built into these securities, such as overcollateralization and subordination, are designed to insulate the senior bond classes from even severe declines in collateral performance. Our overweight to structured products has allowed us to reduce certain types of idiosyncratic risks in the corporate bond market, while in many cases enhancing the yield of our portfolios.
As the credit crisis has deepened in recent months, banks and brokers have come under tremendous pressure by shareholders to hedge balance sheet risk. Brokers have executed those hedges primarily in the credit default swap (CDS) markets, buying default protection on indices such as the ABX and CMBX. These large hedging programs had the impact of pushing spreads wider, and therefore prices lower, relative to Treasury bonds during the first quarter, as there were few "natural" sellers of protection in the CDS markets. Ironically, the hedging of potential mark-to-market risk increased actual mark-to-market risk, as the widening in CDS spreads and the rapidly increasing hedging costs created further strain on asset valuations, exacerbating the liquidity crisis. Declining asset prices and increased volatility scared off potential buyers and led to a wave of margin calls on levered investors in all mortgage-related asset classes, including even agency-guaranteed mortgage-backed securities.
The attendant delevering in the financial markets led to forced liquidations by hedge funds, mortgage REITs, and other levered players. The pace of the leverage unwind became frenetic in February and March, causing several high-profile hedge funds to collapse, and ultimately leading to the downfall of Bear Stearns. With brokers unable to provide adequate liquidity because of their own balance sheet constraints, asset prices plummeted even further, causing valuations to become completely divorced from credit fundamentals. Entire segments of the bond markets have suffered significant price declines, even while structural protections remained intact and collateral quality remained sound.
Returns in our various investment strategies have been mixed during this period. Stable value portfolios have held fairly consistent yields, even with market volatility, due to the book-value guarantees embedded in the portfolios. Insurance portfolios have also held up well. Total-return fixed income portfolios, which mark their securities to market on a daily basis, have fared worse. Our expertise in structured products has allowed us to avoid many of the worst-performing sectors, such as CDOs, CLOs, and second-lien subprime mortgages, but our overweights in asset-backed and commercial mortgage-backed securities have led to considerable underperformance relative to our benchmarks. Of course we are disappointed with our performance in the first quarter of 2008. Our investment decisions are, as they have always been, guided by fundamental analysis and a classic risk/return approach, and we believe that our portfolios are well positioned to outperform their benchmarks over time.
As the delevering process winds down and asset prices find a new equilibrium, spreads on high-quality mortgage-related securities should tighten from their current extremes. The accumulation of interest income and the reinvestment of maturing principal at elevated yield spreads will also allow portfolios to recover mark-to-market losses over time. Further, amid slowing economic growth in 2008, we expect that high-grade structured product should outperform unsecured corporate debt, particularly that issued by companies exposed to more cyclical sectors. We believe that we are better positioned today than we have ever been and that our investment process was, and will continue to be, the hallmark of the firm.
- Market Conditions & Dwight Portfolios
- Credit Crisis Leaves No Sector Unscathed—Fixed Income Sector Review
- Economic Update
- Investment Performance
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