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Subprime Market Captures Headlines
Fixed Income Sector Review

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Written by Dwight Sector Specialists

CORPORATES
The second-quarter total return for corporate bonds was a negative 0.76%, primarily because of higher interest rates and the sector's longer duration. Excess return was almost flat, as spread widening largely offset the sector's yield advantage for the quarter. On a swap-adjusted basis, corporates tightened slightly compared to the other spread-asset sectors, which, with the exception of agencies, have widened. Spreads started off the quarter on a fairly strong basis, recovering somewhat from the widening experienced in March, but then they gave up significant ground in June, widening by 6 basis points as volatility picked up again.

The corporate market's recent and near-term performance has been buffeted by factors largely beyond the sector's control. The near collapse of the Bear Stearns hedge funds has intensified concerns regarding the potential for spillover effects from losses in subprime mortgages into other levered sectors of the market. Fears of a broader repricing of credit have already spread to the secured bank loan market, in which the financings for some recent LBOs have run into difficulties. U.S. Foodservices, ServiceMaster, and Thomson Learning have had to postpone and restructure their recent deals as high-yield investors have pushed back against excessively leveraged or poorly structured deals. The resulting wider high-yield spreads have dampened sentiment in the investment-grade corporate sector as well.

We have long highlighted the strong positive technicals as a justification for historically tight corporate spreads. Those circumstances have changed in the last quarter. In addition to the concerns noted above, we have seen a recent surge in corporate new issuance (22% ahead of last year) that has pressured secondary spreads. Subprime concerns have slowed the synthetic CDO market, which had until this point provided a strong underpinning for valuations in the corporate sector. Additionally, we are seeing a pickup in the number and size of leveraged recapitalizations. Home Depot announced one of the largest-ever share repurchases, to be partially financed with $12 billion of new debt issuance. Their CEO is quoted as saying that "swapping out expensive equity for cheaper debt is a solid strategy for a maturing company." We are concerned that more companies may come to the same conclusion. Therefore we plan to maintain our underweight to the sector, and we may look for the opportunity to reduce further exposure.

MORTGAGE-BACKED SECURITIES
The mortgage-backed securities (MBS) sector returned -0.50% during the second quarter of 2007, comparable to the overall Lehman Aggregate return of -0.52%. On a duration-adjusted basis, however, MBS returned 56 basis points less than U.S. Treasuries, the worst relative performance of any investment-grade sector.

During April and May, MBS performance was mixed. Volatility remained low, and demand for spread assets remained strong. These positive catalysts were offset by record levels of net fixed rate MBS supply. The heavy supply continued to be driven primarily by the flat Treasury yield curve, which encouraged borrowers to select 30-year fixed mortgages over adjustable-rate alternatives.

Market conditions turned more ominous in June, however, causing MBS to substantially lag other sectors. The first half of the month witnessed a significant increase in rates, with the 10-year Treasury piercing 5.30% at one point. This, when combined with a steeper yield curve, caused prepayment forecasts to drop and the durations of MBS to extend. The duration extension led to forced selling by active hedgers, such as mortgage servicers, at a time when supply was already difficult for the market to digest. Toward the end of June, the well-publicized difficulties in the subprime market caused an increase in volatility and a general flight to quality that put further pressure on spread assets, including MBS.

We came into the second quarter with an underweight in MBS relative to our benchmarks. Our rationale centered on the deluge of net supply and the fact that persistently low volatility had driven spreads to a level that left little margin for error. Subsequent to the spread widening in June, we returned our MBS weighting to neutral. While we acknowledge that further weakness is possible if market volatility continues to increase, MBS spreads now look more reasonable relative to other sectors. With this in mind, we would be more likely to view additional widening as a buying opportunity in the third quarter.

COMMERCIAL MORTGAGE-BACKED SECURITIES
Commercial mortgage-backed securities (CMBS) had another difficult quarter as issuance once again broke records and investors grew increasingly cautious on credit. Over $75 billion in new CMBS deals were priced during the second quarter, smashing the previous quarter's record of just over $60 billion. The heavy issuance was fueled both by a favorable lending environment and by a booming commercial property market, where several high-profile REIT acquisitions were financed largely with secured debt.

Those favorable lending conditions, however, were characterized by high loan-to-value ratios and the increasing use of pro forma underwriting. Using pro forma underwriting, originators were able to increase loan amounts by giving properties credit for anticipated future increases in rental income, which in many cases translated into less than one-time debt-service coverage on in-place revenues. Investors balked and drew inevitable comparisons to the subprime mortgage markets, in which high degrees of leverage were largely to blame for the massive increase in defaults in just a short period of time. Many potential buyers viewed the underwriting assumptions as far too optimistic and shied away from new issues in favor of more seasoned deals with lower leverage and more conservative underwriting.

Spreads on the safest, senior-most classes in the CMBS capital structure widened only modestly, but spreads on mezzanine classes saw dramatic widening. The lowest-rated investment-grade classes in the new issue market widened from approximately 180 basis points over swaps at the end of March, to about 250 basis points by the end of the second quarter. The average option-adjusted spread on the CMBS component of the Lehman Aggregate Index widened by 12 basis points, and the sector underperformed Treasuries by 44 basis points on a duration-adjusted basis. A widening of swap spreads also contributed to the underperformance relative to Treasuries.

We maintained our overweight to the sector but concentrated our holdings almost exclusively in AAA rated classes, especially higher-quality seasoned bonds. We continue to believe that weak underwriting and thin levels of credit support leave the more credit-sensitive classes vulnerable to further spread widening, especially as commercial real estate fundamentals soften in the latter half of this year, and we will maintain our high quality bias. We also intend to maintain our overweight in higher-quality CMBS relative to our underweights in agencies and high-grade corporates.

ASSET-BACKED SECURITIES
The subprime mortgage market continued to capture headlines in the second quarter as delinquencies and foreclosures continued to rise, originators continued to fail, and hedge funds started closing their doors. In early April, New Century Financial Corporation filed for Chapter 11 bankruptcy protection as early pay defaults mounted and warehouse lines were squeezed. Once the second-largest originator of subprime mortgages in the United Sates, New Century now has the infamous title of the largest subprime lender to fail. Then, in June, the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund began to collapse. This was a levered hedge fund that invested primarily in bonds backed by subprime and Alt-A collateral. The combination of widening spreads at the beginning of the year and the leverage inherent in the fund caused poor performance early in the year, which prompted investors to withdraw their capital, forcing Bear to suspend redemptions to avoid a fire sale of assets.

As creditors began requesting additional margin on loans collateralized by the fund's holdings in CDOs, subprime mortgages, and other securities, Bear Stearns Asset Management (BSAM) was forced to liquidate some $3.8 billion in securities to meet margin calls. Although the sales apparently went well, it was not enough to cover all margin requirements sufficiently, and Bear Stearns Co. eventually committed to a $1.6 billion line of credit to enable the fund to liquidate assets in a more orderly manner. Many market participants feared that a forced liquidation of collateral could snowball into more mark-to-market losses, leading to even more redemptions across similar vehicles, which would only aggravate the situation further. As a result, the ABX.HE indices, currently our best barometer for how investors feel about the subprime mortgage market, set new lows during the quarter. After rallying in April through roughly the middle of May, sentiment turned sharply negative, and the -BBB tranches of series 07-1, 06-2, and 06-1 indices closed the quarter down by approximately $12.75, $11, and $6.5, respectively. As of June 29, 2007, an individual wanting to buy protection on the -BBB tranche of the 07-1 index would have to pay 46 points up front and 389 basis points running.

Despite the negative headlines surrounding the subprime mortgage market, the ABS index outperformed all other spread sectors in the Lehman Aggregate Index for the second quarter, returning 14 basis points of total return. When adjusting for duration, the ABS index underperformed Treasuries by 17 basis points, but it still outperformed most other sectors of the investment-grade bond markets.

Moving into the rest of the year, we remain cautious on the housing market and the potential for further subprime contagion in CDOs, other hedge funds, and the broader markets in general. To the extent that we are able to source home equity paper amid a dearth of supply, we will continue to overweight the -AAA portion of the capital structure in addition to our overweight to equipment-lease-backed paper. However, if we are unable to source bonds, we will start to decrease our underweight to credit cards, autos, and utilities, while maintaining a full underweight to manufactured housing.

HIGH-YIELD
The high-yield market stumbled in June amid higher equity and treasury volatility. With a loss of 1.80% for the month, June turned in the worst monthly performance since March 2005, when General Motors' lowered earnings preannouncement sent shivers through the leveraged-credit markets. Heightened concerns of a contagion of subprime mortgage weakness to other leveraged asset classes led to the repricing of risk. However, for the quarter, high-yield returned 0.22% on a nominal basis and 0.50% on a duration-adjusted basis, which bested all sectors of the investment-grade market. Investors were deluged by a heavy primary calendar of mostly lower-quality issues-namely, lower-rated, highly levered, poorly structured LBO financings. For the quarter, lower-quality issues continued to outperform the higher-quality; however, the June market decline took the heaviest toll on the lowest credit tiers. Leading sectors included energy, wireless carriers, pharmaceuticals, and automotive issuers; refining, paper, restaurants, and retail lagged the index.

June was the second most active month for issuance on record for the high-yield market, despite the overall weak market tone. With a total of $105 billion of issuance so far this year, the market is on pace to easily break last year's record issuance of $150 billion. As was the case in the first quarter, the bulk of issuance was lower-rated, acquisition-related financing-a far cry from the refinancing wave of issuance seen as recently as early 2006. However, reversing the trend of the first quarter, investors began to push back against issuer-friendly financing structures, such as notes with a PIK/toggle feature and "covenant lite" deals in the leveraged loan market. In fact, several new issues have either been pulled, as in the case of U.S. Foodservice and Catalyst Paper, or structurally modified to enhance covenant protection and pricing.

Despite the recent market weakness, we believe that the market remains overvalued. Downside risks currently outweigh upside potential for most high-yield debt issues. Risks include increased Treasury and equity volatility, an increase in default rates, and an ongoing decline in residential real estate values that potentially weighs on overall economic growth. The near collapse of the two Bear Stearns hedge funds has cast a pall on the leveraged credit markets, as participants fear contagion either within the subprime mortgage markets, or outside these markets as banks and brokers reassess the risks in their securities lending portfolios. Although market liquidity is currently adequate, any decline could have sharply negative implications for market returns. We continue to believe that certain issues offer value, but we also feel that the broader market is likely to experience more spread widening in 2007. Therefore we intend to maintain our bias toward high-quality credits, and we will remain highly selective with new purchases.

MUNICIPAL BONDS
The total return for the Lehman Municipal Bond Index for the second quarter of 2007 was –0.67%, compared with a return of 0.81% for the first quarter. During the past six months, municipals have underperformed Treasuries by 87 basis points. Total return for the year was more favorable in the short end of the curve with returns of 1.57% in the 1-Year Municipal Index, compared to –0.58% for the Long-Term Municipal Index. The lower-rated sectors of the municipal market continue to outperform the investment-grade sectors.

New issue volume for the quarter totaled approximately $123.1 billion, putting year-to-date total volume at $230.3 billion, 28% higher than the first six months in 2006 and 9.7% ahead of 2005's record of $408.3 billion. Given this record pace, total volume for 2007 will likely set a new record. Municipal fund flows continue to remain positive, with AMG Data Services reporting 49 consecutive weeks of inflows into municipal bond mutual funds.

Municipals began the quarter with a flatter curve, with longer maturities offering very little value relative to Treasuries. However, with the subprime turmoil and future uncertainty about inflation, we saw the curve steepen from 58 basis points in April to 78 basis points at the end of June. Municipal bond buying surged, especially among retail investors as long-end rates increased. There was also noticeable activity being generated by tender option bond programs and tax-swapping, with investors selling longer 4.50% coupons and buying 5% structures.

Lastly, the United States Supreme Court on May 21st agreed to review Davis v. Kentucky, a case which centers on the ability of a state to exempt from state income tax the interest on its own municipal bonds, while taxing the interest on municipal bonds issued by other states. In January of 2006, the Kentucky Court of Appeals ruled that Kentucky was unconstitutionally discriminating against interstate commerce by taxing income from out-of-state bonds while exempting earnings from in-state bonds. If the Supreme Court upholds the lower court's decision, each state would have to determine whether to tax (likely on a retroactive basis with significant legal and political burdens) or to exempt interest income earned on all municipal bonds. Between now and the Supreme Court ruling (expected in 2008), there may be buying opportunities for potentially discounted specialty state bonds.