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Credit Markets Remain Vulnerable Despite Improvement in Second Quarter—Fixed Income Sector Review

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Written by Dwight Sector Specialists

CORPORATES
The corporate bond market rebounded from the depths of the credit crisis to outperform duration-matched Treasuries by 158 basis points in the second quarter of 2008. Spreads tightened 24 basis points during the period, making up some of the ground lost after spreads had widened 90 basis points in the first quarter.

The major problems that plagued the financials in the first quarter continued into the second, as brokers continued to write down assets and as mortgage and monoline insurers saw further downgrades from rating agencies. Fears of a systemic failure abated, however, allowing financials to outperform Treasuries during the quarter. Spreads have improved in several sectors within the corporate bond market since March. Nonetheless, concerns driven by a stretched consumer and by skyrocketing commodity prices drove many investors to reevaluate their corporate earnings outlook for the remainder of the year. Industrials generally posted positive excess returns, led by telecom, media, and technology, as earnings proved largely resistant to elevated commodity prices through the first quarter. In contrast, sectors with heavy exposure to commodities inputs, such as transportation, were among the worst performers. Airlines posted the only negative excess return across all industries.

The new issue market was robust in the second quarter. Many deals that were sidelined during the height of the credit crisis rushed to market at the first signs of a reemergence of demand. Year-to-date issuance through June, however, was only slightly above levels in the first half of 2007. Given the continued uncertainty in the market, new issues proved to be an attractive way to invest during the second quarter as issuers were forced to price deals cheaply.

In light of our concerns surrounding the economic outlook, we remain underweight the corporate sector but continue to overweight financial institutions, given their compelling relative value versus industrials. Though the financial sector will continue to face strong headwinds in the second half of the year, healthy balance sheets and improved transparency among the better names in the sector strengthen our conviction in our positions. Furthermore, with respect to industrials, we are just beginning to experience the effects of a weaker economic environment on the consumer and on those industries exposed to elevated commodity prices. This leaves many other sectors more vulnerable to credit deterioration in the second half of 2008.

MORTGAGE-BACKED SECURITIES
The mortgage-backed securities (MBS) sector returned -0.49% for the second quarter of 2008. On a duration-adjusted basis, MBS returned 52 basis points over U.S. Treasuries during the quarter. Despite this relative outperformance, price action continued to be volatile, and liquidity remained poor.

During the first half of the quarter, MBS dramatically outperformed U.S. Treasuries as spreads narrowed significantly from the historically wide levels seen in March. The reduction of the capital restrictions placed on Fannie Mae, Freddie Mac, and some of the Federal Home Loan Banks helped stimulate demand for mortgages. Despite this renewed confidence, the sector’s strong run eventually lost momentum, and relative value began to favor other asset classes.

Higher interest rates and tighter underwriting standards led to slowing prepayment speeds later in the quarter. As a result, fewer homeowners were refinancing their mortgages; this trend ignited investor fears that the durations of their MBS holdings were longer than originally expected. These factors led investors to reduce their allocations in favor of U.S. Treasuries, a pattern that continued throughout the quarter.

We maintain a neutral position in MBS, as we believe that the sector is fairly valued at current levels. Liquidity is still constrained; investor confidence remains tentative; and we expect mortgage supply to be limited, given the higher rates faced by borrowers looking to refinance. Investors have demonstrated a willingness to sell into strength, and we will remain neutral until valuations, sentiment, or liquidity conditions improve.

COMMERCIAL MORTGAGE-BACKED SECURITIES
Commercial mortgage-backed securities (CMBS) staged an impressive comeback in the second quarter, outperforming Treasuries by 2.6% on a duration-adjusted basis. CMBS posted the highest excess return of any major sector in the Lehman Aggregate Index and was the only sector in the index to post a positive total return during the quarter. The sector enjoyed considerable spread tightening that outweighed the rising interest rates that hurt performance in other sectors. CMBS saw strong demand from insurance companies and from money managers who were forced to look to the secondary market amid extremely light new issuance. Having seen the sector reach historical spreads and underperform every other sector except high-yield, CMBS investors took a step back and looked at the fundamental picture, moving to reinvest in relatively cheap securities.

Demand was particularly strong for super-senior and seasoned, higher-quality securities, which led to a more pronounced tiering between the different vintages in the CMBS sector. Older vintage bonds (primarily those issued in 2005 and earlier) were especially coveted by investors, as they tend to offer more conservative underwriting and better credit characteristics relative to their recently issued counterparts. These seasoned securities also offer investors a longer performance history and a proven track record on the underlying loans.

The new issue market was extremely quiet in the second quarter, with only six new fixed-rate conduit deals totaling $5.9 billion coming to market, a steep decline from the $46 billion issued during the same period last year. Issuance is likely to remain anemic until spreads tighten sufficiently to make securitization profitable for lending conduits. Market fundamentals showed some modest signs of deterioration during the second quarter, but overall delinquencies remain near historic lows. Nonetheless, the rise in delinquencies is likely to continue, reflecting weaker economic growth and softening demand for commercial space.

We continue to maintain our overweight to CMBS, favoring the higher-rated tiers of the credit spectrum and the more seasoned securities. Super-senior AAA bonds and conservatively underwritten, de-levered seasoned bonds continue to offer excellent value to investors on both a relative and an absolute basis. While these bonds are not immune to overall market fluctuations, we believe that CMBS will provide attractive spread income, as well as continued potential for spread tightening as market conditions normalize.

ASSET-BACKED SECURITIES
The tone of the financial markets improved considerably during the second quarter, as buyers of high-quality, consumer-related assets returned to the market. Spreads hit their widest levels in March, but subsequently tightened throughout April, May, and most of June. As a result, the asset-backed securities (ABS) sector posted its first positive quarterly excess return in over a year, besting duration-matched Treasuries by 78 basis points. Credit cards, stranded cost utilities, and auto loans led the outperformance, comprising 232, 210, and 204 basis points of excess return, respectively.

The home equity loan (HEL) portion of the Lehman Aggregate Index once again underperformed, returning -5.04% relative to duration-matched Treasuries. The subprime market continued to trade poorly as de-levering in the bank and finance sector, further home price depreciation, and increasing foreclosures put more pressure on the various ABX indices. The AAAs traded lower as participants used the indices to hedge existing exposure or to express a negative view of the market. With no signs of stabilization in the housing market, and with continued uncertainty about the future of the monolines, investor confidence remained tenuous.

Spreads tightened dramatically in a very short period of time, and we believe they came too far, too fast. The consumer is being stretched very thin, as tight lending standards leave little room for error for those dealing with higher food and energy costs, along with falling home values. Given our cautious outlook on the consumer and the overall economy, we have utilized this tighter spread environment to reduce our exposure to longer auto and credit card positions in favor of shorter, higher-quality names.

We will continue to favor top-tier consumer assets but will concentrate our holdings in bonds with shorter maturities, allowing us to maintain a lower risk profile. We continue to believe that high-quality ABS collateral will outperform in the long run, but we expect spreads to remain volatile in the interim.

HIGH-YIELD
High-yield rebounded somewhat from its dismal first-quarter showing, providing a total return of 1.76% and outperforming Treasuries by 3.93%. Positive drivers included the decline in systemic risk, gradual improvement in liquidity conditions, short covering in a markedly oversold environment, and a meaningful reduction in the amount of hung-bridge financings held by banks and brokers. Positive performance was primarily front-loaded in the first 6 weeks of the quarter; those gains were later offset, as the likelihood of a slowing economy once again captured the attention of the market.

The market rally early in the quarter helped thaw the previously frozen primary market. New issuance was approximately $35 billion in the second quarter, well above the $8 billion first-quarter total. Given the lowered appetite for risk among market participants, most issuance was in the highest credit tier. Year-to-date new issuance was approximately $43 billion, about half the total for the same period last year. Secondary market liquidity remained under pressure during the quarter. Banks and brokers have been forced to divert precious capital from trading operations to shore up their ailing balance sheets. This strategy has increased the implicit cost of trading through wider bid-ask spreads and greater spread volatility. Spreads are currently factoring in a year-end default rate of approximately 6%, a forecast well in excess of today’s trailing 12-month rate of 2.3%. While an increase in defaults to 6% by year-end is relatively aggressive, we would not be surprised if the market began to factor in an even higher expected default rate as the year progresses.

Despite the current manageable default rate, market sentiment remains cautious. Spreads reflect both higher credit risk and increased liquidity premiums, and it is not yet clear to what extent a more significant economic slowdown is being priced into the market. As the year progresses, we believe that market participants will focus less on systemic risk and more on minimizing idiosyncratic risk. Accordingly, we will continue to trade up in credit quality and to avoid sectors that lack near-term recovery catalysts, such as autos and consumer discretionary retail. If the downturn is less protracted than we suspect and the technical overhang is removed, the high-yield market could continue its recent momentum and generate positive excess returns in the second half of the year.

MUNICIPAL BONDS
The second quarter came to an end with municipal bonds trading at historically cheap levels. The Lehman Municipal Bond Index returned 0.63% for the quarter, a 124 basis point improvement from its first quarter return of -0.61%. Year-to-date, municipal bonds have underperformed the Lehman U.S. Treasury Index by 221 basis points.

New issue volume for the second quarter totaled approximately $138 billion, down 4.1% compared to the same period in 2007. While the drop in issuance in the first half of 2008 was small, the composition of the new issue market changed dramatically. Fixed-rate issuance fell $40 billion, while variable-rate issuance climbed by over $50 billion as many issuers refinanced their auction-rate securities with variable-rate demand and put bonds. Most dramatically, bonds issued with insurance dropped from 48.5% to only 23.5%, with just three viable insurers remaining in the market.

The municipal bond market continues to struggle with the credit crunch, the housing bust, monoline downgrades, shrinking consumption, higher mortgage payments, bankruptcies, and falling revenue from sales, income, and property taxes. We expect to see this continue into the near future with more job cuts at both state and local levels. In addition, the United States Supreme Court ruled in Kentucky vs. Davis that states can continue taxing interest on out-of-state municipal bonds while exempting interest on their own bonds. This overturned the Kentucky appellate court’s decision that current practice discriminates against interstate commerce. As expected, the Supreme Court was reluctant to hand down a decision that would upend the entire $2.6 trillion municipal bond market.

Though there are reasons to remain cautious, our outlook for the municipal bond market is optimistic. Should the volatility and dislocation persist, we believe that high-quality credits will outperform over the long term. The municipal bond market continues to be of high quality and low risk (second only to U.S. Treasuries), offering investors compelling risk-adjusted return potential.

NON-DOLLAR
In the second quarter, the Lehman Global Aggregate Index ex-USD returned -3.96% on an unhedged basis relative to the U.S. dollar. The same index returned -2.15% on a hedged basis. During the quarter, the downside risks to global growth clearly gained momentum. World economies faced substantial headwinds from record oil prices, surging food prices, and continued depressed financial conditions. Central banks around the globe are raising rates because surging inflation pressures have replaced the global credit crunch as the primary threat to domestic economies.

The economic expansion in the euro area is already deteriorating. In the month of May, the HICP—an indicator for inflation and price stability in the euro zone—showed a flash estimate of 4%, the highest reading since the introduction of the euro in 1999. Despite higher food and energy costs, tighter credit, slower corporate spending, and a strong currency, the European Central Bank (ECB) signaled a tightening after their June 5 meeting. The ensuing jump in volatility and the flattening of the yield curve (which even inverted temporarily) caused extreme pain among banks, brokers, and institutional investors.

Not unlike its European counterpart, the Bank of England (BOE) is also attempting to mitigate headline inflation in light of higher food and energy prices. The housing market is deteriorating at its fastest pace in history; the consumer is increasingly stretched thin; and PMI surveys, which measure growth in manufacturing, are signaling pessimism on all fronts. Under these circumstances, the BOE’s mandate to keep headline inflation below its 2% target rate renders it effectively helpless. To fulfill its mandate, the BOE cannot accommodate the market with a necessary rate cut in this boom-to-bust scenario.

Markets have already priced in the possibility of a second rate hike by the ECB later in the year. Some are even pricing in the possibility of a rate hike from the BOE, an action that would undoubtedly prolong the pain for the United Kingdom’s economy. In our opinion, when inflation pressures finally ease, the tightening bias taken by the ECB will ultimately lead to a series of back-loaded rate cuts in 2009, and the same will be true for the BOE if it follows suit.

Meanwhile, in Japan, confidence levels in the retail sector dropped to an all-time low in the face of a cautious consumer. Japanese exporters are bracing themselves for the prospect of a slowdown at best and a full-blown global recession at worst.

While the market may be ahead of itself in pricing in a series of rate hikes over the coming months, the outcome ultimately depends on the central banks’ abilities to deflate the global commodities bubble. The longer the upward pressure on food and energy prices continues, the greater the risks of a full-blown global recession. The U.S. dollar is being held hostage by the current cycle of higher commodity prices and rising interest rates outside the United States. While we still anticipate a recovery of the dollar, any sustainable appreciation will likely be on hold so long as these external forces persist.