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Fixed Income Sector Review

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Written by Dwight Sector Specialists

Corporates
First-quarter signs of stability in the corporate bond market were followed by the best-performing quarter on record by a wide margin. Investment-grade corporate bonds posted a total return of 10.45%, outperforming duration-matched Treasuries by 13.61% and ending the quarter at an option-adjusted spread (OAS) of 306 basis points.

Hints of economic stabilization, bank capital repair and replenishment, attractive valuations, and a powerful technical environment within corporate credit combined to drive the record-setting returns of the second quarter. Spreads tightened back to pre-Lehman-bankruptcy levels as the market priced out systemic risk, but remain wide relative to the last recession's peak. While fundamental weakness is a persistent reality, historically attractive valuations and significant cash interest in corporate bonds contributed considerably to steady spread tightening. Every subsector within investment-grade corporates produced meaningful excess returns for the quarter. Notable outperformers included life insurance, non-captive consumer, and REITs, which produced 37.69%, 30.51%, and 25.69% of excess return, respectively.

We maintained our overweight position to the corporate sector throughout the second quarter. As high-quality credit positions outperformed, we took the opportunity to move into a few more cyclically sensitive names using both the primary and secondary markets. On balance, we continue to focus on higher-quality credits that have been unduly punished by the current market environment and that are well positioned to manage through a difficult economic landscape. We also maintain an overweight to the banking sector, which provides compelling value and benefits from strong federal support. Going forward, we expect to maintain our overweight to corporate bonds with an eye toward adding to our exposure upon a backup in spreads or a meaningful improvement in our economic outlook.

Mortgage-Backed Securities
The mortgage-backed securities (MBS) sector returned 0.70% for the second quarter of 2009. On a duration-adjusted basis, MBS outperformed U.S. Treasuries by 123 basis points, marking the sector's second quarter in a row of strong relative performance.

The Federal Reserve continued its purchase program during the quarter, leading many mortgage market participants to become complacent about the Fed providing a backstop for mortgage prices. But on a sharp backup in Treasuries the Fed allowed mortgages to fall. Servicers and originators panicked and sold billions of mortgages at falling dollar prices. This hurt mortgage performance briefly, but the sector soon recovered as Treasuries rallied back.

Non-agency mortgages had a very quiet quarter, as prices seemed to stagnate and then drop slightly from the levels reached in the first quarter. Most of the activity was driven by repackaging distressed bonds and increasing the credit enhancement to stabilize their ratings via Re-REMIC (Re-securitization of Real Estate Mortgage Investment Conduit Securities) structures.

We were overweight in the MBS sector in the beginning of the quarter, but moved to an underweight position as mortgages reached their tightest spreads of the past year. Within non-agency mortgages, we sold a few bonds that appreciated in recent months but continue to hold our core position of seasoned bonds in this sector. We are currently neutral in agency MBS and believe mortgages look fairly valued relative to U.S. Treasuries.

Commercial Mortgage-Backed Securities
The commercial mortgage-backed securities (CMBS) sector experienced a massive rebound in the second quarter, providing a total return of 12.46% and outperforming duration-matched Treasuries by 14.48%.

While the sector's fundamentals continued to deteriorate, it was buoyed by investors' general willingness to take on more risk, as well as more localized news that provided a measure of comfort in the relative value of the sector.

CMBS entered the second quarter with expectations of Federal assistance via the Term Asset-Backed Securities Loan Facility (TALF)—the same program that led the asset-backed securities (ABS) market to solid outperformance in the first quarter of the year. Underlying commercial properties experienced stress from retail weakness, consolidation of office space, and continued deterioration within the hotel and multi-family sectors due to lower rental rates. Nevertheless, investors found the credit enhancement and diversification inherent in the CMBS structure to be attractive from a relative risk-adjusted return standpoint.

Investor optimism was muted later in the quarter when S&P called for major downgrades that were predicated on methodology changes that seemed inconsistent and vague to many investors. Uncertainty with regard to the timing and scope of the potential ratings actions created a stir in the sector and led prices drastically lower.

CMBS prices rebounded again, however, when Wall Street dealers began to create and market CMBS Re-REMICs. In this process, dealers re-packaged previously issued bonds into super senior tranches that were better able to hold AAA ratings, and junior tranches that provided support and very attractive yields.

The CMBS sector continues to face uncertainty as we enter the second half of 2009. While we still favor the sector from a relative-value standpoint, we will monitor our overweight and continue to scale back on risk as we head into 2010. We will look to take advantage of short-term TALF and Re-REMIC rallies, and reduce remaining portfolio volatility from ratings uncertainty and further fundamental deterioration.

Asset-Backed Securities
Since its inception in March, TALF has buoyed the ABS market by increasing liquidity and returning confidence to the investor base. Issuers were able to achieve more favorable execution through the government-sponsored program, while investors benefited from stronger underwriting and improved structure. Roughly $48 billion in ABS were priced through the primary market, two thirds of which were TALF eligible. Extremely oversubscribed deals, combined with light net supply and better structure, led to tighter ABS spreads on each successive deal. As a result, the ABS portion of the Barclays Capital Aggregate Index returned 7.64%, outperforming duration-matched Treasuries by 8.75% during the second quarter.

Despite weaker trust performance and the passage of the Credit Cardholders' Bill of Rights, credit card spreads led the rally in ABS. This reform bill that will go into effect in early 2010 will prevent card companies from charging certain fees and will effectively eliminate their ability to re-price existing balances. Fortunately, those firms should have ample time to implement other changes, such as interest rate increases, that will protect profitability.

Autos spreads also tightened nicely throughout the quarter on the heels of tighter supply and improving used car sales. New issue autos benefited even further, with stronger underwriting and improved structure.

The outlook for the consumer remains negative but technicals should keep ABS bonds well bid in the months to come. We will continue to favor shorter, high-quality credit cards, autos, and rate reduction paper while selectively looking at credit opportunities. Finally, given bleak expectations surrounding housing prices and unfavorable refinance initiatives, we will continue to let our home equity exposure decline through amortizations and select sales.

High Yield
The high yield market posted a record-setting 23.07% total return in the second quarter, outperforming duration-matched Treasuries by 25.18%. Outperformance was driven by the lowest credit tiers, as the sector returned to pre-Lehman-bankruptcy valuations. Spreads tightened a massive 569 basis points to a still-swollen 945 basis points as investors raced to add more risk amid improvement in economic numbers and the reopening of the primary issuance market.

Market sentiment improved markedly during the quarter due to a confluence of factors that included strong fund inflows, the reopening of the new issuance market, and the ability of firms to enact bond exchanges and obtain covenant relief from banks, allaying default fears. In fact, the pace of default activity actually declined as the quarter progressed, despite reaching a 7-year high of 10.2% by the end of May. Nevertheless, default activity is likely to remain elevated into 2010 despite the improving macroeconomic environment, given that defaults typically lag spread movement and real economic activity.

The high yield market has had a remarkable rally that has brought spreads back to normal bear-market wides from near depression-like levels. Despite increasing defaults and a tepid economic recovery, we believe that spreads remain compensatory given identifiable risks. That said, spreads of lower-quality CCC names have rallied much more relative to higher-quality tiers and offer less compelling risk-adjusted return potential. We will therefore retain our up-in-quality bias in the coming quarter as we wait for signs that the combination of aggressive fiscal and monetary stimulus positively impacts the economy. In addition, we expect to continue to actively participate in the primary market given attractive pricing and deal structure. Lastly, we will continue to actively reassess our overall strategy pending changes in our firm-wide economic view, as well as changes in the quality and depth of the primary market.

Municipal Bonds
The Barclays Capital Municipal Bond Index returned 2.11% in the second quarter, outperforming the Barclays Capital U.S. Treasury Index by 513 basis points. New issue volume for the year totaled $195 billion, down 15.2% from the first half of 2008.

The states are facing a deteriorating fiscal and financial situation that is without doubt one of the worst in U.S. history. California's crisis is ongoing, as lawmakers have yet to reach an agreement on the state's $26.3 billion budget gap and have started to issue IOUs for only the second time since the Great Depression. Total budget shortfalls have reached almost $170 billion for fiscal year 2010, as states continue to experience serious declines in sales, income, and corporate taxes. The American Recovery and Reinvestment Act of 2009 has provided some relief, but with such large budget deficits, the states must continue to raise taxes and cut spending.

Municipal bonds continue to be a historically safe investment, with a 10-year cumulative default rate of only 0.10% for all rated municipal bonds. We will continue to remain cautious with a focus on high-grade names and essential service revenue bonds in 2009, and expect the sector to continue providing attractive risk-adjusted returns going forward.

Cash
Demand for short-term paper increased over the course of the second quarter as it became abundantly clear that the Fed does not intend to take rates higher in the near term. Due to an influx of supply, 3-month U.S. Treasury bills sold off in June and ended the quarter at a yield of 0.188%, after beginning the period at 0.096%. The spread between 3-month LIBOR and the overnight indexed swap spread (LIBOR-OIS) continues to grind tighter as LIBOR falls. This spread closed out the period at 38 basis points, after reaching a high of over 350 basis points in the wake of the Lehman bankruptcy.

The U.S. commercial paper market continues to contract. With $1.14 trillion outstanding, the market has nearly halved since July of 2007, and now stands at its lowest level in over eight years. With respect to asset-backed commercial paper and similar assets, investors have made a clear distinction between those programs sponsored by stronger financial institutions with a healthy buyer base and those programs that are more thinly traded with weaker support from their sponsors. In some instances, spreads between top-tier names with a 3-month maturity may differ by up to 200 basis points.

Meanwhile, the SEC's efforts to rewrite the rules governing money market mutual funds (as a means of preventing a repeat of the Reserve Primary Fund collapse last year) has been front-and-center in the money markets. In June, the SEC finally proposed increased restrictions on money market funds in the areas of liquidity, duration, and credit quality. The Fed has been busy as well, having enacted a number of liquidity initiatives in recent months. One of the more successful initiatives, the Asset-Backed Commercial Paper Money Market Liquidity Facility (AMLF), which allows investors under certain conditions to effectively return securities to the Fed, was extended through early 2010.

In summary, there are some signs of life in the money markets. Investors are carefully choosing their spots and the commercial paper market is once again robust for the most creditworthy borrowers. Moreover, the contraction in the LIBOR-OIS spread, a widely watched metric, is a welcome sign. Nevertheless, we remain defensive in the face of a potentially long road to recovery. It also remains to be seen how efficiently the money market space will operate in the absence of Fed support.