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2009 Outlook: Prudence & Opportunity

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Written by David Thompson, CFA
President & Chief Investment Officer

As we enter the New Year, the global economy and the financial markets face great uncertainty. The political and regulatory landscapes are undergoing meaningful and rapid changes amid already unprecedented and unconventional monetary policy—factors that will undoubtedly result in elevated levels of volatility. Uncertainty, change, and volatility all translate into risk for investors. Elevated risk calls for prudence, but while the risks inherent to today's markets are significant, tremendous opportunities lie amid the perils. Elevated spreads in virtually all non-Treasury sectors of the fixed income markets offer significant opportunity to be rewarded. We are looking to high-quality, undervalued securities within many sectors of the bond market for sources of excess return.

While the rating agencies have been both inconsistent and unpredictable in their approach to certain areas of the credit markets, numerous sectors remain well insulated from rating-agency risk (and the attendant risk of forced liquidations). For this reason, we are underweighting Treasuries in favor of securities that we evaluate and categorize as having unassailable AAA ratings. For example, agency debentures carry an all-but-explicit guarantee from the federal government. Furthermore, this sector has the support of an ongoing purchase program by the Federal Reserve, ensuring continued demand for the product for some time.

Bank debt issued under the FDIC's Temporary Liquidity Guarantee Program (TLGP) is also compelling due to its explicit guarantee from the federal government. This new sector of the bond market, which is included in the "government-related" category of the recently renamed Barclays Capital Aggregate Index, includes securities with maturities of up to 3.5 years that offer almost double the yields of their Treasury counterparts and bear similar effective credit risk to that of U.S. Treasury securities. The TLGP bond market is also quite liquid, providing investors with flexibility in and ease of transacting in these securities.

We will also look opportunistically to the highest tiers of the structured products market, such as highly-seasoned and de-levered classes of CMBS and ABS. While many securities within these sectors continue to face significant downgrade risks or even potential principal losses, not all bonds are created equal. Investors can be handsomely rewarded by identifying and buying those issues with strong structural protections and ample credit support sufficient to withstand even the worst-case scenarios.

Across all of these sectors, we are partial to short-duration securities. We expect these bonds to benefit from massive yield advantages over other classes of high-grade bonds, while remaining less price-sensitive to spread-widening than longer issues.

Within the investment-grade corporate bond sector, our primary focus will remain on deep credit analysis and security selection. While we incorporate our economic outlook across the board when building portfolios, we will be especially diligent and add credits that we believe can withstand a prolonged economic downturn. Yields remain near record-wide levels and excess return opportunities abound among high-grade corporate borrowers.

Finally, we plan to remain tactical on duration and yield-curve management in our portfolios by responding quickly to short-term disruptions in the interest rate markets. In 2009, we expect to see record Treasury supply, numerous ebbs and flows in flight-to-quality demand, and volatility in currency and commodity markets in response to changes in monetary policy, trade policy, and fiscal initiatives. All of these factors will lead to rapid adjustments in the Treasury markets.

The market events and challenges that presented themselves in 2008 have fundamentally changed the financial landscape—with more changes yet to come, as both regulatory and political environments continue to shift in 2009. We remain cautious in the midst of heightened market volatility, but recognize that we are witnessing opportunities that are unparalleled in the history of fixed income markets. We will continue to weather the storm that developed in 2008, and look forward to reaping the benefits of a prudent and opportunistic approach in the years to come.