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Policymakers Fight to Revive Economy as 2008 Draws to a Close—Fixed Income Sector Review

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Written by Dwight Sector Specialists

CORPORATES
The corporate bond market's negative trend continued through year-end but eased its negative pace when compared to the extreme weakness experienced in the third quarter. The sector experienced a market value gain of 3.98%, but underperformed duration-matched Treasuries by more than 560 basis points. Corporates returned -4.94% for the year, underperforming Treasuries by nearly 20% and widening spreads by 356 basis points.

Fears of total systemic failure in the global financial system eased during the quarter as government programs around the world injected massive amounts of liquidity and capital into financial institutions. The FDIC's Temporary Liquidity Guarantee Program and TARP's evolution to include direct capital injections into banks aided in stabilizing bank spreads during the quarter. Within the finance sector, banking, brokerage, and finance companies posted positive results for the quarter. These gains were offset, however, as concerns over asset quality led to significant underperformance from the insurance and REIT sectors.

These systemic fears were quickly replaced by broader economic concerns, however, as the emergence of the worst economy in decades forced investors to reevaluate their non-financial holdings and default assumptions. As fundamentals continued to deteriorate and concerns over bankruptcies increased, already-poor liquidity in the corporate sector became even worse toward year-end. Brokerage firms and hedge funds spent much of the quarter deleveraging and liquidating assets. When coupled with a buy-side community scrambling to comprehend the depths of the economic weakness, demand was left bleak at best. Despite these factors, the new issue market in investment-grade corporates was not closed. Approximately $85 billion in fixed rate debt from non-financial companies cleared the market during the quarter, though the primary market was open mainly for higher-rated, non-cyclical names.

We continue to be concerned about the severity and duration of this economic downturn. As of this writing, we maintain our underweight to the sector, but are looking toward moving to neutral in the wake of historic spread movement in the second half of 2008. Within our current allocation, we continue to favor financial institutions for their compelling relative value versus industrials. We will also continue to add to our exposure by opportunistically purchasing industrial and utility names that have been unduly punished by economic fears or new issue concessions.

MORTGAGE-BACKED SECURITIES
The mortgage-backed securities (MBS) sector returned an impressive 4.34% for the fourth quarter of 2008. Despite attractive absolute returns, MBS nonetheless underperformed duration-matched Treasuries by 195 basis points during the quarter. For the year, MBS returned 8.34%, but still lagged Treasuries by 232 basis points. Considering the historic rally in U.S. Treasuries and the market's exodus from all types of spread product, however, the sector performed quite admirably.

October was a difficult month for MBS as the wide spreads seen in the third quarter were tested again. We took this opportunity to increase our overweight to agency mortgages. The sector improved steadily until mid-November, when Treasury Secretary Henry Paulson announced that the scope of TARP had changed course and was moving away from buying troubled mortgage assets. Prices plunged as many investors who had purchased mortgages in anticipation of government backing promptly turned around and liquidated their holdings.

This negative sentiment persisted through November, until the Fed announced a program to purchase $500 billion worth of agency MBS and $100 billion worth of agency debt. Mortgage spreads tightened dramatically after the announcement, reminiscent of the price action that occurred upon Fannie and Freddie being taken into conservatorship. While agency mortgage prices rose rapidly, non-agencies lagged due to continued liquidity and economic concerns. Still, the non-agency mortgage market finished 2008 with a slightly better tone as investors gained confidence that prices had seen their lows. We plan to maintain our current overweight to agency MBS until we believe the Fed’s actions are coming to an end, or we find better relative value opportunities in other sectors.

COMMERCIAL MORTGAGE-BACKED SECURITIES
The commercial mortgage-backed securities (CMBS) sector concluded a volatile 2008 with a return of -13.52% for the fourth quarter and -20.52% for the year, underperforming duration-matched Treasuries by -20.43% and -32.74%, respectively. Continuing the overall trend of 2008, the sector experienced large swings in performance, although it ended the year on a positive note and outperformed Treasuries by 15.14% for the month of December.

The CMBS sector was heavily impacted by the turmoil that permeated the larger financial markets in 2008. Economic weakness contributed to increased vacancies in the retail and office sectors, and reduced demand for hotel rooms. While housing weakness seemed to be a positive for the rental or multifamily sector, aggressive underwriting that contained overly optimistic assumptions for future rent increases has already hurt several recent properties—November data showed 3-month delinquencies at 0.83%, a level three times that of the same period in 2007, according to Realpoint Research.

Buyers continued to be scarce in the fourth quarter, with no origination of fixed conduit CMBS deals. Large Wall Street banks and broker-dealers who had been shedding assets from their balance sheet throughout the year really hunkered down in the fourth quarter, decreasing cash holdings and increasing bid-ask spreads. Insurance companies looked to reduce exposure, and money managers, many of whom were already overweight to the sector, shied away from CMBS as it defied fundamental valuations and continued to underperform. As the technical trade drove prices lower, bonds that had been considered bulletproof traded as low as fifty cents on the dollar.

There are significant headwinds facing the CMBS sector, but we feel that the weakness is already more than priced in and that in many instances, the market is oversold. We maintain our overweight to the sector, favoring the highest tiers of the credit spectrum and seasoned securities that exhibit robust underwriting standards. These well-structured securities are designed to withstand default rates many times higher than current levels, and represent tremendous risk-adjusted return opportunities for investors.

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ASSET-BACKED SECURITIES
During the final quarter of 2008, renewed pressure from investors and a wave of liquidations pushed asset-backed security (ABS) spreads to new records. As a result, the ABS sector posted a total return of -6.82% and underperformed duration-matched Treasuries by 11.73% during the fourth quarter. Underperformance was widespread among subsectors, but home equities and credit cards fared the worst.

Accelerated home price declines and rising delinquencies sparked new fears that structural credit enhancements may not be sufficient to cover losses on some of the highest-rated securities at the top of the capital structure. As dealers, servicers, investors, and speculators looked to protect themselves or benefit from further collateral deterioration, they purchased protection on the various ABX indices causing prices to fall even further. Uncertainty surrounding the ramifications of various government-sponsored programs designed to help homeowners and potential mass-loan modifications by servicers only added to these fears.

Credit card trust performance was also negatively affected as charge-offs increased and payment rates declined across major bank trusts. Meanwhile, the securitized market remained all but shut down for auto issuers as investors became concerned with the future residual values of vehicles. In the wake of poor sales and tight credit conditions, Chrysler and GM found themselves on the receiving end of a $13.4 billion bridge loan from the U.S. government, in exchange for restructuring their businesses.

Moving into the New Year, our investment stance remains largely unchanged. We maintain a defensive posture in consumer-related ABS, favoring top-tier, AAA-rated assets with low spread duration, while focusing on structural credit enhancements that we believe can support even extreme-loss scenarios. While the ultimate impact of various government stimulus programs remains uncertain, we believe that many high-quality ABS bonds will provide a source of excess return in the long run.

HIGH-YIELD
The rational re-pricing of risk in the third quarter devolved into a freefall in the fourth quarter, resulting in record-poor performance for the high-yield market. For the quarter, high yield had an excess return of -24.9% as spreads widened 648 basis points. The sector widened 1100 basis points for the year, with a total return of -26.16%, underperforming duration-matched Treasuries by -38.3%. This was by far the worst year in the history of the high-yield market.

Dismal performance was driven by investors' aversion to all risk (including that associated with AAA securities) and was exacerbated by continued de-leveraging throughout the financial markets. The high-yield market has historically carried a significant liquidity premium, but this premium exploded during the quarter due to concerns surrounding the weakening economy, the uncertainty of government actions, and significant stress at both commercial and investment banks.

Given these circumstances, it comes as no surprise that the new issue market was virtually non-existent during the quarter. Only three deals came to market during the quarter, and for the year new issuance was down over 60% with less than $40 billion of true new issuance. The leveraged-loan market shut down as well, and by some measures had negative issuance as several large LBO deals with committed financing were cancelled during the quarter.

We expect that the severe economic downturn and limited financing options will result in significantly higher default rates in 2009. Nonetheless, we believe that certain sub-sectors of the high-yield market offer considerable value at current levels. We expect very weak fundamentals through the first half of 2009, but many companies do not need to access the capital markets and will have sufficient liquidity to weather the downturn. We are maintaining a conservative approach to the high-yield sector given our current economic outlook, but we will look to become more constructive if the new issue market opens up as the year progresses.

MUNICIPAL BONDS
The municipal market continued to struggle through year-end, as the same factors that plagued the sector throughout the year (credit fears, deleveraging, slowing tax revenues, and lower profits in the P&C industry, among others) continued into the fourth quarter. The sector returned 0.74% in the fourth quarter and -2.47% for the year. Municipal bonds underperformed significantly on a relative basis, lagging duration-matched Treasuries by 18.68% for the year. New issue volume for the fourth quarter was down 33%, totaling $69.8 billion. This brought the total volume for 2008 to $390 billion, 9% below that of 2007.

The market environment in the fourth quarter was inhospitable for municipal issuers in the primary market. Demand was weak as municipal bond mutual funds experienced consistent outflows during the quarter. With tepid demand from insurance companies and arbitrage players on the sidelines, the market had to rely on retail investors. Highly-rated issuers had the most success in bringing new issues to market, although many chose to postpone issuance pending market improvement. As such, the shadow calendar continued to grow, which may temper any potential spread tightening in the first quarter of 2009.

More than at any time in the last twenty years, the municipal market is a credit market. With the bond insurance industry on the ropes, very few issues in the fourth quarter came insured. For the year, 18% of new issues were insured versus 47% in 2007, but most insured deals in 2008 were brought to market early in the year. From a ratings perspective, both Moody's and Fitch put their municipal bond upgrade programs on hold, given the current economic climate. We do, however, expect that Moody's may soon begin to implement broad-based upgrades as they move municipal ratings to a global scale, beginning with the general obligation sector

With municipal issuance very light at year-end and significant amounts of cash on the sidelines, the current technicals of the municipal market are fairly favorable. It remains to be seen, however, how the market will react as the issuance calendar builds.