Point of View

The fixed-income markets have been tumultuous, to the say the least, during the past few years. Having survived the bursting of the real estate bubble, a global credit crisis, extreme illiquidity and the collapse of seemingly blue-chip Wall Street investment banks, the time is right to pause and reflect on the road traveled and the financial terrain that lies ahead.

The financial market collapse initially centered on the shutdown of short-term financing in August 2007. “The short-term fixed-income market is the grease of the financial engine, and when there’s no grease, the engine stalls,” says Ali Bleecker, director of short-duration fixed-income investment management, Northern Trust.

Forced selling of complex, and highly leveraged, structured investment vehicles by hedge funds and others fed a market panic that pushed asset prices lower in late 2007. There was no differentiation between high- and low-quality securities as a “sell-anything” mentality took hold. For example, asset-backed commercial paper, issued by banks and backed by physical assets such as receivables, were lumped in with riskier mortgage-backed securities. Heightened fear of credit default led institutional investors to pull back into higher-quality, short-duration securities. In September 2008, the historic “breaking of the buck” occurred, in which some money market funds lost money in the wake of the Lehman Brothers collapse, much to the surprise of investors. The financial engine had ground to a halt, due to a complete lack of liquidity and market confidence.

“Many investors took money out of money market funds,” Bleecker says. “Funds that had increased liquidity were able to handle the market turmoil with minimal disruption. Those money market funds that were focused on Treasuries, other U.S. government securities and municipal bonds received much of the inflow during that period.”

Taking a Detour

The credit crisis and severe liquidity drought left their mark on the fixed-income investment world, shaping future demand and issuance and largely leaving securitized products by the roadside.

“The U.S. capital market has traditionally had a reasonably diversified mix of issuance, comprised roughly one-third each of government bonds, corporate bonds and securitized products,” says Wayne Bowers, chief executive officer of Northern Trust Global Investments, London. “Ten years ago, people assumed that the global fixed-income market would move toward the U.S. market, with a fairly even balance of government, corporate and securitized product. But that just hasn’t happened.”

In Japan during the past several years, there was a collapse in corporate issuance and a significant increase in government-issued bonds. The United Kingdom has made a very slight move toward the U.S. model, but far short of expectations, Bowers notes. And in the rest of Europe, corporate issuance has risen, but with no growth in the securitized market.

Now, in the aftermath of the credit crisis, investors have experienced a sharp loss of risk appetite as complex, leveraged products have left investors with a decidedly bitter taste. “I can’t for the life of me work out why people would expect securitized markets to gain traction and recover to their former size or level,” Bowers says. “Investors just will not buy that product any more.”

Beyond that loss of risk appetite, Bowers points out that companies that had relied on securitization — such as automobile financing companies — have experienced a significant decline in sales volume, which requires far less financing activity.

“With lower consumption of goods and services that rely on credit, the demand for credit should be lower than before,” Bowers says. “There’s simply no current market demand for securitized products. The credit creation bubble has been popped, and you shouldn’t assume that it’s going to inflate again.”

Enabling cash to flow more freely has led financial firms to become more comfortable lending cash out over longer periods of time.

Instead of a move in the direction that people had thought the fixed-income markets were heading, Bowers sees a more basic, less-leveraged product emphasis with an increasing proportion of government-issued debt, along with high-quality corporate bonds.

Under Construction

A rebuilding process has begun in the markets, starting with the U.S. government attempts to restore liquidity. “Close to two dozen government programs were announced to address the financial crisis,” Bleecker notes. “Many of them were targeted to the short end and focused on restoring liquidity.”

Enabling cash to flow more freely has led financial firms to become more comfortable lending cash out over longer periods of time. A fairly recent decline in the London Interbank Overnight Rate (LIBOR) reflects this improved liquidity and a more positive or optimistic mindset among short-term investors. However, concerns remain about being sufficiently compensated for liquidity risk and credit risk.

“It may be challenging for investors to really feel comfortable leaving much of their total portfolio in cash because they’ll be giving up potentially more attractive return opportunities,” Bleecker says. “But this is like taking an insurance policy to protect yourself.”

After settling for not losing money in the midst of the liquidity crisis, more normalized market expectations appear to be returning. “As we observe more stabilization, we’ll likely see a decrease in demand for Treasuries and less reliance on the short-term investor,” Bleecker predicts. “Because growth prospects for corporations are muted, there’s less need for them to issue commercial paper.”

Along with a lack of demand for certain securities, such as complex structured investment vehicles or other leveraged products, Bowers foresees a move back to basics and simplicity. “There won’t be a great demand for innovation,” he says.

Uphill Climb

To Bob Browne, chief investment officer, Northern Trust, the path is clear. “We’re headed for a period of low economic growth, so I expect the Fed and other central banks to keep their short-term rates near zero for a very long time. This may sound obvious, and is in line with market expectations, but if anything, the market may be underestimating the likelihood of an extended period of low official rates.”

Browne sees expectations changing, as investors no longer view the economy as “heading into the abyss,” but he cautions against the risk of too rapid a rise in interest rates. “We don’t think the economy is robust enough to withstand higher rates across the board,” he says. “If we get to 5.5% interest rates on 30-year mortgages, 4% Treasury rates and widening spreads, that may not be good for an economy that’s still in a pretty precarious state.”

High-yield valuations became attractive in March, when the market had discounted a very dire situation, Browne says. However, having seen the market move sharply from one extreme, Browne believes it is beginning to overshoot in the other direction, discounting an economic recovery too quickly.

Browne believes TIPS and municipal bonds are promising sectors. “We don’t think inflation will be an issue during the next year or even two years,” he says. “Eventually, we expect the market will begin to look ahead to potential inflation two to three years down the line. We’re starting to prepare for that now.”

He also sees good value in municipal bonds, particularly for high net worth investors. After-tax yields remain attractive and “there are some very good AAA-rated issuers with rock-solid credit and attractive prices.”

A Closer Look at Cash

Bleecker has observed a greater interest in and appreciation for credit quality, liquidity and diversification, rather than just a focus on investment return. She sees the Term Asset-Backed Securities Loan Facility (TALF) program as an attractive moneymaking opportunity for those who are willing to accept additional government scrutiny.

She cautions investors to appreciate that cash products are not all the same, and to take the time to understand their cash product as they would an intermediate bond fund.

Bleecker also suggests dividing cash holdings into two groups — strategic and tactical. A tactical allotment would be available at all times in case of an immediate need. In contrast, a strategic cash allocation would be money that an investor is comfortable leaving in cash for a year to 18 months. In return for less liquidity, one might earn a slightly higher return or accept some additional credit risk.

Despite his expectation for a resurgence in simple, back-to-basics investing, Bowers does see the potential for more complexity in one area: government-issued inflation-linked bonds. “You could see government-issued debt that has a fixed-rate coupon and a floating element based on inflation,” he says. “At the moment, investors have to choose between fixed-rate bonds or floating-rate that’s fixed to an inflation basket. Why not have both? The governments could plug that gap with a product that provides a level of downside protection while protecting investors from an inflation shock, as well.”

As institutional investors look at the road ahead in fixed-income markets, they might still be in uncharted territory. However, with a gradual return to more normal market behavior, it appears that patience, prudence and diversification should help investors stay on course to reach their destinations.

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