Posted by: Ben Levisohn on November 11, 2008
Putnam Investments held its quarterly fixed income conference call today. With credit markets still under pressure, it should be of little surprise that the subtitle of the event was “Crisis, Credit and Confidence.”
Much of the discussion related to the historical cheapness of bonds relative to Treasuries. All non-US government bonds are trading at unprecedented premiums. The big question is whether the high interest rates reflect greater fundamental credit risk or liquidity issues — that is, supply overwhelming demand. So is it time to buy fixed income? Here’s Putnam’s take in live-blog form:
9:11 “1998 looks quaint by comparison.” Spreads on AAA mortgage securities trading at 600 basis points over treasuries. During Long Term Capital Management crisis, spread was only 100 basis points.
9:15 High Yield. Since 1987, two periods of bad credit conditions: 1990-1991, Drexel Issues, and 2001-2003, dot com bust. Spreads on high yield over Treasuries was around 10 percentage points. Currently, spreads have shot to 14 percentage points, but default rates are still low, under 4%. The market is pricing in much greater level of defaults.
9:19 where is value in the market? When we’ve been at these levels before, you see what happened in the ensuing years relative to equity. During 1990-1993, High yield returned 82.41% v. 49.76 for the S&P500. From 2000-2003: 24.63 return on high yield. -19.71 for the S&P. When looking at high yield, now yielding 18.84%, claims that you have to compare with expected returns from equities.
9:22 The Muni Market. Spreads are over 300 basis points between AAAs and BBBs, and rates are 120% of Treasuries, well above historical norms. (Munis are tax free and typically offer lower interest rates than taxable Treasuries.)Are markets pricing in more muni defaults or is their a liquidity issue?
9:26 Collapse of auction rate securities market increased supply on the muni market. But the market is juggling credit risk and liquidity risk. AAAs have started a recovery, but lower rated investment grade munis are still trading at a huge discount. Default risk is higher, and you have to do your homework, but investment grades are trading at junk muni levels.
9:30 Pockets of muni market under stress: anything connected to real estate, biofuel plants. But opportunities exist in A and BBB bonds.
9:31 Obama administration will probably provide relief to municipalities and the muni bond market.
9:33 Question: What will defaults in high yield market be like? Some of the stress ratios are not as high as you’ve seen in other periods. There are a number of spread widenings, from Libor over Treasury, to AAA corporates over Treasuries. That has to do with liquidity issues, rather than pure fundamentals.
9:35 Fixed income spreads were buys at the beginning of the last quarter and got hammered. What are you telling your shareholders who have watched the value of their funds drop? A bond eventually returns, you’re going to get pull back to par over the time and you get a running yield that is probably paying you handsomely today for the volatility you’re riding. Highest credit quality in portfolio, but the distribution yield relative to cash is higher than it’s ever been as well. High credit quality portfolio and a high running yield.
9:38 Liquidity risk makes up 60-70% of a portfolio’s risk. Market volatility has seen a five fold increase in the risk factor for commercial mortgage spreads over the last year. If you ran that model back in 2007 or 2006, it gives a very different risk perspective than it does today. Commercial mortgages, pre-2007, 5-10 basis point move in one year was a big move. Now, moving 40-50 basis points in a day.
9:42 In 1930s, there was a lot of business-to-business lending. Your supplier would finance your inventor. We expect to see those elements coming down the road.
9:44 Munis: we expect choppiness. We don’t see a significant snap back. When you look at sorting good credits from ok credits, it’s hard to see those snapping backs., We’ve seen some nontraditional buyers coming in on clean stuff. They could venture down into single As and BBBs. Going to be a balancing act until middle of next year, aligning with general economic conditions. I think the opportunity will be around for a little bit of time now. It’s very hard to time tops and bottoms in spreads. Take advantage by buying good credits. The market “still feels a bit fragile.”
9:50 First thought that the China stimulus package would negatively effect Treasuries. But so far that hasn’t been the case. Short term, people are still rushing to safety. In a world where we’ve moved away from the stable disinflationary trend we’ve had over the last 7-10 years. I would anticipate longer term rates to reflect risk consistent what we’ve seen in other sectors. That means higher rates for Treasuries.
9:53: If you go back to Drexel Burnham area — people determined you could be overpaid for high yield. Before that, nobody issued high yield. They became high yield by accident. 16% default in the 1990s. A lot of the fixed income classes will still look good v. equities. Cash flows you get between now and default look good.
The presenters were:
Bill Kohli, Portfolio Manager and Team Leader, Portfolio Construction Thalia Meehan, Portfolio Manager and Team Leader, Tax Exempt
Paul Scanlon, Portfolio Manager and Team Leader, U.S. High Yield