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Fixed-Income Market Commentary: One Year Later and Firing on All Cylinders

|Includes:E*TRADE Financial Corporation (ETFC)
Key Points
  • The flashpoint of the credit crisis marks its one year anniversary.
  • The credit markets thrive today.
  • A word on deflation.
The fixed income markets passed the one-year anniversary of the credit market freeze-up with lots of reflection last month. There were several articles that discussed those mid-September 2008 days when our financial system appeared on the brink of disaster. One particular article reviewed the events surrounding the Reserve Primary Fund. This money market fund saw its net-asset value fall below the $1.00 per share level, or “breaking the buck” as it is referred to. Reserve Primary was the first casualty after Lehman’s bankruptcy filing because the fund held hundreds of millions of dollars in face value in Lehman paper that was suddenly worth nothing. The dash by investors to exit the fund was on and within two days it was reported that investors attempted to withdraw more than 60% of the fund’s $62B in assets, but they couldn’t get all of their money out.
With this kind of fear and reaction prevalent in the market, the result was predictable. Other money market funds came dangerously close to breaking the buck too, but many of the other funds had something that Reserve Primary did not – a parent company that was willing and able to add the necessary guarantees to maintain that coveted $1.00 NAV and meet redemptions. Either that or perhaps they placed less of an emphasis on mark-to-market practices on some of the suddenly illiquid items in the portfolios. Investor demand to withdraw funds from money markets quickly exceeded $130B at a time when liquidity (your fund manager’s ability to sell securities and raise cash to meet redemption requests) was not there. The government saw a need to act, and soon we had a temporary guarantee program from the U.S. Treasury to ease those fears.
Fast forward to today and you would never suspect that anything was ever amiss in the credit markets. Through the first three quarters of 2009 much of the bond market’s returns are nothing short of spectacular. So what is driving these returns? Well, in part at least, it is a correction from last year’s extremes. Then of course you have to consider the Fed’s deliberate efforts in keeping interest rates low. Last month I referred to the very low rates on money market funds. One consequence of the low rates on money market and Treasury yields is that it is driving some investors to take on more risk in search of better yields. It appears that risk-taking has extended across all asset classes and has left the markets firing on all cylinders. Importantly, that risk-taking has also gone a long way toward thawing the credit freeze of 2008. In a perfect world, most everybody wins…except money market investors who have to settle for extremely low yields.
The new issue credit market calendar for both investment grade and speculative grade bonds remains full and the municipal bond calendar, although lighter for a while, remains strong too. Borrowing costs for many issuers are lower and the demand is there to absorb the new debt.
In the muni market, consider that in October 2008 the State of California had to pay 4.25% to borrow for six months. Most recently it was able to borrow in size ($8B+ in a two part offering) for roughly the same time frame for “only” 1.50%. This level is both good and bad for California. The good is that it was able to borrow and do so at significantly reduced levels versus their last note borrowing. The bad is that similar rated states and municipalities are able to borrow for much less. Then at that, California has its own host of fiscal concerns, so they should be pleased with the access they have.
Looking forward, we hear a lot about the “new normal” from our friends at PIMCO. In a nutshell this is defined as slower growth, reduced consumer consumption and increased government intervention / regulation. We are also hearing from a couple of different places that we should expect a period of deflation and, by extension, lower interest rates. The deflationary forces come from a variety of sources including reduced spending at both the consumer and corporate level and the higher unemployment rate. The time and severity is hard to pinpoint, but it could last for a couple of years. In past commentaries I have made suggestions for investors who are concerned about inflation. For those with the opposite point of view and who would like to prepare portfolios for this kind of outcome I suggest taking on duration. Lock in the higher yields available now, because if we do in fact end up with deflation, it will very likely bring long term interest rates even lower still.
September Review:
The beat goes on and, as was the case in prior months, credit led the way. In the best performing bond sector, high yield, the new issue calendar remained strong with over $20B coming to market in September and well over $100B YTD. The sector is also seeing downward revisions of the good kind with default expectations falling. In the municipal bond market, money flows into muni bond mutual funds have been record setting according to an article in The Bond Buyer newspaper. Asset flows into funds are averaging $1.5B per week. For all of our talk above regarding deflation, it appears not to have harmed the inflation-linked bond sector. The TIPS index was the best performer by a good margin in the highest quality arena. Remember, these securities are Treasuries first and foremost and some have long durations, so if deflation does take hold they could still perform well. It was longer duration TIPS by the way that performed best in that sector as the 10+ year component outpaced the shorter maturities. The benchmark 10-year Treasury closes out the month with a yield 3.30%. On a year-to-date basis the 10-year is still well into negative territory with a total return loss of -6.40%.    
Chris Keith is the Director of Fixed Income for E*TRADE Capital Management, LLC.

Chris has been working in the fixed income markets since 1985. Chris was the Vice President and Fixed Income manager at Kobren Insight Management, Inc. (NYSE:KIM) before E*TRADE Financial acquired KIM in 2005, and currently holds the same position at KIM.

Previously he was a Vice President in the Private Client Services Group of Robertson Stephens Inc., in Boston, where he designed and implemented fixed income portfolios for high net worth clients. Before Robertson Stephens, he was a Vice President of Donaldson, Lufkin & Jenrette in Boston, where he was the head fixed income trader for the New England region. Chris graduated from Northeastern University.

Past performance is not an indication of future returns.
Bonds sold by issuers with lower credit ratings may offer higher yields than bonds issued by higher rated or "investment grade" issuers, but are usually associated with higher risks. High yield bonds, also known as "junk bonds", generally have a greater risk of default, which increases the risk that an issuer may be unable to pay interest and principal on the issue. In addition, high yield bonds tend to have higher interest rate risk and liquidity risk, particularly in volatile market conditions, which makes it more difficult to sell the bonds. Before investing in high yield bonds, you should carefully consider and understand the risks associated with investing in high yield bonds.
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Market commentary is provided by E*TRADE Capital Management, LLC, an investment adviser registered with the Securities and Exchange Commission. Form ADV, Part II available upon request. The information provided in the market commentary is for informational purposes only. It does not constitute investment advice.
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