Credit Market Surprises

“If past history was all there was to the game, the richest people would be librarians.”
Warren Buffett

Credit Concerns Reach “Low Risk” Sectors

In our last quarterly Commentary, we discussed the nature of credit cycles and market characteristics associated with cycle phases. We focused then on the direct fall-out from the present mortgage financing crisis and the resulting impact upon financial institutions that had underwritten and retained substantial volumes of mortgage-related securities. Some consequences of the credit disruptions, such as substantial declines in share prices for financial institutions and much wider yield premiums for corporate and mortgage debt, were somewhat predictable. What was difficult then to foresee were the extent and severity of the further consequences of attempts to reduce credit risk.

Since we published our last Commentary, there have been a number of financial events that have surprised many investors: the sudden failure of Bear Stearns; the Fed’s decision to lend directly to broker-dealers, using an expansive, eligible collateral set; auction failures for most of the municipal auction rate securities (ARS) market; and significant mark-to-market losses incurred by “ultra short” debt funds. We will focus on the last two of those surprise events…how it came to be that supposedly short-term, high-credit grade instruments, frequently marketed as “money market” alternatives, would suffer from a combination of illiquidity and actual market valuation losses. Investors have found themselves unable to liquidate ARS holdings. Other investors are facing non-trivial losses in short-term, high quality debt funds. Both markets are likely to undergo major changes from here with a possible outcome for the ARS market being its near elimination (with a possible exception for auction rate preferred securities associated with closed-end funds). Investors will now be much more circumspect regarding credit and price risks contained within supposedly ultra-short debt funds that offer “enhanced” yields.

What happened to cause such wide-spread liquidity and pricing dislocations in these two security types that had exhibited both relative price stability and liquidity over prolonged past periods, and is there a particular villain? In our view, all of the players in the capital markets (fund managers, investment banks, dealers, rating agencies, and of course, the investors themselves) bear some responsibility for weak underwriting and due diligence efforts that provoked the current credit crisis.

Auction Rate Securities: A Near Market Extinction Event

Prior to 2008, there had been relatively few ARS auction failures, despite an overall ARS market that had grown to approximately $330 Billion.1 ARS are long-maturity securities whose yields are reset through periodic auctions (7 to 49 days in frequency) and whose auctions are managed by re-marketing agents. Despite the fact that ARS dealers had been paid an annualized 20 to 25 basis points to conduct ARS auctions in an orderly manner and to ensure that investors wishing to redeem their shares could do so, liquidity largely disappeared from the ARS markets as dealers would no longer commit their balance sheets to cover sell imbalances. As a consequence, hundreds of failed auctions in a largely consecutive fashion constituted a “Black Swan”2 event during this 1st Quarter, resulting in investors mostly not being able to redeem their shares. As of late March 2008, about 70% of auctions continued to fail, meaning that investors who wish to redeem some or all of their shares could not do so fully through the auction process. As a result, ARS rates had increased on average to 6.6% (tax-exempt) in mid-March, up from the mid-3% range in January 2008. Failed auction rates vary widely among ARS, with some issuers paying rates well over 10%.

Happily, tax-exempt money market funds have not been directly affected by auction failures in the ARS markets. These funds have not been allowed to hold ARS as they have not been deemed to be eligible investments for MM funds. ARS do not have mandatory put features or a letter of credit, issued by a suitably rated bank, that would allow, under all circumstances, an investor to put back an ARS security to a liquidity provider on the assigned auction date.

“There’s no such thing as a free lunch.”
Milton Friedman

Enhanced Yield Funds: Mislabeling Risk

In a manner similar to investors reaching for more yield in the ARS markets, taxable debt investors have used “enhanced yield” funds, categorically described as “short-term” or “ultra short”, to improve portfolio yields above those offered by true money market funds. Investors discovered in the 1st Quarter that higher yields can come with substantial additional risks. Some enhanced yield debt funds, despite being labeled as short-term and investment-grade, contained both illiquid assets and asset-backed holdings that were subject to substantial price risk, despite being designated as relatively insensitive overall to interest rate changes due to their very low duration. Some enhanced yield, ultra short funds sustained price losses over the 1st Quarter in the range of 10% or more, despite having stated interest rate durations of less than 2 years. Even longer duration (i.e., more interest rate sensitivity) portfolios had better returns than supposedly less volatile enhanced yield funds. The issue, as it turned out, was not interest rate risk but substantial credit risk, unmasked only when the capital markets became stressed.

Enhanced yield funds that contained substantial exposures to asset-backed investments sustained losses as asset-backed yields increased substantially over the last several months. As such asset-backed paper typically had yields determined from periodic resets (i.e., LIBOR + 1.00%, reset quarterly), the debt was characterized as “short-term” in nature. The reality is that increasing credit spreads over the reset rates caused price declines for these instruments that were more representative of`fixed rate, longer maturity debt. The effective duration for such asset-backed investments was much longer actually than the quoted nominal durations, resulting in much higher-than-expected price volatilities. While multiple investment companies have taken action to avoid “breaking the buck” for money market funds, investment companies have not committed to offsetting investor losses to any extent for enhanced yield, short term fund investments.

“Turbulence is life force. It is opportunity. Let’s love turbulence and use it for change.”
Ramsey Clark

Understanding and Accepting Risks: Portfolio Framework for Risk-Return Trade-offs

While we have focused on shorter-term asset sectors to illustrate adverse outcomes due to market dislocations, we always seek to focus attention on overall portfolio risk and where risk-return trade-offs are more likely to be favorable. For the most part, accepting more risk for cash or cash-equivalent positions is not an effective use of the portfolio risk budget. As these recent developments show, short-term investment risks can be misinterpreted or even misstated substantially. Sudden market dislocations can cause credit spreads to widen, resulting in both price declines and a significant diminution of liquidity even for shorter term, highly rated debt instruments. Instead, risks are much more amply rewarded over the long-term from allocations to longer-term bonds, and, of course, equities and other higher risk asset classes. There simply has not been enough of an interest rate differential in ARS and enhanced yield funds to offset potential price changes and a loss of liquidity from relatively quickly changing investor risk preferences.

Further, some clients could choose to allocate portfolio risk more effectively to opportunistic situations, resulting from market dislocations that are temporary in nature (although perhaps lasting for several quarters). Spreads have widened substantially for credit-sensitive sectors (i.e., investment-grade corporates, agency mortgages, municipal investment-grade and high yield) and are well above historical norms at present. Spreads have widened in response to expectations of slower US economic growth, falling asset prices, higher expected default rates and potentially greater issuance supply (municipals in particular). We expect that credit premiums will drop over the next several quarters and that actual annualized losses from defaults will cumulatively be less than the present yield spreads from these sectors reflect. So, we believe, opportunity does exist for significant profit from this point. If you are already invested in this arena, you can comfortably stay.

What then are the implications for us in assisting our clients in implementing debt allocations?

• Use mutual funds for cash-like allocations, avoiding the holding of individual securities.

• For debt allocations, conform fund selections to the expected holding periods, i.e., the longer the holding period, the higher a fund’s duration.

• Obtain broad-based exposures to the debt markets, meaning the selection of a multi-sector fund that is benchmarked to a broad index, such as the Lehman Aggregate Bond Index.

• Look to make allocations to municipals as municipals are very cheaply valued (measured in yield ratios) versus high-grade taxable debt.

• Consider making moderate longer-term allocations to high yield debt (taxable and tax-exempt) over the next several quarters as an opportunistic capture of current credit spreads.

Although markets suffer dislocations from time to time due to credit cycles, markets do adjust and find new price levels as credit risk assessments change and uncertainty is removed to varying degrees. Already, many institutional investment managers and hedge funds have started to buy failed auction ARS paper. Similarly, distressed debt funds and hedge funds have started to make investments in asset-backed debt. This process will continue and greater liquidity will return to distressed sectors of the debt markets. Along the way, bond insurers and underwriters may become more disciplined and investors will better understand that short term debt is not necessarily low risk.

Long Horizon Debt Investing: Deliberately Capitalizing on Credit and Liquidity Risk

In contrast to the problems of unanticipated risk described above, we are working on developing an enhanced debt-oriented investment for our clients that will involve an expanded opportunity set and is projected to have bond-like return volatility (e.g., 4% to 5% annualized) in arenas where the risk is perhaps over-estimated. We have selected a major institutional bond manager to manage a separate account, available only to our clients at this time, that will be benchmarked off a full maturity (i.e., 1 to 30 years) California municipal index.

This separate account will be managed on an after-tax, total return basis. Permissible investments will include non-California municipal bonds, high yield debt, closed-end funds and limited allocations to taxable debt sectors where total after-tax returns are projected to be greater than those for similar duration and credit quality California municipal debt. We believe that accepting risks, such as credit and liquidity, makes sense only if sufficient return compensation is provided to investors over the long term. We believe that alert investors will generally be compensated over full economic cycles for supplying liquidity to certain debt markets. Those of our clients, with allocations to this general asset class, will be paid, we believe, for deliberately accepting credit risk where other market participants mostly avoid such credit exposures.

We expect to introduce this facility near the end of the 2nd Quarter. We will have more to say about this over the next few months.

Rich Palmer