Paul Grillo, CFA Senior Vice President,
Co-Chief Investment Officer – Total Return Fixed Income Strategy
The enormous buildup of debt during the last two decades continues to have ramifications both for politics and for the capital markets around the globe. Many developed nations in particular have built up debt levels (in all parts of their society) that are greater than 300% of their gross domestic product (GDP). In years past, asset prices were moved to high or extreme levels based on this financing. However, when poor loan collateral performance was introduced via Early Pay Defaults* on sub-prime mortgage securitizations in the fall of 2006, it started a shockwave that is still affecting the global financial markets today.
As politicians and government leaders have tried to deal with the damaging growth aspects of the deleveraging that has ensued, two of the most popular actions seem to have been 1) increasing government spending to stimulate demand and shore up/re-capitalize commercial banks, and 2) injecting significant monetary stimulus into their respective economies. While deleveraging has generally taken place through the destruction of outstanding debt (defaults) and some pay downs of principal, perhaps the dominant theme in recent years has been the transfer of private obligations to the public domain.
Within this environment, we believe 2011 marks a new phase of the credit crisis, in which global investors are making choices about which sovereign debt is apparently either safe enough, or attractive enough, for return opportunity. The recent intensity of the capital market selloffs, in our opinion, represents escalated investor concern over stagnant or declining growth rates across the developed world. This is significant because austerity programs have become increasingly difficult or impossible to implement under today’s very slow growth, or recessionary, environments, and leaves policy makers in many developed countries with few remaining options other than keeping interest rates at their current low levels, likely through the next couple of years.
During this phase of the credit crisis, we, as investors, should go back to an environment in which high quality fixed income investments should continue to perform well in our opinion. While it has become difficult to make this assessment with the current low level of yields for these investments, do not be fooled. To us, today’s environment is about returning capital intact, and not searching for stretched return on capital. In our opinion, high quality country debt should continue to meet this goal (Australia, Norway, and Canada) while high debt-to-GDP countries should continue to struggle (Greece, Ireland, Portugal, and now Italy and Spain). Additionally, we continue to view corporate debt — both high grade and high yield — as an attractive option as many of these entities have either already restructured or delevered to face the growth challenges that lie ahead.
In our opinion, growth challenges should continue to intensify sovereign concerns and U.S. government debt ratings will come under further pressure as our recovery stalls. However, possibly the biggest concern, in our opinion, revolves around the effects that the slow-growth environment could have on France. France is currently an “AAA rated” country that we believe is key to the ongoing bailouts of the peripheral European nations. If France’s AAA rating were threatened, we believe the European Financial Stability Facility (ESFS) that Europe is counting on to assist in peripheral financing over the next two years (it has recently been granted expanded responsibility for this action) might be called into question.
We will continue to monitor credit indicators for this country as a barometer for sovereign crisis levels. Yet, given the many macroeconomic uncertainties that remain in place, quality, liquidity, an emphasis on downside protection through careful corporate and sovereign credit selection will remain keys to our approach to fixed income security selection as we face the remainder of 2011.
Current positioning across our diversified mutual funds:
Regarding international investments, we continue to concentrate on developing countries that offer natural resources or competitive labor advantages as well as those that we believe offer credible fiscal and monetary policy.
In the developed world, the characteristics we seek are much the same. Our core investments include Australian, Norwegian, and Canadian government bonds. These countries have similar characteristics in that they are natural-resource rich, and have exercised good fiscal discipline in covering their populations with social or savings safety nets.
We maintain a core investment in the high grade corporate sector, where credit fundamentals have continued to improve. We maintain an overweight to the finance sector, mostly in domestic bank and finance companies, which are partially hedged with credit default swaps on the European banking sector.
We have hedged some of our investments in the high yield bond sector.
We have small exposure to U.S. Treasury debt. We also have exposure to agency mortgage-backed securities (MBS) for their added yield potential.
*An Early Payment Default generally is considered to be a property owner who defaults on their payments within a short period of time of the close on the loan.
These downgrades may have repercussions for certain clients’ investment guidelines. For example, investment guidelines may not anticipate a downgrade of U.S. Treasury debt below AAA (and with that the average quality of many indices). This could restrict a desirable portfolio action or even direct the sale of one or more portfolio holdings. If this is the case, we strongly recommend that you provide at least temporary relief from your guidelines relating to investments in U.S. government securities, consistent with your investment objective.
Client service offices will be in touch in the event there are any questions about your guidelines.
IMPORTANT RISK CONSIDERATIONS
Investing involves risk, including the possible loss of principal.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer's ability to make interest and principal payments on its debt.
Fixed income securities may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by a Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
High yielding, noninvestment grade bonds (junk bonds) involve higher risk than investment grade bonds. The high yield secondary market is particularly susceptible to liquidity problems when institutional investors, such as mutual funds and certain other financial institutions, temporarily stop buying bonds for regulatory, financial, or other reasons. In addition, a less liquid secondary market makes it more difficult for a Fund to obtain precise valuations of the high yield securities in its portfolio.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
If and when a Fund invests in forward foreign currency contracts or uses other investments to hedge against currency risks, it will be subject to special risks, including counterparty risk.
The views expressed were current as of Aug. 9, 2011, and are subject to change at any time.