Paul Grillo, CFA Senior Vice
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
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
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
- 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
- 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
- We have hedged some of our investments in the high yield bond
- We have small exposure to U.S. Treasury debt. We also have exposure to
agency mortgage-backed securities (MBS) for their added yield
*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
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
Investing in emerging markets can be riskier than
investing in established foreign markets due to increased volatility and lower
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.