© 2009 Northern Trust Corporation northerntrust.com
FALL FOCUS
2009
INVESTMENT CONFERENCE
Colin A. Robertson Managing Director Fixed Income
Fixed Income Update
2 2009 Fall FOCUS Investment Conference
Review – 2008 Fall FOCUS
Environment
Outlook
Update – Fixed Income Markets
Environment
Outlook
Fixed Income - Agenda
3 2009 Fall FOCUS Investment Conference
Fixed Income Update
2008
Environment and Outlook
4 2009 Fall FOCUS Investment Conference
Globally, authorities grasped the scale of threats relatively quickly and have taken drastic actions
Fed moves have been aggressive in both traditional and unorthodox channels
Reduced funds rate from 5.25% to 1.5% in short time frame
Created new borrowing facilities (PSCF, TSLF)
Backstopped money market mutual funds
Took Bear Stearns and AIG assets onto Fed’s balance sheet
Purchased high quality commercial paper from corporate entities
ECB and BOE actions have been equally aggressive and creative
Highly complex, globally integrated, fast-moving global financial system has complicated efforts at repair
Authorities have limited understanding of aggregated risks created by inter-connections between assets, especially derivatives and securitizations
Pattern of financial institution rescues/failures (especially Lehman) has confused investors which has severely damaged confidence
Primary focus of banks and investors is on deleveraging only
Fixed Income Update
Environment - 2008 Fall FOCUS
5 2009 Fall FOCUS Investment Conference
Turmoil will have lasting impacts for macro economy
High growth/low inflation environment not likely to return for years
Expect prolonged period of weak growth as de-levering process follows a decentralized, case-by-case path
Set back for a globalization and integrated financial system
Governments will have bigger fiscal deficits and greater financing needs
Growth will be slower
Need to absorb costs of rescuing banks, additional stimulus programs
Consequences longer term will be higher taxes
Companies will seek stronger balance sheets, have lower need for day-to-day financing
Fixed Income Review
Outlook - 2008 Fall FOCUS
6 2009 Fall FOCUS Investment Conference
Turmoil will have lasting impacts for credit creation
Duration of de-levering will depend on severity of US recession and impacts on bank balance sheets
Tightening credit conditions will slow future growth
Slow growth will cause defaults to rise
Rising defaults will cause banks’ non-performing assets to rise, undermining capital raising efforts
Thus, outlook for restarting credit creation is not good, absent launch of special government programs
Current de-levering process has damaged functioning of cash, collateral and counterparty risk management frameworks – these will need to be repaired, revamped or rebuilt
Process will be slow, arduous and highly political
Essential for return of risk appetites and restarting of innovation efforts
Institutional investors will end up with fewer, larger and more regulated counterparties
Fixed Income Review
Outlook – 2008 Fall FOCUS
7 2009 Fall FOCUS Investment Conference
Turmoil will have lasting impacts for issuers
Issuance preferences and risk premiums will change across instruments and capital markets.
Shift back to simplicity and away from complexity in credit instruments
More equity
Less structured, floating rate and wrapped debt
More long term debt, issued at higher yields
Growing portion of debt will be supported by government
Credit premia to be permanently elevated for any/all complex securities
Fed to become central counterparty and biggest player in repo market
Fed to start paying interest on reserve balances
Enables it to have a credit policy that’s independent of monetary policy
Puts a floor under the traded overnight rate (so can provide liquidity in times of stress without affecting overnight rate)
Eventually (3+ years), expect credit conditions to normalize around pre-bubble levels
Fixed Income Review
Outlook – 2008 Fall FOCUS
8 2009 Fall FOCUS Investment Conference
Turmoil will have lasting impacts for investors
Investors will be in risk avoidance mode for next several years
Investment guidelines will be overhauled
Transparency will be emphasized
All types of oversight will be increased
Focus will return to traditional instruments/practices
Experience will matter more than innovation
Liquidity and marketability will be stressed
Leverage will be avoided
Fixed Income Review
Outlook – 2008 Fall FOCUS
9 2009 Fall FOCUS Investment Conference
Turmoil will have lasting impacts on investment strategies used by short term funds
Investment guidelines will be made more restrictive
Will be structured for liquidity/safety and not for yield
Instruments: Only very high quality securities, including repo, time deposits, CD's, commercial paper, corporates and Government Agencies
Interest Rates: Focus will be on rate and curve positioning, waiting for revamp and rebuild of short credit and funding markets
Credit: Not a focus. Will be de-emphasized indefinitely, at least until de-levering process is complete and next generation investment instruments and portfolio guidelines are developed and fully vetted
Fixed Income Review
Outlook – 2008 Fall FOCUS
10 2009 Fall FOCUS Investment Conference
Turmoil will have lasting impacts on investment strategies used by core and high yield bond funds
Investment guidelines may be made more restrictive
Will revert to more traditional investment instruments and strategies
Rate and curve positioning/bets
Traditional, independent credit analysis (No reliance on NRSROs)
Use of CDS for signaling and trading strategies will change Shift from OTC to exchange
Regulation to increase
Trading spreads will increase
Trading volume / flow will gradually build
Number of dealers will increase
Capital commitments by dealers will decrease
Fixed Income Review
Outlook – 2008 Fall FOCUS
11 2009 Fall FOCUS Investment Conference
Fixed Income Update
2009
Environment and Outlook
12 2009 Fall FOCUS Investment Conference
Change in paradigm for consumers and corporate profitability
Changes in securitization market
Limitations of global fiscal stimulus to produce sustained economic recovery
Changes to regulatory frameworks
Shortcomings/revisions to globalization thesis
Rise of non G8 countries as drivers of global growth, especially China
Fixed Income Update
Environment
13 2009 Fall FOCUS Investment Conference
Post-Lehman bankruptcy
Continued slowdown in bank lending across industrialized economies
Unprecedented monetary liquidity in global financial system
Governments acted to promote credit creation via capital markets
Amid banking crisis, capital markets have become the main channel of monetary transmission in the economy
Allows borrowers to bypass bank lenders and raise funds directly from capital markets
Economic benefits of this development are unevenly distributed
Can the 2009 capital markets rally end the credit shortage in the real economy?
Fixed Income Update
Environment
14 2009 Fall FOCUS Investment Conference
Aggressive/expansive government policies are heavily influencing all bond markets (types, maturities and regions)
Monetary
Fiscal
Emergency support policies/programs are motivated by political as well as economic considerations
Investment outlooks must incorporate analysis of traditional and novel drivers
Traditional
Economic
Credit
Technical
Novel
Government Programs (timeline, permanence, unwind)
Fixed Income Update
Environment
15 2009 Fall FOCUS Investment Conference
Fed to maintain record low interest rates for extended time period
Real cash rate to stay close to zero
Key catalyst for US growth to strengthen
Persistent sub-par growth and low inflation likely to outstrip concerns about US deficits and heavy Treasury (UST) supply
Foreign buying of USTs to continue unabated
Additional demand for growing volume of USTs expected to come from increasing US savings rate, former buyers of securitized products
Benign inflation backdrop likely to favor coupon Treasuries over TIPS of comparable maturity
Fixed Income Update
Outlook – Money markets, Treasuries and TIPS
16 2009 Fall FOCUS Investment Conference
Using BarCap Credit Index as proxy
Expanded reliance/use of government guarantees will increase weighting of AAA issuers
AA and A rated issuer weightings to decline for same reason
Significant churn likely among BBB credits, with some falling to junk
Non-corporate sector to grow at expense of others (industrial, utility, financial), as result of Build America Bonds and similar programs
Financial and non-corporate OAS levels likely to tighten, based on increased presence of government guarantees
Investment Grade credit generally positioned to do well in post-crisis credit/funding environment
Banks - reduced ability and willingness to lend
Investors - ongoing distaste for innovative, complex, opaque credit structures
Investors – strong demand for traditional, transparent, plain vanilla debt
Fixed Income Update
Outlook – Investment Grade Credit
17 2009 Fall FOCUS Investment Conference
Era of tight junk spreads, easy credit terms now over
End of voluntary shift by “A” rated companies toward below investment grade credit ratings and balance sheets
Accelerating slide of investment grade companies to below investment grade ratings, due to business and/or financial difficulties
Junk bond market to adjust to changed economic and risk environments
High yield market to refocus on basic (not alternative) credit structures and meeting needs of traditional high yield investors
High yield spreads will not return to compressed levels of recent years
Instead, will trend sideways around historical median level
Cooling of trend toward globally integrated high yield market
Performance bifurcation by sector likely to sharpen
Some to implode amid creative destruction
Other to sail along relatively untouched
Fixed Income Update
Outlook – High Yield
18 2009 Fall FOCUS Investment Conference
Fallout from credit markets crisis and subsequent economic developments
Exit of monoline bond insurers from municipal new-issue market
New municipally-focused programs included in federal stimulus package
Build America Bonds (BAB) initiative
Waiver of Alternative Minimum Tax on tax-exempt issues sold to finance private activity bonds
Increase in size of municipal issuers purchased by banks that qualify for tax exemption
Programs have helped to repair municipal market and rally prices
Constrained volume and type of tax-exempt municipal issuance
Increased demand from existing and new sources
Changed composition of buyers of municipal debt
Overall result, richened municipal valuations relative to Treasury yields
Fixed Income Update
Outlook – Municipals
19 2009 Fall FOCUS Investment Conference
Fallout from credit markets crisis and subsequent economic developments
Expect smaller/simpler short-term municipal market
Short-structured debt issuance to shift to intermediate maturity range
Downward trend of fundamental municipal credit quality
No regional safe-harbors, negative trend is nationwide
Do not expect federal government to provide direct guarantees of municipal debt
Using BarCap Municipal Index as proxy
Downgrades to monoline insurers have decreased weighting of AAA rated new issues
AA and A rated issuer weightings to increase for same reason
From a sector perspective (general obligation, revenue, insured, pre-refunded), the market’s composition is expected to gradually rebalance
Reduced weighting for insured sector Increased weighting for general obligations and revenue sectors
Fixed Income Update
Outlook – Municipals - 2
© 2009 Northern Trust Corporation northerntrust.com
FALL FOCUS
2009
INVESTMENT CONFERENCE
Colin A. Robertson Managing Director Fixed Income
Thank you.
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