The fixed interest pretenders

For fixed interest managers, the events of the past three months have been a wake-up call, particularly after a period of low volatility and yields.

In my mind, it could be likened to an earthquake shaking a tree housing a colony of monkeys, with only those monkeys closest to the trunk able to hold on, while those out on the branches eating the leaves likely to fall out of the tree.

Those who ignored risk did so at their peril, while those who trod more cautiously and held true to fixed interest investments are still in a relatively good position.

Events such as the sub-prime crisis have been a useful reminder for all market participants, who have perhaps become complacent in an era of low volatility, about the dangers of risk and the complexity of leveraging.

I believe the ultimate effect remains to be seen, as the repercussions continue to play out.

In the meantime, investors will be asking their advisers some tough questions about the fixed interest component of their portfolios.

For many of them, what they thought was fixed interest should really have been treated as an equity investment, and understanding and explaining what these investments are based on will be a major theme in coming months.

It’s worthwhile reviewing what has actually happened, and considering some of the lessons that can be taken out of these events.

Recent events

One reason for the market complacency is that the past five years have been a period of low volatility and a low return for risk, both credit and term risk. This can largely be attributed to a benign economic environment and plenty of liquidity.

But there have been warning signs.

The first major signal of a change to this environment was, ironically, the bond sell-off in early June, when the Australian 10-year bond dramatically broke the 6.0 per cent level — the upper level for yields for the past five years.

In addition, the yields on swaps, which formed the basis for term corporate paper, also broke above their recent trading range. All the signs were pointing to a tightening of liquidity after years of plenty.

However, the big shock came with the worsening of the situation in the US sub-prime market, which affected the securities held by leveraged funds.

As these funds tried to de-leverage, other structured products were caught up in the ensuring maelstrom and investors began to question their underlying economic worth.

As a result, liquidity in secondary markets dried up and, at the same time, leveraged funds de-leveraged, risk positions were unwound, and volatility in the markets increased dramatically.

Investors also questioned the asset holdings in structured conduits and boycotted the commercial paper raisings of these structures.

Increasingly, the money market failed to function as investors sought to hold increasing amounts of cash in preference to short term debt. Corporate and financial entities were less and less able to meet their short-term funding needs and had to resort to bank lines. As a result central banks needed to inject liquidity into the banking system to help unblock this log jam.

Lessons in liquidity

The major lesson from these events is that liquidity cannot be assumed.

Although the events of 2007 can be best likened to those of 1987, when all assets were shunned as investors looked to raise cash, we have only to look as recently as the events surrounding the September 11, 2001, terrorist attacks when even the US treasury curve tiered between the liquid benchmark stocks and the so called off-the-run non-benchmark securities.

In the worst case scenario, liquidity becomes largely dependent on the securities repo eligibility with the central banks.

It is likely that there will be three major consequences from these events:

1) Risk will be more appropriately priced.

With the tightening of liquidity it is unlikely we will see risk being as under-priced as it has been up to now. In my view, investment grade spreads look very attractive when compared to the breakeven using present historical default risk.

High yield debt, although offering better value, is still not as cheap as it was in the aftermath of, for instance, the Enron situation.

2) The role of structured credit will change.

To say that structured credit and the asset-backed commercial paper market is history is likely to be premature, although their halcyon days are probably behind us.

The fact is that structured products were developed to meet investors’ demand for high grade assets. By restructuring a pool of low grade assets one can develop a range of tranches to meet a range of investors’ requirements.

As an example, asset-backed commercial paper was developed to meet the increasing demand for short-term paper, which was not being met by conventional means. This demand will still need to be satisfied in the longer term.

However, as with any good thing, too much can be harmful to your health. The technology was abused and the risk was under-estimated.

Highly-rated structured credit security will require a different risk profile to similarly rated government or corporate debt. Structured debt has a risk profile that exhibits ‘fat tails’ and is therefore more vulnerable to extremes in volatility. As long as this is recognised then structured credit is a useful tool.

3) Perhaps most importantly, investors will demand better understanding of fixed interest investments.

It is highly likely investors will look to dissect the assets they hold and the risk levels of the funds they invest in. Openness will now be the “order of the day”.

The previous situation was that, as investors looked for yield, funds were sold as ‘fixed interest’ based on their historical negative correlation to the equity market. This meant that even funds based on the highly-leveraged lower (that is, riskier) tranches of collateralised debt obligations were treated as fixed interest funds when realistically they were more akin to equity.

This situation ignores the secondary role of fixed interest funds, which is to provide a steady cash-flow. Obviously leveraging funds increases potential returns but it dramatically increases risk and makes funds extremely vulnerable to any liquidity crisis. This was compounded by the usually illiquid nature of some of the assets held.

In summary, it is likely that investors will demand more openness before they invest their money.

Many of the structures being sold to investors have been opaque in nature. Funds with vastly different risk profiles were largely grouped together as fixed interest.

The market is likely to look to differentiate funds according to their risk profiles and it is probable that there will be much more scrutiny of these structures before investors commit to them in future.

Therefore a better understanding of the differing risk/return profiles resulting from the different strategies employed by different fixed interest funds should help ensure investors understand the reality behind a higher yield resulting from funds using high risk strategies.

Roger Bridges is head of bonds at Tyndall .