Many investors are likely worried about how the fallout in the subprime mortgage market and the Bear Stearns hedge-fund failures will impact the broader financial markets—and their own portfolios. The dealings of the hedge-fund world and the large financial institutions have demonstrated that even "smart" money can severely misjudge risk. (Here, the missteps of Long-Term Capital Management in the late 1990s serve as a prime but not isolated example.)
We believe the Calamos portfolios are appropriately positioned to weather this storm. By now, you may have read our Second Quarter Review and Outlook, in which we shared our views about the more speculative parts of the markets. However, these topics have been on our minds for quite some time. (Risk—and more importantly, risk management—is always on our minds at Calamos!) As you may recall, in our First Quarter Review and Outlook, we discussed our thoughts on subprime lending and the effects of easy credit. We wrote:
The Fed: Orchestrating A Selective Slowdown
Over the last few years, the Fed has raised rates from 1% to 5.25%. By doing so, the Fed has sought to reduce leverage in the financial markets and deflate the real estate asset bubble. As short-term adjustable-rate mortgages have rolled to higher rates and new fixed-rate mortgage rates have moved upward, it should come as no surprise that the subprime mortgage market—the most risky segment of the mortgage market—has imploded. We believe it unlikely that the subprime mortgage market's downturn will be the catalyst that causes a recession. The Fed has engineered a slowdown to pop the asset inflation in a section of the market. It has bet on the economy's ability to contain the isolated losses and avoid a full-fledged financial debacle reaching beyond the mortgage markets. The Fed also has significant flexibility to come to the rescue with lower rates if necessary to stem the slide.
Then, as now, we are not forecasting a recession or a cataclysmic ending to the high-yield market. However, we continue to be concerned that, at current yields and prices, investors are not being compensated for the risks in the lowest-quality paper.
For quite some time now, the macro environment and market conditions have encouraged us to take an extremely selective approach to higher-yielding securities. As such, we have long been positioned in higher-quality bonds in all of our strategies. In the case of our high-yield strategies, we have remained underweighted in the most speculative tiers of the high-yield universe. Additionally, within our high-yield strategies, we continue to utilize higher-yielding convertible debt to manage risk.
High-yield spreads have widened this past month, but they only sit at levels that we've experienced throughout most of 2005 and 2006. While our outlook on the overall economic landscape and financial markets remains favorable, we believe higher-quality businesses with more sustainable growth prospects make the most sense today. We believe our rigorous credit work and bottom-up analysis will be of even greater importance in this current market environment.