Commentary

As the new year began, the U.S. yield curve behaved similarly to how it did at the end of 2007, moving to lower yields and steepening in shape. This was driven by a massive 125 basis points of interest-rate cuts by the Federal Reserve within an eight-day span in late January. The lower short-term rates helped to pull down yields across the rest of the Treasury curve with the exception of the 30-year yield, which actually increased.

Rates and Risk
Short-term rates have fallen while the Fed has eased interest rates. Credit spreads have widened as de-leveraging continues. (Basis points unless otherwise noted.)
	9/28/2007	12/31/2007	2/15/2008
Fed Funds Rate	4.75%	4.25%	3.00%
3-month Libor	5.23%	4.71%	3.07%
2-year Treasury	3.98%	3.05%	1.92%
10-year Treasury	4.59%	4.03%	3.77%
Investment Grade Corp Spread	+145	+198	+234
AA Corp Spread	+120	+164	+183
A Corp. Spread	+138	+196	+229
BBB Corp. Spread	+173	+233	+285
High Yield Corp. Spread	+405	+569	+709
Mortgage Spread	+81	+87	+118
Source: Lehman Brothers, Bloomberg LP.
Steepening Curve
The Treasury yield curve steepened as the Federal Reserve in January made deep cuts in short-term interest rates.
Source Bloomberg LP

The rally in foreign yield curves has been much more muted as there has been a lack of monetary easing by foreign central banks. Both the European Central Bank and the Bank of Japan are choosing to hold rates steady while the United Kingdom, the exception, has begun the process of cautiously cutting interest rates. Central banks have stopped short of coordinating their interest-rate setting activities, but we are encouraged by the increased coordination they have shown in providing liquidity to global capital markets. This global approach helps to reduce systemic risk and moderate volatility as the de-leveraging process continues.

Corporate Bonds and Credit Default Swaps

The negative momentum in the corporate bond market is weighing on the sector and has resulted in very poor returns. This is true even against the backdrop of relatively strong earnings growth (outside of financials). While a substantial portion of the weakness can be ascribed to the concerns about the outlook for economic growth, the majority of the pressure on the corporate bond market appears to be technical in nature and driven by the credit default swap (CDS) market.¹

Currently, there is a steady shedding of credit risk in the CDS market that is pushing the market consistently higher in yield (lower in price). Much of this pressure is coming from losses in leveraged investment vehicles that have triggered the unwinding of risk positions. While we are confident that a long-term value opportunity is being built, we are mindful of the near-term economic headwinds. We are even more mindful that the extremely strong technical conditions that drove the credit default swap market to its historic low in yields in 2007 was a multi-year process. Unfortunately, the current technical conditions that have widened yields may also be here for a while as well.

Corporate Credit Weakness
Leveraged investment vehicles are shedding credit risk, causing the spreads of corporate bonds and credit default swaps to widen. The corporate spreads are based on the Lehman Brothers benchmark corporate index and CDS spreads are represented by the CDX IG. 5 index.
Source: Lehman Brothers, J.P. Morgan

The woes of bond insurers are exacerbating the weakness in the corporate bond market, and are also negatively impacting the mortgage securities market. While these entities are most commonly known as the providers of guarantees on the debt of municipalities, their forays into the subprime mortgage and credit-default swap markets over recent years now threatens their financial viability. The reverberations felt in the corporate bond and mortgage markets make the near-term outlook appear even more challenging.

Conclusion

In this environment, we feel the place to be in debt markets has been in the safest of U.S. government and sovereign issues. When determining our positioning in the higher-yielding segments of the market, we are still biased towards higher-quality corporate issuers that have a strong global presence and towards agency-backed mortgage securities.