Capitalising on credit risk

Credit risk is essentially the risk that a debt investor will not be paid all that they are owed. With housing-related losses flowing through the bond market into the global financial system and the real economy, market participants became increasingly averse to lending money to virtually anyone. The result has been massive dislocation in the fixed income market. Bond prices in some sectors have declined by unprecedented amounts, with little regard for the credit quality of individual securities within the sector. The upheaval in the bond market creates two key opportunities. First, there are tactical opportunities to purchase high quality bonds at extremely discounted prices in sectors most affected by the crisis, including mortgage-backed securities (MBS) and corporate bonds. Second, we believe the relative stability in emerging market bonds throughout the credit crisis confirms the longer-term strategic opportunities in this sector. Mortgage and corporate The ongoing credit crisis has hit the mortgage and corporate sectors of the bond market hard. Fundamentals are weakening in both sectors as default risk has increased for both mortgage-related debt and corporate debt. However, price declines have been widespread in both sectors, with little differentiation among securities with vastly different credit quality, as rising risk aversion caused investors to throw out the good with the bad. Meanwhile, demand has been limited by the fact that mortgage and corporate securities require investors to do a significant amount of research to understand the risks involved in each security. The lack of differentiation creates extremely attractive opportunities for investors capable of analysing the risk characteristics of individual bonds. In the mortgage sector, we see particular opportunity in “super senior” securities backed by adjustable-rate mortgages. Super senior bonds are the last to absorb losses on the underlying mortgage loans and include credit enhancements well above those required for a traditional AAA rating. At current prices, many of these super senior securities offer strong return potential even in the most dire housing market scenarios we can imagine. In the corporate sector, securities backed by bank loans to corporations, which are senior to corporate bonds, offer a tactical opportunity to capture yield premiums at or near all-time highs. The window of opportunity to capitalise on current, extreme valuations in MBS and bank loans may be limited. US policymakers are taking unprecedented steps to restore liquidity in the fixed income markets. As liquidity improves and risk appetite returns, buyers waiting on the sidelines for the markets to stabilise will step in. Emerging markets In a marked change from previous years, emerging markets have been one of the more stable sectors of the bond market, which is a testament to the solid balance sheets that characterize and underlie emerging market country fundamentals. We see particular opportunity in emerging market debt denominated in local currencies. Risk premiums on local emerging market debt continue to be very significant despite balance sheet improvements and disinflationary trends in many emerging market countries. Local debt investors gain exposure to emerging market currencies, which remain very well underpinned by strong current account surpluses and productivity trends in the emerging world. But security selection and patience will be critical. Picking the good from the bad in today’s bond market requires a deep understanding of the cash flows and risks associated with each individual security. And while we expect liquidity to return and that high quality assets trading at distressed prices will outperform low quality assets at similar prices, recovery from risk aversion can be a lengthy process.