The global fixed income markets have seldom offered more attractive opportunities than investors will find in today’s environment. Since the summer of 2007, trading activity has fallen off sharply in many fixed income sectors as concerns about the US housing market and economy set off a widespread flight from almost every form of credit risk.

Credit risk is essentially the risk that an investor will not be paid all that they are owed, and 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, the relative stability in emerging market bonds throughout the credit crisis confirms the longer-term strategic opportunities in the emerging market sector.

The ongoing credit crisis has hit the mortgage and corporate sectors of the bond market particularly 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, there is 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 imaginable. In the corporate sector, securities backed by bank loans to corporations, which are senior to corporate bonds, offer another attractive 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, particularly in mortgage sectors where improved liquidity would benefit the housing market. As liquidity improves and risk appetite returns, buyers waiting on the sidelines for the markets to stabilise will step in to purchase high quality assets at discounted prices.

Emerging markets have been one of most stable sectors of the bond market amid the general turmoil. This is a marked change from previous years, when emerging markets were often among the most volatile asset classes in times of crisis, or were themselves the source of the crisis. The outperformance by emerging markets during the last six months of turmoil is a testament to the solid balance sheets that characterise and underlie emerging market country fundamentals. Many emerging countries have accumulated large foreign exchange reserves and significant fiscal surpluses, which provide a source of stability in times of market turmoil. Supply and demand factors have also become increasingly positive in the emerging markets. Because of fiscal surpluses, net debt growth is actually negative. On the demand side, we continue to see strategic interest in emerging market debt from a variety of investors around the world.

There are also opportunities 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. In addition, 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.

While there are tremendous opportunities in today’s bond market, security selection and patience will be critical to realising these opportunities.

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 liquidity will return to the bond markets over time, causing high quality bonds to outperform relative to lower quality securities, recovery from risk aversion can be a lengthy process.

KEY FACT

• Credit risk is the risk that an investor will not be paid all that they are owed
• A lagging US housing market has meant that creditors are more risk averse and less likely to lend money to consumers or businesses
• The global credit crunch has led to large discounts on high quality bonds in the hardest hit sectors
• Emerging market bonds have remained stable throughout
  
  

SPONSORED BY

Goldman Sachs Asset Management

Contact:

Amna Karim, head of Nordic region,
Goldman Sachs Asset Management

Tel: +44 207 774 6792
E mail: amna.karim@gs.com