Domestic Fixed Income Outlook and Strategy for 2008

Good riddance 2007, the year when relative value and creditworthiness were arcane concepts and “sub-prime”, “credit meltdown”, and “liquidity crisis” were the theme in the fixed income market. HGK (along with most banks, brokers, mortgage lenders, and rating agencies) vastly underestimated the extent of the carnage from the housing market decline and the resulting losses that would occur in the financial sector. The weakness in financials ultimately spread to other sectors in the corporate market as the consensus in the market has turned to a recession or near-recession scenario fueled by a drop in the “wealth effect” and consumer spending due to the formidable combination of declining home prices, falling valuations in equity portfolios, soaring energy prices, and tightening bank lending.

Gregory W. Lobo
Managing Director
Fixed Income Investments

To the extent that we believe the economy will avoid a recession in 2008 (GDP of 1.0-1.5% in first half, 2.5-3.0% in second half), primarily with the help of an accommodating Fed, there exists unprecedented value in the fixed income market that HGK is poised to capitalize on. Our overweight to the financial sector, specifically quality broker/bank/insurance hybrid securities that massively underperformed, should fuel outperformance in 2008, particularly in the second half of the year as the primary pain (losses, write-downs, unfounded bankruptcy rumors) dissipates and the market moves towards a return to relative valuations and liquidity (albeit not at previous levels). For now, in part due to the compelling (a.k.a. “stupid cheap”) valuations and scarce liquidity provided by the dealer community (massive losses tend to limit risk-taking), our strategy is to continue to hold those issues that contributed largely to 2007 underperformance and possess solid long-term creditworthiness (i.e. Allstate, Chubb, First Boston, Goldman Sachs, Lehman Brothers, Bank of America, Citigroup, Capital One, CIT Group, XL Capital, to name a few) and capitalize on a return to market “normalcy”. As support for this stance, Lehman Brothers index data shows that since 1990 financials have provided significant positive excess returns in the years following negative excess returns. Of the five factors that are needed to cure a credit crisis (easier monetary policy, a steep curve, new capital, consolidation, time), four are presently in motion (with consolidation now on the table with the acquisition of Countrywide) and we are waiting on the fifth. All we (and our clients who saw us give back much of the outperformance from 2003-2006) need is some time (and patience) and this sector (and these issues) will fuel outperformance.

As for interest rates, after the massive rally that was fueled by a “flight to quality” and more recently, recession fears and Fed easings, we believe all, if not most, of the rally is behind us. Future cuts by the Fed should serve to steepen (normalize) the yield curve and our portfolios enter 2008 with a steepening bias and duration posture slightly shorter than the index.

From a sector allocation standpoint, in addition to our continued overweight to the battered financials, we will add select industrial names (those in “safe” sectors) that come to the market at significant pricing concessions and anticipate maintaining a selective overweight to the AAA-rated due to their relative attractiveness after posting negative excess returns in 2007.

In a market where all spread sectors underperformed US Treasuries, in some cases of record magnitude, our strategy in 2007 clearly did not produce the expected results. That said, the market dislocations and the incredible relative value opportunities present in the market play into our strengths as fixed income managers and our portfolios should have a profitable year relative to their benchmarks in 2008.

Gregory W. Lobo
Managing Director
Fixed Income Investments