Domestic Fixed Income 2007 Review

The fixed income market in 2007 can perhaps best be summed up with the famous quotation by Charles Dickens: “It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity”. This year was a study in contrasts, and for those that had the “wisdom” to have a portfolio with a majority of US Treasuries, it certainly was “the best of times” as that sector posted a 9.01% return. That said, as a manager who maintained an over-weight to the spread products (AAA-rated Agencies, MBS, ABS, CMBS, and corporate bonds) that had fueled the strong performance of the past few years, it was “the worst of times”.

Christopher Gerne
Analyst
Fixed Income Investments

Our portfolios entered 2007 positioned for an economy that we firmly believed could withstand the continued slump in the housing market and avoid a recession despite a slowdown in consumer wealth/spending. While we were correct that the economy would continue to post positive growth (in fact, greater than we had forecast), we vastly underestimated the extent to which the housing slump would lead to a “sub-prime crisis” that would spark a meltdown in spread products of unprecedented magnitude. In looking at the excess returns versus Treasuries, it is clear that there was really no place to hide, as all spread sectors underperformed significantly (Corporate bonds -464 bps, Agency -83, MBS -167, ABS- 620, CMBS -410).

Our strategy going into 2007 was to maintain a relatively duration-neutral posture since we expected the Fed to remain on hold for most of the year and to overweight corporate bonds and Agency debt. Within the corporate allocation, our theme was avoiding LBO/event risk in select sectors and continue to overweight financials as a “safe haven” in which we could move down in structure/subordination in solid credits (primarily within the hybrid and Tier 1 issues). As the housing market, and subsequently the mortgage market melted down (leading to unparalleled losses at major banks and brokers), market liquidity evaporated, leading to massive spread widening across the board and relative underperformance in the finance sector that was the worst on record (negative 687 bps excess return). HGK clients can take comfort in the fact that our portfolios contain no direct sub-prime or CDO exposure, nor own any issues whose ultimate creditworthiness is in doubt, and the relative underperformance is a function of a mark-to-market issue in a temporarily dysfunctional market that has virtually no liquidity.

To the extent that our posture entering 2007 could have been described as a fairly conservative one, there is a great deal of “incredulity” (back to the Dickens’ quote) and disappointment in our relative performance for the year. The massive decline in interest rates provided somewhat acceptable absolute returns, but from a relative return standpoint we failed to deliver what we had over the previous years. The fixed income team will incorporate the painful lessons of 2007 to position our portfolios to likely recapture some of the relative performance in 2008.

Christopher Gerne
Analyst
Fixed Income Investments