In the Trenches

In the Trenches
A fixed income manager’s view of risks and opportunities post-crunch

By Terry Carr, vice-president and managing director, Fixed Income MFC Global Investment Management (Canada)

The U.S. subprime loan crisis and the broader financial crisis and economic slowdown provided a good lesson in the interconnectedness of global financial markets. The depth and breadth of the repercussions were unexpected by some market participants. For the astute observer, though, there’s always a canary in the coal mine. With the credit crisis, that warning came in the form of a sharply slowing U.S. housing market, starting in 2006.

In Canada, the slowdown in housing and the broader economy has been cushioned by the fact that economic fundamentals are more resilient and homeowners have less leverage. Despite strong global demand for Canada’s natural resources, though, Canada has not been able to decouple from U.S. policy and interest rates on both sides of the border have fallen sharply in the wake of the crisis. In the spring of 2008, the Canadian yield curve showed that markets were anticipating still lower policy rates, and higher inflation. Historical comparisons also showed that further curve steepening was in store. In an environment of continuing yield curve volatility, investors will have to be careful about how they position portfolios on that curve.

The crisis has had a dramatic impact on risk premiums and, consequently, on the cost of debt. Interbank lending spreads blew out past levels reached after the terrorist attacks of September 11, or the dot-com bust of 2000. The once-bitten, twice-shy risk aversion now shared by most major lenders should keep spreads well above historic averages for some time.

Eye of the storm

The fact that the financial sector was at the epicentre of the crisis also showed in the rare widening of financial sector credit spreads to wider levels than those on non-financial corporate debt. However, this extreme move is expected to reverse just as sharply, as the sector’s well-established status as one of the market’s least risky credit exposures means it will lead any rally in credit as risk appetites return.

Investors who wait for confirmation of an economic recovery to get back into credit markets will miss the opportunity. Already twice in this decade, spreads have moved before the economy did—most recently, as they widened ahead of the current slowdown and before that, when they tightened ahead of a rebound in economic growth in 2003. As noted above, financial sector spreads will be the most sensitive barometer of improved market and economic conditions, and will move most quickly and most dramatically ahead of the recovery. Key economic data—like payrolls—will be a lagging indicator of the recovery, but will confirm it.

The credit crisis will change the universe. With investors now far more wary about opaque securitized debt, the weight of that asset class will fall on Canada’s DEX Universe Bond Index. Despite a possible slowdown-related blip, Ottawa will continue to pay down federal debt, driving down the weight of Government of Canada debt on the index. Provincial debt won’t fall as quickly and its index weighting will rise. As the biggest corporate issuer, the financial sector will see its weighting rise. The net result will be a drop in the overall duration and a rise in the overall yield of the index.

The other major lesson of the credit crisis is that risk management has become more important than ever. The risks remain heightened, with central banks struggling with whether to continue cutting rates to prop up economies or tighten policy in response to very real inflation worries. For their part, financial markets are pulling in their horns as the dust from the crisis continues to settle and balance sheets are rebuilt. But financial innovation is not dead. Already, market professionals are devising new ways to both protect against risk and to package it up in fungible financial instruments. For better and for worse, the financial sector will remain at the epicentre of world markets.

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