CALAMITY OR CORRECTION?
THE REALITY BEHIND THE BOND MARKET SHAKEUP
By: Terry O'Grady, Chief Bond Trader

What a difference a few weeks make!

Only a short time ago, volatility was largely absent from the financial markets. Stocks seemed to be reaching new highs every week and credit spreads between high-grade and lower-grade bonds were at historic lows.

This all changed in the blink of an eye after Bear Stearns reported trouble in two of its hedge funds that invested in sub-prime mortgages and Collateralized Debt Obligations (CDOs). These funds were subsequently liquidated. This event was inaccurately characterized by the financial press as a blowup caused by hedge funds investing in risky, low-grade bonds. 

Bonds fine, too much leverage

Ironically, the bonds these funds owned were actually highly rated, and the losses were really caused by the high degree of leverage employed by the managers of these hedge funds. The combination of bond price declines (caused by rising interest rates) and leverage of more than 90% proved to be a formula for disaster.

Despite the fact that the Bear Stearns’ debacle was not caused by risky bonds, the financial press was so enamored of the story that they ran with it anyway. Suddenly, institutional investors were scouring their portfolio to purge any potentially risky assets. The suspect bonds were dumped indiscriminately without regard to value or price.

Sometime down the road, these machinations will be described correctly as a reassessment of risk in the credit markets. For some time, investors had not been demanding enough yield for lower-rated securities. These recent events, however, will cause a widening of credit spreads that will more fairly evaluate the risk in fixed income markets. As is always the case, markets overshoot, and while spreads were too tight before, this spread widening process in the markets is probably already overdone.

Opportunity

So what’s a bond investor to do?

Evaluate your holdings. Is there any danger of your bonds missing their next interest payment?  Probably not, so there is obviously no need to panic. As a matter of fact, the market action we are experiencing is likely a unique buying opportunity.

While other investors are throwing the baby out with the bath water, keep your eyes open for the exceptional values becoming available in lower-grade bonds.

07/30/07