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2009 FALL FOCUS INVESTMENT CONFERENCE Fixed Income Update Colin A. Robertson Managing Director Fixed Income © 2009 Northern Trust Corporation northerntrust.com Fixed Income - Agenda Review – 2008 Fall FOCUS Environment Outlook Update – Fixed Income Markets Environment Outlook 2 2009 Fall FOCUS Investment Conference Fixed Income Update 2008 Environment and Outlook 3 2009 Fall FOCUS Investment Conference Fixed Income Update Environment - 2008 Fall FOCUS Globally, authorities grasped the scale of threats relatively quickly and have taken drastic actions Fed moves have been aggressive in both traditional and unorthodox channels Reduced funds rate from 5.25% to 1.5% in short time frame Created new borrowing facilities (PSCF, TSLF) Backstopped money market mutual funds Took Bear Stearns and AIG assets onto Fed’s balance sheet Purchased high quality commercial paper from corporate entities ECB and BOE actions have been equally aggressive and creative Highly complex, globally integrated, fast-moving global financial system has complicated efforts at repair Authorities have limited understanding of aggregated risks created by inter-connections between assets, especially derivatives and securitizations Pattern of financial institution rescues/failures (especially Lehman) has confused investors which has severely damaged confidence 4 Primary focus of banks and investors is on deleveraging only 2009 Fall FOCUS Investment Conference Fixed Income Review Outlook - 2008 Fall FOCUS Turmoil will have lasting impacts for macro economy High growth/low inflation environment not likely to return for years Expect prolonged period of weak growth as de-levering process follows a decentralized, case-by-case path Set back for a globalization and integrated financial system Governments will have bigger fiscal deficits and greater financing needs Growth will be slower Need to absorb costs of rescuing banks, additional stimulus programs Consequences longer term will be higher taxes Companies will seek stronger balance sheets, have lower need for day-to-day financing 5 2009 Fall FOCUS Investment Conference Fixed Income Review Outlook – 2008 Fall FOCUS Turmoil will have lasting impacts for credit creation Duration of de-levering will depend on severity of US recession and impacts on bank balance sheets Tightening credit conditions will slow future growth Slow growth will cause defaults to rise Rising defaults will cause banks’ non-performing assets to rise, undermining capital raising efforts Thus, outlook for restarting credit creation is not good, absent launch of special government programs Current de-levering process has damaged functioning of cash, collateral and counterparty risk management frameworks – these will need to be repaired, revamped or rebuilt Process will be slow, arduous and highly political Essential for return of risk appetites and restarting of innovation efforts Institutional investors will end up with fewer, larger and more regulated counterparties 6 2009 Fall FOCUS Investment Conference Fixed Income Review Outlook – 2008 Fall FOCUS Turmoil will have lasting impacts for issuers Issuance preferences and risk premiums will change across instruments and capital markets. Shift back to simplicity and away from complexity in credit instruments More equity Less structured, floating rate and wrapped debt More long term debt, issued at higher yields Growing portion of debt will be supported by government Credit premia to be permanently elevated for any/all complex securities Fed to become central counterparty and biggest player in repo market Fed to start paying interest on reserve balances Enables it to have a credit policy that’s independent of monetary policy Puts a floor under the traded overnight rate (so can provide liquidity in times of stress without affecting overnight rate) Eventually (3+ years), expect credit conditions to normalize around pre-bubble levels 7 2009 Fall FOCUS Investment Conference Fixed Income Review Outlook – 2008 Fall FOCUS Turmoil will have lasting impacts for investors Investors will be in risk avoidance mode for next several years Investment guidelines will be overhauled Transparency will be emphasized All types of oversight will be increased Focus will return to traditional instruments/practices Experience will matter more than innovation Liquidity and marketability will be stressed Leverage will be avoided 8 2009 Fall FOCUS Investment Conference Fixed Income Review Outlook – 2008 Fall FOCUS Turmoil will have lasting impacts on investment strategies used by short term funds Investment Will guidelines will be made more restrictive be structured for liquidity/safety and not for yield Instruments: Only very high quality securities, including repo, time deposits, CD's, commercial paper, corporates and Government Agencies Interest Rates: Focus will be on rate and curve positioning, waiting for revamp and rebuild of short credit and funding markets Credit: Not a focus. Will be de-emphasized indefinitely, at least until delevering process is complete and next generation investment instruments and portfolio guidelines are developed and fully vetted 9 2009 Fall FOCUS Investment Conference Fixed Income Review Outlook – 2008 Fall FOCUS Turmoil will have lasting impacts on investment strategies used by core and high yield bond funds Investment guidelines may be made more restrictive Will revert to more traditional investment instruments and strategies Rate and curve positioning/bets Traditional, independent credit analysis (No reliance on NRSROs) Use of CDS for signaling and trading strategies will change Shift from OTC to exchange Regulation to increase Trading spreads will increase Trading volume / flow will gradually build Number of dealers will increase Capital 10 commitments by dealers will decrease 2009 Fall FOCUS Investment Conference Fixed Income Update 2009 Environment and Outlook 11 2009 Fall FOCUS Investment Conference Fixed Income Update Environment 12 Change in paradigm for consumers and corporate profitability Changes in securitization market Limitations of global fiscal stimulus to produce sustained economic recovery Changes to regulatory frameworks Shortcomings/revisions to globalization thesis Rise of non G8 countries as drivers of global growth, especially China 2009 Fall FOCUS Investment Conference Fixed Income Update Environment Post-Lehman bankruptcy Continued slowdown in bank lending across industrialized economies Unprecedented Governments monetary liquidity in global financial system acted to promote credit creation via capital markets Amid banking crisis, capital markets have become the main channel of monetary transmission in the economy Allows borrowers to bypass bank lenders and raise funds directly from capital markets Economic 13 benefits of this development are unevenly distributed Can the 2009 capital markets rally end the credit shortage in the real economy? 2009 Fall FOCUS Investment Conference Fixed Income Update Environment Aggressive/expansive government policies are heavily influencing all bond markets (types, maturities and regions) Monetary Fiscal Emergency support policies/programs are motivated by political as well as economic considerations Investment outlooks must incorporate analysis of traditional and novel drivers Traditional Economic Credit Technical Novel Government Programs (timeline, permanence, unwind) 14 2009 Fall FOCUS Investment Conference Fixed Income Update Outlook – Money markets, Treasuries and TIPS Fed to maintain record low interest rates for extended time period Real cash rate to stay close to zero Key 15 catalyst for US growth to strengthen Persistent sub-par growth and low inflation likely to outstrip concerns about US deficits and heavy Treasury (UST) supply Foreign buying of USTs to continue unabated Additional demand for growing volume of USTs expected to come from increasing US savings rate, former buyers of securitized products Benign inflation backdrop likely to favor coupon Treasuries over TIPS of comparable maturity 2009 Fall FOCUS Investment Conference Fixed Income Update Outlook – Investment Grade Credit Using BarCap Credit Index as proxy Expanded reliance/use of government guarantees will increase weighting of AAA issuers AA and A rated issuer weightings to decline for same reason Significant churn likely among BBB credits, with some falling to junk Non-corporate sector to grow at expense of others (industrial, utility, financial), as result of Build America Bonds and similar programs Financial and non-corporate OAS levels likely to tighten, based on increased presence of government guarantees Investment Grade credit generally positioned to do well in post-crisis credit/funding environment Banks 16 - reduced ability and willingness to lend Investors - ongoing distaste for innovative, complex, opaque credit structures Investors – strong demand for traditional, transparent, plain vanilla debt 2009 Fall FOCUS Investment Conference Fixed Income Update Outlook – High Yield Era of tight junk spreads, easy credit terms now over End of voluntary shift by “A” rated companies toward below investment grade credit ratings and balance sheets Accelerating slide of investment grade companies to below investment grade ratings, due to business and/or financial difficulties Junk bond market to adjust to changed economic and risk environments High yield market to refocus on basic (not alternative) credit structures and meeting needs of traditional high yield investors High yield spreads will not return to compressed levels of recent years Instead, will trend sideways around historical median level Cooling of trend toward globally integrated high yield market Performance bifurcation by sector likely to sharpen Some to implode amid creative destruction Other to sail along relatively untouched 17 2009 Fall FOCUS Investment Conference Fixed Income Update Outlook – Municipals Fallout from credit markets crisis and subsequent economic developments Exit of monoline bond insurers from municipal new-issue market New municipally-focused programs included in federal stimulus package Build America Bonds (BAB) initiative Waiver of Alternative Minimum Tax on tax-exempt issues sold to finance private activity bonds Increase in size of municipal issuers purchased by banks that qualify for tax exemption Programs have helped to repair municipal market and rally prices Constrained volume and type of tax-exempt municipal issuance Increased demand from existing and new sources Changed composition of buyers of municipal debt Overall result, richened municipal valuations relative to Treasury yields 18 2009 Fall FOCUS Investment Conference Fixed Income Update Outlook – Municipals - 2 Fallout from credit markets crisis and subsequent economic developments Expect smaller/simpler short-term municipal market Short-structured debt issuance to shift to intermediate maturity range Downward trend of fundamental municipal credit quality No regional safe-harbors, negative trend is nationwide Do not expect federal government to provide direct guarantees of municipal debt Using BarCap Municipal Index as proxy Downgrades to monoline insurers have decreased weighting of AAA rated new issues AA and A rated issuer weightings to increase for same reason From a sector perspective (general obligation, revenue, insured, pre-refunded), the market’s composition is expected to gradually rebalance 19 Reduced weighting for insured sector Increased weighting for general obligations and revenue sectors 2009 Fall FOCUS Investment Conference 2009 FALL FOCUS INVESTMENT CONFERENCE Thank you. Colin A. Robertson Managing Director Fixed Income © 2009 Northern Trust Corporation northerntrust.com