Transcript Northern Trust

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

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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
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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
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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
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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
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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
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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
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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
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
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

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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)
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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
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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
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- 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
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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
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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
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
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