© 2009 northern trust corporationnortherntrust.com fall focus 2009 investment conference colin a....

© 2009 Northern Trust Corporation northerntrust.com

FALL FOCUS

2009

INVESTMENT CONFERENCE

Colin A. Robertson Managing Director Fixed Income

Fixed Income Update

2 2009 Fall FOCUS Investment Conference

Review – 2008 Fall FOCUS

Environment

Outlook

Update – Fixed Income Markets

Environment

Outlook

Fixed Income - Agenda


Fixed Income Update

2008

Environment and Outlook


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

Primary focus of banks and investors is on deleveraging only

Fixed Income Update

Environment - 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

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

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

Fixed Income Review



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

Fixed Income Review



Turmoil will have lasting impacts on investment strategies used by short term funds

Investment guidelines will be made more restrictive

Will 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 de-levering process is complete and next generation investment instruments and portfolio guidelines are developed and fully vetted

Fixed Income Review



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 commitments by dealers will decrease

Fixed Income Review



Fixed Income Update

2009

Environment and Outlook


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

Fixed Income Update

Environment


Post-Lehman bankruptcy

Continued slowdown in bank lending across industrialized economies

Unprecedented monetary liquidity in global financial system

Governments 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 benefits of this development are unevenly distributed

Can the 2009 capital markets rally end the credit shortage in the real economy?

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)

Fixed Income Update

Environment


Fed to maintain record low interest rates for extended time period

Real cash rate to stay close to zero

Key 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

Fixed Income Update

Outlook – Money markets, Treasuries and TIPS


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 - reduced ability and willingness to lend

Investors - ongoing distaste for innovative, complex, opaque credit structures

Investors – strong demand for traditional, transparent, plain vanilla debt

Fixed Income Update

Outlook – Investment Grade Credit


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

Fixed Income Update

Outlook – High Yield


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

Fixed Income Update

Outlook – Municipals


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

Reduced weighting for insured sector Increased weighting for general obligations and revenue sectors

Fixed Income Update

Outlook – Municipals - 2

© 2009 Northern Trust Corporation northerntrust.com

FALL FOCUS

2009

INVESTMENT CONFERENCE

Colin A. Robertson Managing Director Fixed Income

Thank you.

© 2009 northern trust corporationnortherntrust.com fall focus 2009 investment conference colin a....

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