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Investment Insights Series l 2009 July 2009 Why Credit Matters: Fixed Income Investing in a

Investment Insights Series

l

2009

Investment Insights Series l 2009 July 2009 Why Credit Matters: Fixed Income Investing in a Changed

July

2009

Why Credit Matters:

Fixed Income Investing in a Changed Landscape

The recent dislocation in the fixed income market is likely to transform how investors and asset managers approach fixed income investing for years to come. Aggressive government intervention has essentially resulted in the four basic fixed income sectors collapsing into two: government and corporate credit. As a result, corporate credit may now be the single most important factor in generating risk-adjusted performance in fixed income. In this brief, we discuss the structural market changes that have occurred and the importance of fundamental, bottom-up credit analysis and robust investment risk management in navigating this changed landscape.

Overview

Since the birth of the securitization market in the 1990s, the fixed income market has been segmented by most professional money managers into four basic sectors: U.S. Treasuries, government agencies, agency mortgages 1 and corporate credit. However, the recent credit crisis and resulting aggressive government intervention has structurally changed the fixed income market, compressing the four fixed income sectors into two: government and corporate credit (see Exhibit 1).

For investors seeking traditional “spread product,” or fixed income investments with yields above equivalent U.S. Treasuries, we think corporate credit is the most viable

option. Many asset managers will likely have to change their approach to fixed income investing, as corporate credit analysis could become the single most important factor in generating risk-adjusted outperformance. Managers already focused on a fundamental, credit- oriented investment process may be best positioned to add value in the new environment.

For investors seeking traditional “spread product,” we think corporate credit is the most viable option.

1 Agency mortgages refer to mortgage-backed securities (MBS) that were issued by Fannie Mae or Freddie Mac, and are represented by the Barclays Capital U.S. MBS Index.

FOR FINANCIAL PROFESSIONAL USE ONLY / NOT FOR PUBLIC VIEWING OR DISTRIBUTION

Exhibit 1 Converging Sectors THEN: Four Basic Sectors in Fixed Income % of the Barclays

Exhibit 1

Converging Sectors

THEN: Four Basic Sectors in Fixed Income

% of the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09

the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09 Co rporate Credit 22.79% Co rporate
the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09 Co rporate Credit 22.79% Co rporate
the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09 Co rporate Credit 22.79% Co rporate
the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09 Co rporate Credit 22.79% Co rporate
the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09 Co rporate Credit 22.79% Co rporate
the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09 Co rporate Credit 22.79% Co rporate
Co rporate Credit 22.79%
Co rporate
Credit
22.79%
Co rporate Credit 22.79%
Co rporate
Credit
22.79%

Agenc y

 

U.S.

 

Mo rtgages*

Gove rnmen t Agencies

 

Treasuries

 

38.51%

9.65%

25.15%

  Treasuries   38.51% 9.65% 25.15% Gove rnmen t 73.31% NOW: Compression has resulted in two

Gove rnmen t

73.31%

NOW: Compression has resulted in two sectors:

Corporate Credit and Government

*The securitized market includes agency mortgages and asset-backed securities/commercial mortgage-backed securities (ABS/CMBS). Given the small size of the ABS/CMBS sectors and their combined small weighting in the Barclays Capital U.S. Aggregate Bond Index (3.89% as of June 30, 2009), it is generally not considered a primary sector in fixed income. As of June 30, 2009 Source: Janus, Barclays Capital

Why Credit Matters

Many fixed income managers have typically used sector allocation to construct portfolios, adding value by over- or underweighting exposure among the different spread products—government agencies, agency mortgages and other securitized sectors, and corporate credit—based on a macro view of the economy, interest rate expectations, and/or relative valuations and perceived risks. Before the recent turmoil in the financial markets, most managers attempted to earn a spread over Treasuries largely through greater allocation to agency mortgages, which make up the largest part of the securitized sector. Up until the end of 2008, this strategy paid off as agency mortgages outperformed corporate credit with a cumulative 77% total return versus a roughly 59% return from January 2000 through December 2008. 2

However, given the structural changes that have occurred in the fixed income market over the past year as a result of the credit crisis (see Exhibit 1), the agency mortgage space may no longer offer the same viable strategy for generating risk-adjusted outperformance. In addition, certain segments

of the securitization market such as non-agency mortgages,

commercial mortgage-backed securities (CMBS) and asset- backed securities (ABS) lack clarity due to the continuing shakeout from the financial crisis. CMBS and ABS also represent such a small percentage of the index that even if they do recover, their impact will likely be less meaningful than agency mortgages. Lastly, the government agency market may not be a significant source of outperformance given the narrow spread that these securities typically offer over U.S.Treasuries. What’s left for fixed income managers? Essentially, just corporate credit.

How Did We Get Here? The credit crisis originated in the mortgage market— specifically within the subprime market—and spread to other areas of the credit and fixed income markets,

then infected the global financial system and eventually impacted economies worldwide. Complexity and the lack

of transparency in the U.S. mortgage market during the last

several years created a situation where there was actually more risk in securitized debt instruments such as mortgage- backed securities (MBS) than understood by many investors. The mispricing of risk led to an inability to value or sell complicated securitized debt.

Another contributing factor was the amount of leverage embedded in the system. Hedge funds and speculators had

the ability to borrow and leverage their investments—some

at a rate as high as 10-to-1—which turned ordinarily small

profits into huge profits and, eventually, ordinarily small losses into huge losses. As a result, the U.S. government along with other governments and central banks around the world was forced to support the mortgage and financial markets directly through an alphabet soup of intervention programs—TSLF, TARP, TALF and PPIP, to name a few. 3

A key event impacting the structure of the fixed

income market occurred in September 2008 when the U.S. government placed Fannie Mae and Freddie Mac (government-sponsored enterprises, or GSEs) into conservatorship, meaning that their relationship to the government is tighter than ever. Given the GSEs’ significant role in the mortgage and agency markets, this action has had a profound impact on spreads and the correlation of

returns within the fixed income sectors.

2 Source: Bloomberg, Barclays Capital 3 Term Securities Lending Facility (TSLF) was rolled out in March 2008,Troubled Asset Relief Program (TARP) came in October 2008, and Term Asset- Backed Securities Loan Facility (TALF) and Public-Private Investment Program (PPIP) were initiated in March 2009.

Under normal market conditions, spreads, or the difference in yields over U.S.Treasuries, generally increase when moving from government agencies to agency mortgages to corporate credit, given the greater perceived risk associated with getting away from government-issued or -backed securities. Since the GSEs were placed under conservatorship by the U.S. government, the spreads between government agencies and agency mortgages have converged. Given that the government’s support for the mortgage sector is likely to continue for some time and the agency market is now receiving an explicit federal backing, relatively low spreads for these two sectors may be the new norm.

Conversely, the overall lack of liquidity in the bond market in late 2008 created the widest spreads on investment grade corporate credit in 100 years. Spreads have tightened since late last year but were still high at the end of June 2009—roughly 300 basis points (bps), which is more than twice the 129 bps average from January 2000 to December 2007 (see Exhibit 2). After a decade of relatively low interest rates and tight spreads resulting from small risk premiums, corporate credit investors are now being compensated for the risk associated with these securities. We think this will continue as the U.S. economy will likely take a while to fully recover.

Corporate credit investors are now being compensated for the risk associated with these securities.

Exhibit 2

Investment Grade Corporate Credit Spreads

700 600 500 400 300 9/07/2008 - Freddie and Fannie placed into conservatorship 200 100
700
600
500
400
300
9/07/2008 - Freddie and Fannie
placed into conservatorship
200
100
0
U.S. Agencies OAS
U.S. MBS (Mortgage) OAS
U.S. Corporate OAS
Option Adjusted Spread (OAS) (Basis points)
Jul-07
Aug-07
Sep-07
Oct-07
Nov-07
Dec-07
Jan-08
Feb-08
Mar-08
Apr-08
May-08
Jun-08
Jul-08
Aug-08
Sep-08
Oct-08
Nov-08
Dec-08
Jan-09
Feb-09
Mar-09
Apr-09
May-09
Jun-09

As of June 30, 2009 Source: Bloomberg, Barclays Capital

A Changing Landscape The unprecedented government involvement in the mortgage and agency sectors and the breakdown in correlations among corporate credit and the other spread sectors suggest that long-term structural changes within the fixed income market are underway. First, we believe the government’s involvement will likely need to continue over the near and possibly intermediate term given the weak housing market and “legacy” assets still on the balance sheets of many financial companies.The unwinding of these assets and the government intervention will likely be difficult and take some time.

Exhibit 3

Breakdown in Correlation of Returns Among Sectors

1 0.9 0.8 0.7 0.6 0.5 0.4 0.3 0.2 Correlation Coefficient Jan-00 May-00 Sep-00 Jan-01
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
Correlation Coefficient
Jan-00
May-00
Sep-00
Jan-01
May-01
Sep-01
Jan-02
May-02
Sep-02
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Jan-08
May-08
Sep-08
Jan-09
May-09

U.S. Corporate to U.S. MBS (Agency Mortgages)

U.S. MBS (Agency Mortgages) to U.S. Treasury

U.S. Corporate to U.S. Treasury

U.S. Aggregate Agency to U.S. MBS (Agency Mortgages)

Rolling 36-month correlations of monthly returns as of June 30, 2009 Source: Bloomberg, Barclays Capital

Second, the breakdown in correlations is evident. Exhibit 3 compares the rolling 36-month correlations between the returns of corporate credit and U.S.Treasuries, corporate credit and agency mortgages, agency mortgages and U.S. Treasuries, and government agencies and agency mortgages. Since August 2008 there has been a breakdown in the correlation of returns between corporate credit and the other three sectors—from relatively high levels of above 0.80 to a relatively low level of 0.40 to 0.50 for corporate credit to agency mortgages and roughly 0.30 for corporate credit to U.S. Treasuries. Meanwhile, the correlations of agency mortgages to U.S. Treasuries and government agencies to agency mortgages have held relatively steady, still above 0.80 through the end of June 2009.This, coupled with little

difference in yields on agency mortgages and government agencies and both with tighter spreads to

difference in yields on agency mortgages and government agencies and both with tighter spreads to U.S. Treasuries suggests to us that basically only two main sectors are left:

government and corporate credit.The low correlations of corporate credit also suggest this sector could provide a much greater opportunity for a fixed income manager to generate superior risk-adjusted returns.

Credit Investing Has Its Challenges

Generating alpha within fixed income has traditionally been done in a number of ways, from sector allocation and duration or yield curve positioning to bottom-up, fundamentally driven individual credit selection. Most fixed income managers, particularly those with sizeable asset pools, have used agency mortgages in an attempt to earn a spread because of their historically higher yields relative to U.S.Treasuries, the size of the market and overall liquidity. With the structural changes leading to the compression of spreads in this market, we don’t think pursuing this strategy will produce the results most investors have been accustomed to over the past decade. The rest of the securitized market may not offer an attractive alternative given its small size and recent implosion. For this reason, corporate credit will likely garner more interest by fixed income managers and investors alike.

The challenges many fixed income managers face in pursuing greater corporate credit exposure are twofold. First, corporate credit is much smaller than the agency mortgage sector, making it difficult for large fixed income managers to venture into individual security selection. An issue’s liquidity or size may limit a large firm’s ability to take a full position in the company for fear of owning the whole issuance and not being able to exit the position very easily. Relatively small boutique firms may be more successful because this would be less of a concern.

Second, to be successful—particularly in an environment of rising defaults—individual security selection is imperative in our view. As such, managers with a deep research capability and intensive investment risk management are better positioned in our opinion to assess and manage the asymmetric risk inherent in corporate credit. On the upside, there is the periodic coupon or interest payment received and the principal repayment, with the potential for some increase

in value, when the bond is called or matures. On the downside, there is the potential for the complete loss of capital.

Managers with a deep research capability and intensive investment risk management are better positioned in our opinion to assess and manage the asymmetric risk inherent in corporate credit.

Indexing may be considered by some as a way to gain corporate credit exposure, particularly for fixed income managers who do not have the depth of research required to do extensive fundamental credit analysis. We think this poses a challenge in the current environment because pursuing an index strategy exposes the portfolio to the average default rate across the entire corporate sector. Since early 2008, default rates have been moving higher, rising from 0.70% in January 2008 to 8.40% in May 2009. 4 Given the weak economic environment, these rates are likely to continue their upward trajectory, potentially weighing on relative performance.

The value of successful individual security selection— picking the winners and avoiding the losers—can be significant. For instance, reallocating financials exposure within the Barclays Capital U.S. Aggregate Corporate Index to industrials 5 would have added roughly 180 bps of excess return over the five-year period from December 2003 through December 2008. At the quality level, moving out of BBB-rated securities to A-rated securities within the same index over a two-year period from December 2006 to December 2008 5 would have generated 70 bps of excess return. If an investment firm lacks research capability, it will likely struggle in corporate credit, largely because the penalty for being wrong is greater than the reward for being right, as many managers discovered in 2008.

Exhibit 4 shows how large the dispersion of returns was for fixed income managers within the credit space last year. The more than 2000 bps difference between the top and bottom managers versus the 10-year average dispersion

4 High yield default rates are used because deteriorating credit quality affects investment grade credits, which typically move to the high yield category prior to defaulting. (Source: JP Morgan-Chase)

of roughly 525 bps reveals the difficulty of credit investing and highlights the need for intensive investment risk management.The bottom-performing managers may have had investment risk management systems in place, but they may not have been embedded in the security selection process. We think an effective investment risk management process goes beyond attribution analysis and relative value to encompass a value at risk (VaR) approach that looks at a portfolio’s exposures to various adverse market events, such as a lack of liquidity.

Exhibit 4

Dispersion of Returns Within Fixed Income

2500 2000 1500 1000 Average: 525 bps 500 0 Difference Between 10th and 90th Percentile
2500
2000
1500
1000
Average: 525 bps
500
0
Difference Between 10th and 90th Percentile
Average Dispersion
Dispersion of Returns (Basis points)
Jun-99
Oct-99
Feb-00
Jun-00
Oct-00
Feb-01
Jun-01
Oct-01
Feb-02
Jun-02
Oct-02
Feb-03
Jun-03
Oct-03
Feb-04
Jun-04
Oct-04
Feb-05
Jun-05
Oct-05
Feb-06
Jun-06
Oct-06
Feb-07
Jun-07
Oct-07
Feb-08
Jun-08
Oct-08
Feb-09

eA Core Plus Fixed Income Category As of March 31, 2009 Source: eVestment Alliance (eA)

In 2008, we saw liquidity in the credit markets dry up, and given the data in Exhibit 4, many managers were unsuccessful— maybe even ill-equipped—to address this condition. In our opinion, a firm’s research capabilities and investment risk management process will be key to successfully navigating the world of corporate credit.

Conclusion

The events within the global financial markets in 2007 and 2008 have had a profound effect on the fixed income market. The spread sectors have gone from agency mortgages, government agencies and corporate credit to essentially just credit following an unprecedented period of government intervention. Agency and agency mortgage spreads have converged to roughly the same level, leaving corporate credit the only viable option, in our view, for spread-seeking investors to earn potential returns above U.S. Treasuries. Following an unprecedented widening late last year, credit spreads remain at attractive levels (as of June 2009) relative to historical averages and relative to agency mortgage and agency spreads.

No one knows the long-term fate of the agency mortgage market, nor does anyone know exactly how long these structural changes will exist. But it seems clear that the structural changes that have occurred will have a long- lasting impact on the fixed income landscape. Many market participants have only just begun to understand this, and many fixed income managers may have difficulty navigating the new environment.

We have always been a proponent of fundamental, bottom- up credit analysis given the value that can be added if done properly. We think a focus on credit analysis will provide the most compelling opportunities for fixed income managers to generate alpha. In our opinion, this new paradigm favors those willing to pursue a fundamentally driven, credit- oriented investment process with deep research capabilities and an intensive investment risk management system.

5 The reallocation of financials exposure to the industrials sector and the reallocation from BBB-rated securities to A-rated securities within the Barclays Capital U.S. Aggregate Corporate Index are hypothetical, back-tested performance scenarios. Both scenarios and their performance are hypothetical, and do not represent the actual investment performance of any account or investor. Allocations in the hypothetical scenarios were selected based on typical portfolio construction principles. Each allocation was selected with the full benefit of hindsight after the performance for the period was known. It is not likely that similar results could be achieved in the future. The hypothetical scenarios performance information is based on the backtested performance of a hypothetical investment over the time period indicated. These figures are not annualized.“Backtesting” is a process of objectively simulating historical investment returns by applying a set of rules for reallocating securities, backward in time, testing those rules, and hypothetically investing in the allocations that are chosen. Backtesting is designed to allow investors to understand and evaluate certain strategies by seeing how they would have performed hypothetically during certain time periods. Although the information contained herein has been obtained from sources believed to be reliable, its accuracy and completeness cannot be guaranteed. Backtested results have certain limitations and should not be considered indicative of future results. In particular, they do not reflect actual trading in an account, so there is no guarantee that, in fact, an actual account would have achieved the results shown. An actual investor may have lost money by investing in the manner suggested. The index reallocations assume the reinvestment of dividends, no deductions for investment advisory or other brokerage fees.The indexes are unmanaged and not available for direct investment.

Please consider the charges, risks, expenses and investment objectives carefully before investing or recommending to

Please consider the charges, risks, expenses and investment objectives carefully before investing or recommending to clients for investment. For a prospectus containing this and other information, please call Janus at 877.335.2687 or download the file from janus.com/info. Read it carefully before you or your clients invest or send money.

Past performance is no guarantee of future results.

The opinions are those of the authors as of July 2009 and are subject to change at any time due to changes in market or economic conditions. The comments should not be construed as a recommendation of individual holdings or market sectors, but as an illustration of broader themes.

In preparing this document, Janus has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources.

Janus makes no representation as to whether any illustration/example mentioned in this document is now or was ever held in any Janus portfolio. Illustrations are only for the limited purpose of analyzing general market or economic conditions. They are not recommendations to buy or sell a security, or an indication of the authors’ holdings.

This document is not intended to be an offer or solicitation, or the basis for any contract to purchase or sell any security or other instrument, or for Janus Distributors LLC to enter into or arrange any type of transaction as a consequence of any information contained herein. This document is not an advertisement and is not intended for public use or distribution.

Statements in the brief that reflect projections or expectations of future financial or economic performance of a strategy, or of markets in general, and statements of any Janus strategies’ plans and objectives for future operations are forward-looking statements. Actual results or events may differ materially from those projected, estimated, assumed or anticipated in any such forward-looking statement. Important factors that could result in such differences, in addition to the other factors noted with forward-looking statements, include general economic conditions such as inflation, recession and interest rates.

Janus Distributors LLC (07/09)

151 Detroit Street, Denver, CO 80206 I 877.335.2687 I
151 Detroit Street, Denver, CO 80206
I
877.335.2687
I

www.janus.com

Street, Denver, CO 80206 I 877.335.2687 I www.janus.com FOR FINANCIAL PROFESSIONAL USE ONLY / NOT FOR
Street, Denver, CO 80206 I 877.335.2687 I www.janus.com FOR FINANCIAL PROFESSIONAL USE ONLY / NOT FOR

FOR FINANCIAL PROFESSIONAL USE ONLY / NOT FOR PUBLIC VIEWING OR DISTRIBUTION