Investment Insights Series l 2009

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 option. Many asset managers will likely have to change

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 mortgages1
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
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 Capital U.S. Aggregate Bond Index as of 6/30/09
Corporate Agency Government U.S.
Credit Mortgages* Agencies Treasuries
22.79% 38.51% 9.65% 25.15%
Corporate
Government
Credit 73.31%
22.79%
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.

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Why Credit Matters: Fixed Income Investing in a Changed Landscape INVESTMENT INSIGHTS
Under normal market conditions, spreads, or the difference A Changing Landscape
in yields over U.S. Treasuries, generally increase when The unprecedented government involvement in the
moving from government agencies to agency mortgages to mortgage and agency sectors and the breakdown in
corporate credit, given the greater perceived risk associated correlations among corporate credit and the other spread
with getting away from government-issued or -backed sectors suggest that long-term structural changes within
securities. Since the GSEs were placed under conservatorship the fixed income market are underway. First, we believe the
by the U.S. government, the spreads between government government’s involvement will likely need to continue over
agencies and agency mortgages have converged. Given that the near and possibly intermediate term given the weak
the government’s support for the mortgage sector is likely housing market and “legacy” assets still on the balance sheets
to continue for some time and the agency market is now of many financial companies. The unwinding of these assets
receiving an explicit federal backing, relatively low spreads and the government intervention will likely be difficult and
for these two sectors may be the new norm. take some time.

Conversely, the overall lack of liquidity in the bond market

in late 2008 created the widest spreads on investment Exhibit 3
Breakdown in Correlation of Returns Among Sectors
grade corporate credit in 100 years. Spreads have tightened
1
since late last year but were still high at the end of June
0.9
2009—roughly 300 basis points (bps), which is more than
0.8
twice the 129 bps average from January 2000 to December
Correlation Coefficient

2007 (see Exhibit 2). After a decade of relatively low interest 0.7

rates and tight spreads resulting from small risk premiums, 0.6

corporate credit investors are now being compensated for the 0.5
risk associated with these securities. We think this will continue 0.4
as the U.S. economy will likely take a while to fully recover.
0.3

0.2
Corporate credit investors are now being

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compensated for the risk associated with U.S. Corporate to U.S. MBS (Agency Mortgages)
U.S. MBS (Agency Mortgages) to U.S. Treasury
these securities. U.S. Corporate to U.S. Treasury
U.S. Aggregate Agency to U.S. MBS (Agency Mortgages)

Exhibit 2 Rolling 36-month correlations of monthly returns as of June 30, 2009

Investment Grade Corporate Credit Spreads Source: Bloomberg, Barclays Capital
700
Option Adjusted Spread (OAS) (Basis points)

600 Second, the breakdown in correlations is evident. Exhibit 3

500
compares the rolling 36-month correlations between the
returns of corporate credit and U.S. Treasuries, corporate
400
credit and agency mortgages, agency mortgages and U.S.
300 Treasuries, and government agencies and agency mortgages.
9/07/2008 - Freddie and Fannie
placed into conservatorship Since August 2008 there has been a breakdown in the
200
correlation of returns between corporate credit and the
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other three sectors—from relatively high levels of above 0.80
0 to a relatively low level of 0.40 to 0.50 for corporate credit
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to agency mortgages and roughly 0.30 for corporate credit

U.S. Agencies OAS U.S. MBS (Mortgage) OAS U.S. Corporate OAS to U.S. Treasuries. Meanwhile, the correlations of agency
mortgages to U.S. Treasuries and government agencies to
As of June 30, 2009 agency mortgages have held relatively steady, still above
Source: Bloomberg, Barclays Capital 0.80 through the end of June 2009. This, coupled with little

INVESTMENT INSIGHTS Why Credit Matters: Fixed Income Investing in a Changed Landscape
I 3
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
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)
4 I
Why Credit Matters: Fixed Income Investing in a Changed Landscape INVESTMENT INSIGHTS
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 industrials5 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 20085 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
 of roughly 525 bps reveals the difficulty of credit investing Conclusion
and highlights the need for intensive investment risk The events within the global financial markets in 2007 and
management. The bottom-performing managers may have 2008 have had a profound effect on the fixed income market.
had investment risk management systems in place, but they The spread sectors have gone from agency mortgages,
may not have been embedded in the security selection government agencies and corporate credit to essentially just
process. We think an effective investment risk management credit following an unprecedented period of government
process goes beyond attribution analysis and relative value intervention. Agency and agency mortgage spreads have
to encompass a value at risk (VaR) approach that looks at a converged to roughly the same level, leaving corporate
portfolio’s exposures to various adverse market events, such credit the only viable option, in our view, for spread-seeking
as a lack of liquidity. investors to earn potential returns above U.S. Treasuries.
Following an unprecedented widening late last year, credit
Exhibit 4 spreads remain at attractive levels (as of June 2009) relative
Dispersion of Returns Within Fixed Income to historical averages and relative to agency mortgage and
2500
agency spreads.
Dispersion of Returns (Basis points)

2000 No one knows the long-term fate of the agency mortgage

market, nor does anyone know exactly how long these
1500 structural changes will exist. But it seems clear that the
structural changes that have occurred will have a long-
1000 lasting impact on the fixed income landscape. Many market
Average: 525 bps participants have only just begun to understand this, and
500
many fixed income managers may have difficulty navigating
the new environment.
0
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We have always been a proponent of fundamental, bottom-

Difference Between 10th and 90th Percentile Average Dispersion 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
eA Core Plus Fixed Income Category
As of March 31, 2009 to generate alpha. In our opinion, this new paradigm favors
Source: eVestment Alliance (eA) those willing to pursue a fundamentally driven, credit-
oriented investment process with deep research capabilities
In 2008, we saw liquidity in the credit markets dry up, and given and an intensive investment risk management system.
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.

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.

I
INVESTMENT INSIGHTS Why Credit Matters: Fixed Income Investing in a Changed Landscape 5
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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.
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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
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