jan us changed credit landscape

8/14/2019 Jan Us Changed Credit Landscape

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Overview

Since the birth o the securitization market in the 1990s,

the xed income market has been segmented by most

proessional money managers into our 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 xed income market, compressing

the our xed income sectors into two: government and

corporate credit (see Exhibit 1).

For investors seeking traditional spread product, or xed

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 xed income investing, as corporate

credit analysis could become the single most important

actor in generating risk-adjusted outperormance.

Managers already ocused on a undamental, 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 themost viable option.

Investment Insights Series l 2009

J u l y 2 0 0 9

Why Credit Matters:Fixed Income Investing in a Changed Landscape

The recent dislocation in the fxed income market is likely to transorm how investors and asset managers

approach fxed income investing or years to come. Aggressive government intervention has essentially

resulted in the our basic fxed income sectors collapsing into two: government and corporate credit.

As a result, corporate credit may now be the single most important actor in generating risk-adjusted

perormance in fxed income. In this brie, we discuss the structural market changes that have occurred

and the importance o undamental, bottom-up credit analysis and robust investment risk management

in navigating this changed landscape.

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

1Agency mortgages reer 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.


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2 Why Credit Matters: Fixed Income Investing in a Changed LandscapeI INVESTMENT INSIGHTS

Exhibit 1Converging Sectors

THEN: Four Basic Sectors in Fixed Income% of the Barclays Capital U.S. Aggregate Bond Index as of 6/30/09

NOW: Compression has resulted in two sectors:

Corporate Credit and Government

Corporate

Credit22.79%

Corporate

Credit22.79%

Government73.31%

Agency

Mortgages*38.51%

Government

Agencies9.65%

U.S.

Treasuries25.15%

*The securitized market includes agency mortgages and asset-backedsecurities/commercial mortgage-backed securities (ABS/CMBS). Given the

small size o the ABS/CMBS sectors and their combined small weighting in

the Barclays Capital U.S. Aggregate Bond Index (3.89% as o June 30, 2009),

it is generally not considered a primary sector in fxed income.

As o June 30, 2009

Source: Janus, Barclays Capital

Why Credit Matters

Many xed income managers have typically used sector

allocation to construct portolios, adding value by over- or

underweighting exposure among the dierent spread

productsgovernment agencies, agency mortgages and other

securitized sectors, and corporate creditbased on a macro

view o the economy, interest rate expectations, and/or relative

valuations and perceived risks. Beore the recent turmoil in the

nancial markets, most managers attempted to earn a spread

over Treasuries largely through greater allocation to agency

mortgages, which make up the largest part o the securitized

sector. Up until the end o 2008, this strategy paid o as agency

mortgages outperormed corporate credit with a cumulative

77% total return versus a roughly 59% return rom January

2000 through December 2008.

2

However, given the structural changes that have occurred

in the xed income market over the past year as a result o

the credit crisis (see Exhibit 1), the agency mortgage space

may no longer oer the same viable strategy or generating

risk-adjusted outperormance. In addition, certain segments

o 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 rom the nancial crisis. CMBS and ABS also

represent such a small percentage o the index that even i

they do recover, their impact will likely be less meaningul

than agency mortgages. Lastly, the government agency

market may not be a signicant source o outperormance

given the narrow spread that these securities typically oer

over U.S. Treasuries. Whats let or xed income managers?

Essentially, just corporate credit.

How Did We Get Here?

The credit crisis originated in the mortgage market

specically within the subprime marketand spread

to other areas o the credit and xed income markets,

then inected the global nancial system and eventually

impacted economies worldwide. Complexity and the lack

o 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 o risk led to an inability to value or sell

complicated securitized debt.

Another contributing actor was the amount o leverage

embedded in the system. Hedge unds and speculators had

the ability to borrow and leverage their investmentssome

at a rate as high as 10-to-1which turned ordinarily smallprots into huge prots 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 orced to support the mortgage and nancial

markets directly through an alphabet soup o intervention

programsTSLF, TARP, TALF and PPIP, to name a ew. 3

A key event impacting the structure o the xed

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 signicant

role in the mortgage and agency markets, this action has

had a proound impact on spreads and the correlation o

returns within the xed income sectors.

2Source: Bloomberg, Barclays Capital3Term Securities Lending Facility (TSLF) was rolled out in March 2008, Troubled Asset Relie 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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3INVESTMENT INSIGHTSIWhy Credit Matters: Fixed Income Investing in a Changed Landscape

Under normal market conditions, spreads, or the dierence

in yields over U.S. Treasuries, generally increase when

moving rom government agencies to agency mortgages to

corporate credit, given the greater perceived risk associated

with getting away rom 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 governments support or the mortgage sector is likely

to continue or some time and the agency market is now

receiving an explicit ederal backing, relatively low spreads

or these two sectors may be the new norm.

Conversely, the overall lack o 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 o June

2009roughly 300 basis points (bps), which is more thantwice the 129 bps average rom January 2000 to December

2007 (see Exhibit 2). Ater a decade o relatively low interest

rates and tight spreads resulting rom small risk premiums,

corporate credit investors are now being compensated or the

risk associated with these securities. We think this will continue

as the U.S. economy will likely take a while to ully recover.

Corporate credit investors are now being

compensated or the risk associated with

these securities.

Exhibit 2Investment Grade Corporate Credit Spreads

0

100

200

300

400

500

600

700

Jul-07

Aug-0

7

Sep-0

7

Oct-07

Nov-0

7

Dec-0

7

Jan-0

8

Feb-0

8

Mar-08

Apr-08

May-0

8

Jun-0

8

Jul-08

Aug-0

8

Sep-0

8

Oct-08

Nov-0

8

Dec-0

8

Jan-0

9

Feb-0

9

Mar-09

Apr-09

May-0

9

Jun-0

9

OptionAdjuste

dSpread(OAS)(Basispoints)

U.S. Agencies OAS U.S. MBS (Mortgage) OAS U.S. Corporate OAS

9/07/2008 - Freddie and Fannie

placed into conservatorship

As o 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 xed income market are underway. First, we believe the

governments 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

o many nancial companies. The unwinding o these assets

and the government intervention will likely be dicult and

take some time.

Exhibit 3Breakdown in Correlation of Returns Among Sectors

0.2

0.3

0.4

0.5

0.6

0.7

0.8

0.9

1

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

CorrelationCoefficient

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

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

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

Rolling 36-month correlations o monthly returns as o 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 o 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 o returns between corporate credit and the

other three sectorsrom relatively high levels o above 0.80

to a relatively low level o 0.40 to 0.50 or corporate credit

to agency mortgages and roughly 0.30 or corporate credit

to U.S. Treasuries. Meanwhile, the correlations o agency

mortgages to U.S. Treasuries and government agencies to

agency mortgages have held relatively steady, still above

0.80 through the end o June 2009. This, coupled with little


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4 Why Credit Matters: Fixed Income Investing in a Changed LandscapeI INVESTMENT INSIGHTS

dierence 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 let:

government and corporate credit. The low correlations o

corporate credit also suggest this sector could provide a

much greater opportunity or a xed income manager to

generate superior risk-adjusted returns.

Credit Investing Has Its Challenges

Generating alpha within xed income has traditionally

been done in a number o ways, rom sector allocation

and duration or yield curve positioning to bottom-up,

undamentally driven individual credit selection. Most xed

income managers, particularly those with sizeable asset

pools, have used agency mortgages in an attempt to earn a

spread because o their historically higher yields relative to

U.S. Treasuries, the size o the market and overall liquidity.

With the structural changes leading to the compression

o spreads in this market, we dont think pursuing this

strategy will produce the results most investors have

been accustomed to over the past decade. The rest o the

securitized market may not oer an attractive alternative

given its small size and recent implosion. For this reason,

corporate credit will likely garner more interest by xed

income managers and investors alike.

The challenges many xed income managers ace in

pursuing greater corporate credit exposure are twoold. First,

corporate credit is much smaller than the agency mortgagesector, making it dicult or large xed income managers to

venture into individual security selection. An issues liquidity

or size may limit a large rms ability to take a ull position in

the company or ear o owning the whole issuance and not

being able to exit the position very easily. Relatively small

boutique rms may be more successul because this would

be less o a concern.

Second, to be successulparticularly in an environment o

rising deaultsindividual 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 or some increase

in value, when the bond is called or matures. On the downside,

there is the potential or the complete loss o 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 or xed income

managers who do not have the depth o research required

to do extensive undamental credit analysis. We think thisposes a challenge in the current environment because

pursuing an index strategy exposes the portolio to the

average deault rate across the entire corporate sector. Since

early 2008, deault rates have been moving higher, rising

rom 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 perormance.

The value o successul individual security selection

picking the winners and avoiding the loserscan be

signicant. For instance, reallocating nancials exposure

within the Barclays Capital U.S. Aggregate Corporate

Index to industrials5 would have added roughly 180 bps

o excess return over the ve-year period rom December

2003 through December 2008. At the quality level, moving

out o BBB-rated securities to A-rated securities within the

same index over a two-year period rom December 2006 to

December 20085 would have generated 70 bps o excess

return. I an investment rm lacks research capability, it

will likely struggle in corporate credit, largely because the

penalty or being wrong is greater than the reward or being

right, as many managers discovered in 2008.

Exhibit 4 shows how large the dispersion o returns was or

xed income managers within the credit space last year.

The more than 2000 bps dierence between the top and

bottom managers versus the 10-year average dispersion

4High yield deault rates are used because deteriorating credit quality aects investment grade credits, which typically move to the high yield category

prior to deaulting. (Source: JP Morgan-Chase)


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5INVESTMENT INSIGHTSIWhy Credit Matters: Fixed Income Investing in a Changed Landscape

o roughly 525 bps reveals the diculty o credit investing

and highlights the need or intensive investment risk

management. The bottom-perorming 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 eective investment risk management

process goes beyond attribution analysis and relative value

to encompass a value at risk (VaR) approach that looks at a

portolios exposures to various adverse market events, such

as a lack o liquidity.

Exhibit 4Dispersion of Returns Within Fixed Income

0

500

1000

1500

2000

2500

Jun-9

9

Oct-99

Feb-0

0

Jun-0

0

Oct-00

Feb-0

1

Jun-0

1

Oct-01

Feb-0

2

Jun-0

2

Oct-02

Feb-0

3

Jun-0

3

Oct-03

Feb-0

4

Jun-0

4

Oct-04

Feb-0

5

Jun-0

5

Oct-05

Feb-0

6

Jun-0

6

Oct-06

Feb-0

7

Jun-0

7

Oct-07

Feb-0

8

Jun-0

8

Oct-08

Feb-0

9

DispersionofReturn

s(Basispoints)

Average: 525 bps

Difference Between 10th and 90th Percentile Average Dispersion

eA Core Plus Fixed Income Category

As o 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 unsuccessul

maybe even ill-equippedto address this condition. In our

opinion, a rms research capabilities and investment risk

management process will be key to successully navigating the

world o corporate credit.

Conclusion

The events within the global nancial markets in 2007 and

2008 have had a proound eect on the xed income market.

The spread sectors have gone rom agency mortgages,

government agencies and corporate credit to essentially just

credit ollowing an unprecedented period o government

intervention. Agency and agency mortgage spreads have

converged to roughly the same level, leaving corporate

credit the only viable option, in our view, or 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 o June 2009) relative

to historical averages and relative to agency mortgage and

agency spreads.

No one knows the long-term ate o the agency mortgage

market, nor does anyone know exactly how long these

structural changes will exist. But it seems clear that thestructural changes that have occurred will have a long-

lasting impact on the xed income landscape. Many market

participants have only just begun to understand this, and

many xed income managers may have diculty navigating

the new environment.

We have always been a proponent o undamental, bottom-

up credit analysis given the value that can be added i done

properly. We think a ocus on credit analysis will provide the

most compelling opportunities or xed income managers

to generate alpha. In our opinion, this new paradigm avors

those willing to pursue a undamentally driven, credit-

oriented investment process with deep research capabilities

and an intensive investment risk management system.

5The reallocation o nancials exposure to the industrials sector and the reallocation rom BBB-rated securities to A-rated securities within the Barclays

Capital U.S. Aggregate Corporate Index are hypothetical, back-tested perormance scenarios. Both scenarios and their perormance are hypothetical,

and do not represent the actual investment perormance o any account or investor. Allocations in the hypothetical scenarios were selected based

on typical portolio construction principles. Each allocation was selected with the ull benet o hindsight ater the perormance or the period was

known. It is not likely that similar results could be achieved in the uture.

The hypothetical scenarios perormance inormation is based on the backtested perormance o a hypothetical investment over the time period

indicated. These gures are not annualized. Backtesting is a process o objectively simulating historical investment returns by applying a set o rules

or 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 perormed hypothetically during certain time periods.

Although the inormation contained herein has been obtained rom sources believed to be reliable, its accuracy and completeness cannot be

guaranteed. Backtested results have certain limitations and should not be considered indicative o uture results. In particular, they do not refect actual

trading in an account, so there is no guarantee that, in act, 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 o dividends, no deductions or investment

advisory or other brokerage ees. The indexes are unmanaged and not available or direct investment.


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C-0709-136 01-30-10 107-15-951 07-09

Please consider the charges, risks, expenses and investment objectives careully beore investing or recommending to clients or investment.

For a prospectus containing this and other inormation, please call Janus at 877.335.2687 or download the fle rom janus.com/ino. Read it

careully beore you or your clients invest or send money.

Past perormance is no guarantee o uture results.

The opinions are those o the authors as o 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 o individual holdings or market sectors, but as an illustration o broader themes.

In preparing this document, Janus has relied upon and assumed, without independent verication, the accuracy and completeness o all inormation

available rom 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 portolio.Illustrations are only or the limited purpose o analyzing general market or economic conditions. They are not recommendations to buy or sell a security, or

an indication o the authors holdings.

This document is not intended to be an oer or solicitation, or the basis or any contract to purchase or sell any security or other instrument, or or

Janus Distributors LLC to enter into or arrange any type o transaction as a consequence o any inormation contained herein. This document is not an

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Statements in the brie that refect projections or expectations o uture nancial or economic perormance o a strategy, or o markets in general, and

statements o any Janus strategies plans and objectives or uture operations are orward-looking statements. Actual results or events may dier materially

rom those projected, estimated, assumed or anticipated in any such orward-looking statement. Important actors that could result in such dierences, in

addition to the other actors noted with orward-looking statements, include general economic conditions such as infation, recession and interest rates.

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