Morningstar Advisor - April/May 2009 - 45

that they have to go back to a cash-flow-based investment program in credit and not the price-based investment program of the past. A lot of people have gone into an area way too early or they’ve become disillusioned too quickly because they haven’t gotten the type of price payoff that their experience told them they should get. Also, I agree with Bob. Default rates are going higher, particularly in the corporate credit market and the commercial market, where they’ve just really gotten started on the upside. It reminds me a lot of where the nonagency mortgage market was one year ago. Let’s take it back to St. Patrick’s Day 2008. Bear Stearns went under and was taken over by JP Morgan. It was a cathartic moment that had trashed out the nonagency mortgage market with massive liquidations occurring in the SIVs, REITs, hedge funds, and bank balance sheets. There was a big rally after the Bear Stearns takeover that took us into May. A lot of people were claiming that that might be a bottom in the credit market and, in particular, in the nonagency mortgage market. I wrote in May 2008 that the rally was very near its end and that we would be looking for much lower prices, even taking out the lows of the Bear Stearns day. The reason I thought that way is similar to what I think now about the corporate credit market. After prices got low in the nonagency market and they started to rally in March and April 2008, a lot of people said, “Well, the market has gotten itself reconciled to high default rates now.” At the time, there was a new idea, which was certainly appropriate, that Alt-A type of mortgages—the ones right below prime that have limited documentation programs—were no longer going to see the single-digit default rates modeled in by most investors. Instead, they would experience 30% default rates. To this day, it’s not clear whether default rates will go higher than 30%. I think they will, but they’re running at about We’re walking very gingerly, letting others be smarter than us and, hopefully, destroy themselves. Bob Rodriguez the nature and size of our operations, we’re more like a PT boat, and we’ve found some pockets in the prime mortgage area, in seasoned mortgage product. We entered this year with the expectation that this would be one of the most difficult years for the fixed-income manager. At the highquality end, the yields are, shall we say, wanting. Thus, there isn’t a margin of safety to a high degree to any appreciable rise in rates. Secondly, if you don’t get it right on what I would call the credit-spread area—either in the high-grade corporate credit area or in the high-yield area—it will come back to haunt you in the second half of the year. Thus, this could be a very difficult year. To exit the year with a positive rate of return will be a challenge. So we’re working from a very defensive position, with the idea that default rates are going to be rising in ’09, ’10, and into ’11. There’s just been too much of what I would call “professional investors” trying to kick off the bottom, whether it’s been in equities or banks or mortgages. “Gee, the mortgage market is breaking, and there are a lot of these alphabet-soup securities around. We’ll go out and buy that.” That was their thought process back in the fourth quarter of ’07, and it was premature. We’re walking very gingerly, letting others be smarter than us and, hopefully, destroy themselves. Gundlach: The secular environment that most bond managers are accustomed to was one of increasing leverage and increasing debt/ GDP ratios. That environment has left the building. Debt and leverage tremendously increased the velocity of market trading. It was routine for sectors to recover very sharply and stay depressed for very temporary periods. Most bonds managers just don’t understand MorningstarAdvisor.com 45

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Morningstar Advisor - April/May 2009

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