Historic dislocations in fixed-income prices have created compelling value in many sectors

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      By Payson F. Swaffield, CFAChief Income Investment Officer, Eaton Vance Management

      Boston - Liquidity-driven dislocations, caused by investor demand for cash, have hit fast and furiously in many fixed-income sectors, including US Treasuries, commercial paper, investment-grade corporate credit, US municipal bonds, asset-backed securities, mortgage-backed securities, commercial mortgage-backed securities, floating-rate loans and high-yield bonds.

      It is a good idea to consider why we feel many sectors are trading well below their intrinsic value. At the broadest relative value level, the S&P 500 Index is down about 27% from its peak. We can use floating-rate loans as an example of undervalued assets, based on the S&P/LSTA Leveraged Loan Index. As of March 25, loans were off 19% from their peak — not very far behind the decline in the S&P 500. Historically, loans have had just one-third the volatility of stocks, so from strictly a historical, technical perspective, loans look significantly oversold, relative to stocks.

      In fundamental terms, remember the basic risk/reward equation of equities vs. bonds. Equities (usually) have more upside potential, but are junior to debt in any restructuring, potentially leading to a transfer of ownership from equity owners to bondholders.

      The S&P/LSTA Index was trading at 76.4 on March 24, yielding over 10%. Current market pricing now reflects a default rate of 59% over three years (the average life of loans), assuming recovery rates drop from their historical level of 80% to 60%. (Remember that loans are senior and secured in the capital structure.) Today's implied default rate is more than four times the actual default level during the 2008 recession.

      The current fixed-income selloff happened prior to the major monetary and fiscal actions — the aggressive moves by the US Federal Reserve to shore up market liquidity and the $2 trillion package scheduled to be enacted by Congress this week. The Fed established a host of mechanisms to supply banks and dealers with the necessary liquidity for market functioning, like the primary dealer credit facility, the commercial paper funding facility, and the term assetbacked securities loan facility (TALF) which was created in 2008, and is being revived.

      Such programs take time for full results to develop, but it is clear that the initial impact has been positive. For example, on March 23, we saw credit default swaps (CDS) of major banks like Goldman Sachs get more expensive — its spread touched 200 basis points. By March 24, that had subsided to 168.

      Bottom line: Fixed-income prices have undergone an historic dislocation and current levels in many sectors offer compelling value.