"Free to those who can afford it - very expensive to those who can't"

Having been away for three weeks, for one reason and another, it's been interesting watching the markets as a neutral observer or, more to the point, the behaviour of those involved. The increasingly hysterical commentaries from credit pundits are testament to the fact that what had been a simple and lucrative one-way game had come to an abrupt end. Naturally, the end game where the mendacious and greedy have finally gotten their comeuppance has been accompanied by dire predictions of the end of known civilisation as by way of justifying past excesses.

There is a really easy way of looking at the past three weeks. According to Moody's, the 5-year default rate on high yield bonds is around 5%. As a rule of thumb, if a bond defaults you usually lose about 60% of your money. If you have a portfolio of this stuff then you should expect 3% of your money to disappear (5% x 60) over time so to break-even against cash you need a portfolio that yields LIBOR plus 3%. If you look at spreads recently in these markets, investors have been funding high yield bonds at LIBOR plus 2.5%. In other words over time, investors have been funding the new issuance programme at LIBOR minus 0.5%, which was crazy and unsustainable. In the past three weeks, spreads have widened out to LIBOR plus 5%, which means that a portfolio can expect to return LIBOR plus 2% if you apply historical default rates which is much better than recent history. Since investors can expect a return which is better than LIBOR, they are now paying for the risk they are taking. In other words, this process is really about the rightsizing of risk.

So, far from having "dysfunctional markets" as people have claimed, we have markets that are behaving as they should and perfectly rationally. What is dysfunctional is the behaviour of investment bankers who would rather pay a billion dollars of penalties than take on their own book loans that a few weeks ago they were quite prepared to flog to their clients - using glowing recommendations and slick presentations. I suspect the US Federal Reserve is quietly rubbing its collective hands with glee at the idea that risks are being normalised and it doesn't have to enact a rescue package (such as rates cuts and manufacturing a steep yield curve) that contains the morally reprehensible sentiment that money is "Free to those who can afford it, but very expensive to those who can't".

There has been some unfortunate contamination of other markets during this process; equities have fallen, government bond yields have dropped and the currencies that have been funding the carry trade (Japanese yen, Swiss franc) have appreciated as money flows have been reversed while emerging markets bonds have seen spreads widen and their currencies fall. Since we have been running a low duration policy this has cost us some performance but has been far from being a disaster because of our currency positions.

With regard to government bond yields, it's difficult to get enthusiastic about them unless you can put a convincing case on the table that there are serious and real economic consequences to the High Yield high noon. Looking at available cash rates and targeting the end of the year, it's easy to show (see first illustration) that just to match what you get in the bank, bond yields in the US would have to fall a further 17bp in the short-end 1 . This is on top of the 60bp fall seen in the past 3 weeks don't forget. The same applies to the UK. In that sense, we don't feel inclined to change our low duration policy at this time as we expect government bond holdings to be sold in favour of the more correctly priced credit markets.

Similarly, we have been overweight the Japanese yen and Swiss franc during this process which has saved and created performance. In the re-risking process that we expect to occur going forwards these currencies will decline (reversing recent appreciations) somewhat as the carry trade is put back on. For that reason we have reduced our exposure to the yen and Swiss franc. However, there are some issues relating to the Japanese yen in the coming months which we think makes it vulnerable to a rapid appreciation so we are replacing some of the yen position with a call option which makes us a winner under a number of possible scenarios.

All in all, we expect this episode to pass into history and be marked as one of those events which come along from time to time in this new financially engineered world which teaches us some lessons but doesn't deflect the long-range gravitational forces that are at play. What would change our mind is if there was decisive evidence that these market effects are having an affect on the real economy through employment and incomes. While we remain open-minded about this possibility it may take several months to define the pattern.

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