Alice in Bondland and Pirates of the Carribbean (Commentary)

2008 will certainly go down in the record books not only for the historic results of the presidential election as Barack Obama will become the first African-American elected to the White House, but also for what’s happening in the economy.

As the country has signaled by a large margin that they are ready for change in Washington, so too have investors signaled a stark change in their risk appetite. This year is shaping up to be one of the worst ever for many assets classes, not just stocks, as investors shun risk across the board.

Most of the pain has come in the last two months as panic has gripped Wall Street, Main Street and every other street around the globe. We have seen what I would consider an unprecedented flight to quality. No one wants to take any risk of any kind right now as investors flee almost every asset class and want to hold U.S. government bonds and the dollar. For those of you thinking our capitalist system is broken, or our place in the global economy is waning, think again. When things start to fall apart, the entire world looks to the U.S. for leadership and they place their bets accordingly, by buying our currency and our government debt.

During times of panic and chaos, opportunity always presents itself to those willing to see past the next hour, day, month and year. One such opportunity has presented itself in the investment grade corporate bond world. One way portfolio managers assess risk and value in the corporate bond world is to compare the yield of the bond in question to those on a government bond with a similar maturity structure. For instance, a 10-year Government bond can currently be purchased to yield around 3.70 percent, when compared to a AT&T bond of similar maturity which yields 6.79 percent. The “spread” between the two bonds is 310 basis points or 3.10 percent. The extra 3.10 percent a year you get for owning an AT&T bond vs. the U.S. Government is to compensate you for the risk you are taking since AT&T is not as safe an investment as an obligation of the United States of America.

The relationship between government bonds and corporate bonds fluctuate daily. Over the past decade, investors have been willing to take on much more risk with relatively little additional reward. It can easily be seen in the historical spread relationship in not only high quality corporate bonds, but also high yield (better known as junk) bonds. Up until the fourth quarter of 2007, investors were willing to lend money to corporations for just a fractional bump in yield. Earlier in the year we started seeing this “spread” relationship drift back to historical averages as investors began demanding additional compensation for their risk taking. Then in September and October we’ve seen that “spread” relationship explode. After the failure of Lehman Brothers on Sept. 15, panic set in for many investors not only in the U.S., but around the globe as mass selling began in almost all asset classes and continued gaining steam throughout October. There has been an enormous shift in investors’ willingness to take on risk of any kind. Yields on corporate bonds of high quality companies have risen drastically in the face of lower interest rates. The Fed has cut rates 7 times since late last year, dropping the Fed Funds rates to 1.0 percent from 5.25 percents in August 2007.

In sectors as a whole, here are how things stand on average. Single A rated industrial bonds with 10-year maturities are spread at +330 basis points versus +126 one year ago. Banks are spread at +487 basis points (versus +162 one year ago), and financials as a whole are +569 basis points (versus +166 one year ago). Even utilities are +381 versus +125.

What does all this mean? No doubt some of this spread widening has occurred solely due to the run up in Treasuries, but to us there is great potential value in the high grade corporate debt of some of the strongest companies around the globe. In order to take advantage of what the market is giving us, we continue to focus on sound credit research and seek to find the best risk/reward opportunities for our clients in the ever-changing markets.

One might ask: Have investors’ psyches been so brutally damaged by the recent problems in the financial markets that the willingness to take on risk of any kind is gone forever? I doubt it, as risk appetites ebb and flow just as the markets do. Our view is that the current environment has created some enormous opportunities for those willing to do the homework like we at Garrison Asset Management are and invest in the future of our country and the global economy.

(Glenn E. Atkins, CFA, is executive vice president and fixed income portfolio manager at Garrison Asset Management Co. He may be reached at [email protected].)