The third quarter of 2011 was the worst for stocks and other so-called “risk assets” since the financial crisis unraveled markets in 2008. Following the supply chain disruptions caused by the disasters in Japan, already cautious investors were confronted by a series of negative headlines: the threat of political impasse surrounding attempts to raise the federal debt ceiling, S&P’s downgrade of U.S. Treasury debt, continued challenges in the European sovereign debt negotiations, and some weaker-than-expected economic data at home.
Despite the macroeconomic challenges facing U.S. markets, we believe the fundamentals across a range of fixed-income sectors remain attractive. Corporate debt, including investment-grade and, in particular, high-yield bonds, is now priced at levels suggesting an imminent severe recession in the United States, which is unlikely in our view. Defaults in high-yield corporate debt are well below the long-term average, and we believe that the default rate is likely to remain low, even in this weak economic environment. Within the mortgage-backed sector, we continue to find opportunities both in non-agency RMBS and interest-only CMOs, and we believe that both strategies can perform well in a weak housing market. On the international stage, we believe a recession in Europe appears likely, but we continue to believe that a Greek default, while a distinct possibility, is unlikely to spark continent-wide contagion, and our analysis suggests the direct impact to the United States could be minimal.
Although volatility may continue over the near term, for investors with longer time horizons, today’s valuations could represent an opportunity to establish positions at attractive prices.