Investors Reappraise Investment Risks to Include Credit Worthiness

By: Richard_Shaw

Investors, not just mortgage lenders, whether owning bonds or stocks, need to pay more attention to credit worthiness now and in the future than they have in the past.

Investors have become used to thinking of risk as merely volatility (standard deviation of return), but there is also absolute risk — the risk of permanent loss of value.

Mortgage REITs and banks are examples from the past. Money market funds are “close call” examples of the present.  Tax exempt funds and exchange traded notes could be examples of the future.

Money Market Funds:

Bank of New York (BK) and Northern Trust (NTRS) have joined the list of sponsors contributing capital to bolster their money market funds to avoid “breaking a buck”.

Others including Wachovia (WB) and Legg Mason (LM) have done the same since the run on money funds began recently with the Primary Reserve Fund, the oldest money market fund and the first in 14 years to see its money market fund price drop below $1.00.

From Bloomberg today:

Investors pulled a record $120.5 billion from the funds in the week ended Sept. 23, according to the Money Fund Report, a newsletter based in Westborough, Massachusetts. …

“Even with withdrawals there is more than $3 trillion in money market mutual funds that has to find a home,” Credit Suisse's Jersey said.

The problem is that general money market funds invest in assets that include commercial paper and CDs that now have questionable credit worthiness, and therefore low Bids, and therefore market-to-market hits to money fund NAV.  Treasury Bills have Bids and don't have mark-to-market problems.

Today (Sep 29), the US Treasury opened a program to insure the value of all publicly offered money market funds for those funds that apply and pay a premium.  ( see Treasury press release ).

We have been advising clients during this difficult period ( see prior articles ) to use money market funds that invest only in US Treasury Bills.  We continue to make that recommendation, unless you are certain that your money fund is a participant in the US Treasury program that guarantees money fund value.

Tax Exempt Bond Funds:

We recommend investors with tax exempt muni funds be cautious about those funds relying on revenue bonds versus general obligation bonds.  The chance of default on revenue bonds is probably higher now.

Exchange Traded Notes (ETNs):

Similarly, we recommend limiting exposure to ETNs (single issuer bonds pegged in maturity value to some independent index), because ETN's are subject to the risk of the credit worthiness of the issuer.

We wouldn't stop using ETNs in areas where they provide unique exposure if the credit quality of the issuer is high, but we would be aware of the nature of the counter-party risk and keep exposures in reasonable proportion to the overall portfolio. ( see article on specific ETN issuers ).  The most significant ETN issuers include Deutsche Bank (DB) and Barclays' Bank (BCS).

Summary:

I nvestors have been too focused on yield and earnings growth at the expense of credit worthiness.  That has contributed to the market dilemma we face today.

Investors, as well as mortgage lenders, whether owning bonds or stocks, need to pay more attention to credit worthiness now and in the future than they have in the past.

By Richard Shaw 
http://www.qvmgroup.com

Richard Shaw leads the QVM team as President of QVM Group. Richard has extensive investment industry experience including serving on the board of directors of two large investment management companies, including Aberdeen Asset Management (listed London Stock Exchange) and as a charter investor and director of Lending Tree ( download short professional profile ). He provides portfolio design and management services to individual and corporate clients. He also edits the QVM investment blog. His writings are generally republished by SeekingAlpha and Reuters and are linked to sites such as Kiplinger and Yahoo Finance and other sites. He is a 1970 graduate of Dartmouth College.

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