Relax - The sky has not fallen (Part 1)

I know what you're thinking - is this a case of deja vu? Most of us experience some anxiety every time the stock market dips, especially when the media is announcing each excruciating downtick on an hourly basis. It's easy to have a sense of hopelessness that makes any negative news feel like a ton of bricks. These circumstances have evolved from a possible infection originating in the fear that investment vehicles incorporated by brokers and bankers are tainted, or worse.

What happened?

Has something gone wrong? Is the sky falling? Not in our opinion. And we would like to assure you that you can safely assume that the sky will, in fact, remain overhead for the foreseeable future.

Financial markets around the globe have been shaken by fears about credit problems that started in the United States. Home mortgages for those with poor credit histories led to collapses in hedge funds speculating on these mortgages. Investors are worried that these problems will infect the larger financial system and possibly hurt the global economy.

A Lesson can be learnt

As some investors are starting to realize, many hedge funds have invested in risky and sometimes illiquid financial instruments (such as sub prime mortgages) in order to deliver higher returns. In essence, these vehicles were taking on even higher risks.

After seeing the eye-popping returns, investors jumped into these hot investments. The evidence is seen by the fact that the lightly regulated hedge fund industry has grown by five times since 2000, to exceed $1.7 trillion in assets under management, without experiencing a full-fledged credit or business cycle. However, human nature being what it is, risk perception quickly changed from greed to fear.

The result was a global panic over mortgage loans made to Americans with bad credit ratings. You have to realize that there is no sub prime mortgage market to speak of in Canada, and no indications that Canadian banks were aggressive players in the U.S. market. Yet one reason for concerns about potential exposure to the debacle is that Canadian financial stocks have been taking somewhat of a beating lately.

What's really annoying Canadian investors is the potential for gun-shy banks around the world to make it more difficult for corporations and businesses to borrow money. If banks and other financial institutions were less willing to lend to corporate and business customers, economic growth would moderate.

Slower growth would mean reduced demand for oil and metals, which would have a significant effect on Canada's economy. About 44% of the S&P/TSX composite index is accounted for by stocks in these sectors.

Blame it on the Boomers!

How did this happen in the first place? In our opinion, an aging society needed safe investments with a reasonably high yield over the years. As a result, banks and brokerages invented a solution that sounded too good to be true -- and it turns out it was. Money was poured into investments that were deemed to be low in risk with high yields, such as income trusts, sub prime investing and hedge funds. What we have seen is the unravelling of these investments.

In the world of U.S. corporate bonds, since 1992 the number of issuers of investment-grade corporate bonds has decreased, and the number of speculative-grade issuers has climbed. According to Standard & Poor's, the percentage of all issuers with speculative-grade ratings has climbed from a low of 28% in 1992 to a record 49% by the end of 2006.

The number of B-rated issues, according to Standard & Poor's, has doubled in the past decade, and the number of CCC-rated firms has more than tripled. Just seven non-financial companies in the U.S. now earn an AAA rating. The overall median credit rating of an issuer declined in the same period from A- in 1992 to BBB- by the end of 2006. BBB- is the lowest credit rating that still qualifies as investment grade. Everything below that is known as a Junk Bond.

This decay in the credit quality of corporate bonds could not have come at a worse time for the managers of pension funds, insurance company portfolios and, indeed, any portfolio designed to cover the huge costs of retirement in a rapidly aging world. By the middle of this century, demographers estimate that about 15% of the world's population will be older than 65, the traditional retirement age in North America. That's a huge increase from today when 7% of the world's population is older than 65.

Faced with this rising tide of retirement obligations, managers of retirement money in one form or another found themselves in a difficult situation. They needed safe assets. The portfolio rules often require them to invest in only investment-grade assets. They needed long-lived assets that matched the dates in the future when they were obliged to issue retirement payments. They also required assets that would deliver high returns while meeting the requirements of safety and long maturity.