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As safe as houses?

From almost nowhere, a situation has developed in which the safer assets – money-market assets and fixed interest – appear to be the areas worst affected by the US sub-prime turmoil.

Not that long ago, few would have heard of or understood the concept of sub-prime or cared much about its state. Now it is all you read about. But it is actually of lesser concern compared with the set of events it seems to have set off throughout the US and UK economies.

Central banks are stepping in to help with inter-bank rates, debate rages over the state of play with regard to the position of interest rates here and in the US and the headlines warn of a sub-prime issue on this side of the pond. Meanwhile, bonds of all type appear to be struggling, there is the instinctual flight to quality in the form of gilt demand while questions are being raised over whether or not Libor-plus vehicles and cash funds are really as safe as they have always seemed.

This uncertainty has caused volatility in the markets, with corporate debt funds looking to be most affected in an environment which Rathbones chief investment officer Julian Chillingworth calls a “buyers’ strike and liquidity crunch”.

He says: “The credit crisis was sparked by the problems in the sub-prime area.” Then, over the past few months, hedge funds started to suspend and close, debt instruments were turning up in the hands of people who did not understand what they were holding, the ratings of these came into question and buyers became hard to find and banks started to be wary of lending to one another.

This has cumulated into the situation we are left with today where debt funds are struggling, money-market funds are in a precarious situation and comparisons are being drawn with the 1987 equity market crash and the 1970s and 1980s’ savings and loan disaster in the US, although it does not appear that bad just yet.

It is not hard to see the retail impact of the credit crisis. Within UK retail funds, the average UK other bond and corporate bond portfolio posted losses over one, three and six months to September 7, according to Trustnet. In fact, only one fund within the UK other bonds sector, which houses most of the total return, strategic and absolute return bond funds launched in recent years, achieved gains over six months. This was Schroders strategic bond, which was up by 0.3 per cent.

That is not to say returns have been disastrous. The worst return over the same timeframe was -6.4 per cent from Marlborough high-yield fixed interest.

Money-market funds invest in term deposits as well as floating rate notes, which are often pegged to the now unpredictable Libor, and have not yet posted negative returns – something few have thought possible in a vehicle that is so liquid. According to Trustnet, the average money-market fund returned 0.3 per cent in the month to September 7, 1 per cent over three months and 1.9 per cent over six months.

Chillingworth says he doe not expect money-market funds to be hurt too badly so long as investors sit tight. Forced redemptions – a common occurrence when investors get scared – is where the problem lies, he says.

Thames River Capital investment director Mike Warren says: “If you were a pure money-market fund investing in term deposits, you would probably be okay. The problem would be if huge amounts comes out of these, as the managers would then have to break the term deposits. For those with floating rate note exposure, the funds are taking additional risks and may find it harder.”

He points out there are a number of Libor-plus funds in the UK which now look to be Libor-minus funds. Libor-plus has always been seen as quite safe and an objective not that dissimilar to the aim of the BNP Paribas funds that were suspended from trading although these did have holdings in asset-backed securitiesThere are a lot of Libor-plus portfolios in the UK and retail investors are not the only ones exposed to such vehicles, with many institutional clients and pension funds also participating in portfolios with such mandates.

The problem is not necessarily sweeping with these funds but Warren says those with more aggressive stances in the affected asset classes, such as the lower end of the credit spectrum or asset-backed securities, could struggle. He says: “No one imagined this would happen, where something as solid looking as mortgage-backed securities would get into trouble.”

Such is the situation today that economists are trying to draw comparisons with similar market situations from the past. Chillingworth says there is no shortage of examples of when banks lent money to the wrong people.

With regard to the comparison with 1987 markets, Chillingworth points out that the difficulties at that time were driven by the equity market, not the credit market. However, he notes that in 1987, problems were also caused by a seemingly safe investment – index fund programmes.

Another, perhaps more worrying comparison is with the savings and loan crisis in the US which resulted in a $125bn bail-out from the US government.

At that time, S&L institutions saw huge outflows from low-rate deposits as interest rates were driven up in an inflationary period and investors moved assets to higher interest accounts and money-market funds. There was more than one deciding factor that caused that crisis and it did spark off a number of significant economic events that had a longlasting effect.

Still, that is not to say that history will be repeated in this case. Chillingworth says the S&L disaster happened over a long period of time and went on to become recessionary – something he does not see happening in the US at the moment. He says: “I am not sure the current housing market situation is that dire. I see there will be more of a softness in house prices and there will be slower growth but not a recession.”


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