The United States is currently in a significant recession and we anticipate a difficult environment for the next several quarters, including
-5% to -6% GDP in the fourth quarter, driven by tight credit and slowed consumer demand. We believe we are likely to see continued
global fiscal and monetary easing over the next several months and anticipate the passage of a massive fiscal stimulus program early into
the new Obama Administration. With last year’s 4% rally of the U.S. dollar vs. the Euro, which has continued into 2009, with the dollar
appreciating a further 7.4%, we have become more neutral with respect to the relative value of the U.S. dollar.
We believe high-yield valuations are compelling, although high-yield spreads have recently tightened over 500 basis points to their current
levels of 1673 basis points. But even at these levels, investors are being compensated for an estimated 17% implied default rate, compared
to our 12-month forecast of 8% to 10%, which assumes that one of the automakers (along with affiliated auto parts suppliers) does not
enter bankruptcy. (Moodys included GMAC in its December defaults, based on its exchange offer at less than par.) The 20 year TTM
high default rate of 12.7% was achieved in June, 1991. The convertible bond market also offers significant value in our view. Certain
convertible bonds are trading at dramatic discounts (and higher yields) than their straight debt equivalents, often enabling us to receive
the equity option of the convert for free.
We continue to favor U.S. high yield over international high yield and emerging markets. While U.S. high-yield spreads of 1673 basis
points are approximately 250 basis points lower than European spreads, the higher leverage and lower liquidity of European issuers
warrants increased spreads. Emerging market sovereign spreads continue to be significantly lower than U.S. high-yield spreads, at around
658 basis points. Given the commodities exposure as well as inflation risks of these countries, we do not believe sovereign spreads are
attractive on a relative value basis. We continue to invest in emerging market corporates, which offer spreads of approximately 2450 basis
points, but on a highly selective basis. We believe that our emerging market exposure offers significant potential for outperformance over
the medium term. Many of our investments have lower leverage, higher interest coverage and are more competitive firms than typical
U.S. high-yield companies. The global flight to quality has reduced liquidity in the emerging markets asset class, but we believe that our
companies will survive and could fare well in the next three years.
We believe our ability to invest in the most attractive high-yield bond opportunities globally, including those from emerging markets,
gives us the potential for strong returns with reduced volatility by taking advantage of market inefficiencies that may not be available to
portfolios with more limited mandates.
The portfolio uses a three-legged approach: The first leg is traditional U.S. high yield, which offers the breadth and depth of the highly
developed markets in the US. The second leg is emerging markets, which provides us the flexibility to gain exposure to some of the
world’s best companies that are located in emerging market economies. The third is international high yield or non-dollar high yield.
By investing in non-dollar-denominated high-yield assets, we are able to reduce overall volatility. Typically when risky assets fall in value,
the dollar falls, and holding non-dollar denominated assets helps offset that effect.