This article explains the background to the current turbulence in the markets. The message is clear – stay with high quality products that can deliver the market return with the least amount of risk and avoid being exploited by big brand name Product Providers dressing up ‘flavour of the month’ products. It also further re-iterates the role played by Fixed Interest in ones portfolio.

One sage observer of financial markets once quipped that it 's only when the tide goes out that you get to see who's been swimming naked.

Well, there are a lot of red faces near the shore now, including right here in Australia, as hedge funds reveal their exposure to the so-called "sub-prime" mortgage crisis in the US.

The still unfolding disaster has some salient lessons for investors everywhere about the nature of risk and the role of fixed interest in a diversified portfolio. We'll get to those lessons in a moment, but first some background.

If you haven't been watching the headlines, the US housing market has been undergoing a correction, a development which has exposed not only lax lending policies but also sophisticated attempts by the financial services industry to parcel up and sell the resulting debt to yield-hungry investors.

Sub-prime mortgages are housing loans given to less creditworthy borrowers. There was an explosion in this form of lending in the US in recent years as the housing market boomed.

Typically, sub-prime borrowers took out variable rate mortgages (unlike the fixed rates that most US home buyers secure). These loans were set at low, honeymoon rates. But they ratchet up very quickly after the first year.

The originators of these loans, with the assistance of clever investment bankers, packaged them together into complex financial derivatives known as collateralised debt obligations (CDOs). These were then sold on to hedge funds and other investors, who were happy to leverage up these high-risk securities for the promise of a high return.

The system worked pretty well for a while. With the US housing market booming in the first half of this decade, borrowers were happy. If they missed a mortgage repayment, they could sell their property at a profit. And with default rates low, the lenders enjoyed high returns.

So successful was this form of lending that investors poured more and more money into these schemes. Flush with liquidity, the originators moved further out the risk curve, granting loans to ever less creditworthy borrowers—many of whom had no hope of paying the loans back—even when rates were lower than they are now.

But then from mid-2004, the US Federal Reserve-the equivalent of our own Reserve Bank- started raising its benchmark funds target rate from historic lows of 1 per cent to 5.25 per cent over a two-year period.

Home prices began falling, which left high-risk borrowers with no exit hatch when their repayments started to rise. As defaults and foreclosures increased, the share prices of the originators slumped.

The king-hit came recently when all of the three major credit rating agencies announced that they were downgrading their ratings of billions of dollars in mortgage pools. This drove down the value of sub-investment grade credit (commonly referred to as 'junk') held by hedge fund managers and cast a shadow over the entire $US7 trillion market for mortgage-related bonds.

Aside from the poor families who have lost their homes and the small investors whose retirement savings have been eroded, the highest-profile victims of all this have been two hedge funds run by the US investment banking and brokerage firm, Bear Stearns. After announcing in June plans for a $US3.2 billion bailout of the funds, Bear Stearns confessed to investors in mid-July that the two funds were essentially worthless and they would seek an orderly wind down of both.

The crisis also spilled over to Australia, with the Sydney-based hedge fund operator Basis Capital slapping limits on withdrawals from two of its vehicles that had invested in CDOs.

There are a number of lessons for investors in all of this. Firstly, you should never pursue high return through fixed interest, let alone complex and opaque derivative vehicles based on fixed interest securities.

Both history and theory confirm that expected returns on equities exceed expected returns on fixed interest. The primary reason for adding fixed interest to a diversified portfolio is the reduction of volatility.

The bulk of the variation in bond market returns is explained by two risk factors.1 The first is maturity risk—longer-term debt instruments are riskier than shorter-term. The second is default risk—instruments of lower credit quality are riskier than those of higher credit quality.

This means the only systematic way to take more risk and increase returns in fixed interest is by going into longer maturities and/or "junkier' quality paper.

Unfortunately, the data shows that while longer-term maturities are more volatile, they do not deliver a reliable return premium.

Default risk, unlike maturity risk, does not show up in volatility. But it carries its own problems-namely that the risks only become apparent when the underlying conditions are not so buoyant or, to use our earlier analogy, when the tide goes out.

In this case, the sub-prime boat sailed along fine when the seas were friendly—interest rates were historically low and the appetite for investors for risk and extreme leverage was historically high.

But history shows that when conditions worsen, the underlying credit quality is exposed and the losses are severe, even more so when leverage is involved.

The consequences of sailing too close to the rocks are worse than being caught swimming naked, and a lot more painful.

(Source – Dimensional Fund Advisers)
1. Eugene F. Fama and Kenneth R. French, 'Common Risk Factors in the Returns on Stocks and Bonds', Journal of Financial Economics 33 (1993)