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<br />For the past six months, volatility has rocked the financial
<br />markets. Fears of the housing slowdown and credit
<br />market problems have led to concern about an economic
<br />downturn and perhaps even a recession. To make
<br />matters worse, several financial firms have reported
<br />immense losses from exotic financial products that many
<br />people had never even heard of. Previously esoteric
<br />acronyms such as "SIV," "CDO," and "ABCP" have
<br />increasingly made their way into the popular lexicon.
<br />Worst of all, financial market headlines became main
<br />street reality in Florida when large losses in the local
<br />government investment pool there resulted in a freeze on
<br />withdrawals.
<br />For the past several years, credit analysis seemed to lose
<br />its importance. Defaults and downgrades were few and
<br />far between, and investors purchasing risky assets
<br />seemed willing to accept additional yields that were
<br />meager, at best, compared to historical averages. Of
<br />course, as has been proven time and time again, there is
<br />no such thing as a free lunch in the financial markets.
<br />Risk and reward are always correlated in the long run. As
<br />financial markets have once again begun to recognize
<br />this all-important fad, we believe it's a good time to look
<br />at some of the important steps in performing proper
<br />credit analysis.
<br />The first step in deciding whether to purchase any credit
<br />product is to come to a full understanding of the product
<br />under consideration. The managers of the Florida pool,
<br />as well as many on Wall Street, clearly did not fully
<br />understand the complexities of the securities that they
<br />were purchasing, exposing investors to potentially
<br />greater losses than they were comfortable accepting. In
<br />managing a portfolio, taking risk is acceptable, but it is
<br />extremely importantthatthe level of risk be quantified in
<br />advance. Without understanding the securities being
<br />purchased, this is impossible to do.
<br />A second mistake that many investors have made recently
<br />is that they became overly reliant upon the ratings
<br />agencies. The ratings agencies perform a useful
<br />function, and examining a potential investment's credit
<br />rating is an important step in the analysis process.
<br />However, credit ratings alone are not sufficient evidence
<br />that a security carries an acceptable level of risk. As we
<br />have seen, rating agencies can and do make mistakes.
<br />Therefore, it is important to conduct additional research
<br />in orderto support the conclusions of the rating agencies.
<br />Credit analysis comes in many forms and depends upon
<br />the type of credit product under consideration. In
<br />general, all credit analysis is concerned with determining
<br />the financial strength and revenue-generating potential
<br />of the entity under consideration. This information can
<br />then be used to make a determination as to the ability of
<br />the issuer to service its debt. A complete discussion of
<br />techniques used to evaluate individual credits is beyond
<br />the scope of this article. However, investors considering
<br />purchasing credit instruments should be confident that
<br />they do have a procedure for evaluating those credits,
<br />and then follow it strictly.
<br />As recent events have demonstrated, conditions can change
<br />rapidly in the financial markets. Therefore, in addition to
<br />conducting credit research, it is vital that investors keep a
<br />close watch on developments regarding any securities that
<br />that they already hold or are considering for purchase. The
<br />Internet has made this task somewhat easier, and a
<br />Bloomberg terminal is invaluable for monitoring
<br />developments in the credit markets. In addition to following
<br />news events as they develop, it is also important that investors
<br />have the ability to analyze the significance of these events and
<br />place them into an appropriate context. For instance, a rising
<br />stock price is often a sign of a strong credit. However, if the
<br />stock price is rising because the company in question is the
<br />subjectof a leveraged buyout, the company's bonds are likely
<br />to suffer. It is important to always look beyond the headlines
<br />of the news in order to determine the actual impact on the
<br />creditmarkets.
<br />If all of this seems somewhat overwhelming or unnecessarily
<br />time consuming, it is because we like to follow legendary
<br />investor Warren Buffet's two rules of investing: Rule #1 -
<br />Don'tlose money. Rule #2 -See rule number 1. Losses can
<br />occur as the result of market fluctuations, particularly in the
<br />short term. However, the idea is to avoid large, credit related
<br />losses that can damage a portfolio's performance for an
<br />extended period of time. That is why rigorous credit analysis
<br />is so important.
<br />If an investor does not have the resources to conduct credit
<br />analysis, -there are three available options. Two of these
<br />options are prudent, the third one is not. The first option is to
<br />avoid credit products. The second option is to outsource the
<br />management of the credit portfolio to someone that does
<br />have the capability and experience to conduct credit analysis.
<br />And the third option is to purchase credit products without
<br />performing a thorough analysis. As recent events have
<br />demonstrated, this approach can be extremely damaging to
<br />an investor's returns and peace of mind.
<br />At some point the credit cycle will change, and a sense of
<br />complacency might once again return to the financial
<br />markets. Then, as now, investors that generate consistent
<br />risk-adjusted returns will be those who remember that proper
<br />credit analysis is equally important to the investment process
<br />in good times and bad because conditions do change rapidly.
<br />Brian Perry, Vice President, Portfolio Specialist
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<br />®2008. Chandler Asset Management, Inc, A Registered lnvestmenrAdvaec
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