Making Sense Of The Current Crisis Of Confidence In Financial MarketsZacks Investmentupdated Sep 30, 2008TweetAt GET.com we maintain complete editorial integrity on our content & provide transparent & unbiased information. Companies don't pay us to include their products although we receive a compensation when you successfully apply to products from our partners. See how we make money here.At GET.com we maintain complete editorial integrity.Trying to make sense of the crisis on Wall Street is not easy, as most investors know by now. Helping us navigate through the gnarly forest of largely-unknown terms and tools today is Manish Jain, the Fixed Income Portfolio Manager for Zacks Investment Management.What exactly happened when "the markets froze" that caused the fear of a market meltdown and the need for a $700 billion bailout by the Fed?Basically what’s going on is a crisis of confidence. It’s a lack of confidence at the person sitting across from you when you are lending him money. What AIG (AIG), Lehman, Bear Stearns and Merrill Lynch (MER) have taught us is that how quickly a company can be collapsed.With this fear in their mind, banks have been reluctant to lend money and have been hoarding cash in case they themselves need it for their own survival. Rates on any unsecured lending have again shot up dramatically over the past week. Lenders were basically saying that if you want to borrow some money from us without putting up any collateral, we are going to charge you much more today than yesterday.What about Commercial Paper? Did this trading stop for some time period?The Commercial Paper market involves companies borrowing money either overnight or for some really short term (7 days or 30 day). In some cases they can go up to one year. The borrowings are mostly unsecured. A lot of companies borrow money in this market for their day-to-day operations. The types of companies borrowing span the entire globe, but mostly its financial companies.The Commercial Paper market has not stopped but has shrunken quite a bit over the past couple of months. As lenders demand higher and higher rates, borrowing companies are either forced to pay up the higher rate or issuer longer term debt so they don’t have to go back to the market on a daily basis. In either case, the borrower is forced to pay a lot higher rate than what they were paying before.For example, a company could have been paying around 3% to borrow overnight money. Now the same company is probably looking to pay around 4% to 5% for the same amount of time. If the company decides to borrow for a longer term, then the rates start climbing up and now they are looking at in the 5% to 6% area.Can you tell us a little about LIBOR? LIBOR means London Inter Bank Offering Rate. It is calculated and issued by the British Bankers Association (BBA). It is the rate that the banks lend to each other for various maturities. There is the overnight Libor rate, 1 week Libor, 3 month Libor, 1 year Libor, etc.I believe there are about 16 banks that participate in this, and each one of them submits early in the morning the rates where they can borrow money from other banks. BBA lops off the lowest as well as the highest rate and then calculates the average from the remaining rates. This rate is then published around 11:00am London time and is used as a reference rate for borrowing purposes world-wide. A lot of floating rate loans are based of Libor rates. These include variable rate borrowings by corporations, adjustable rate mortgages, home equity loans, etc.How does Libor impact you? If the banks are going to be charging a higher rate to lend to each other because they don’t trust the other bank’s strength, then the rate that we are paying on our loans will go up. For another example, the 3-month LIBOR rate on Sep 1 was 2.81% and it was at 3.76% [late last week]. For someone whose loan rates are based on the 3 month LIBOR rate, they basically saw their borrowing cost increase by nearly 1% over the past month. So as credit becomes tight, our borrowing rates have increased along with it.Thanks. Can you clear up what “spreads” are for us?When people talk about spreads, they are talking about the difference between the yield of a corporate or municipal bond and the yield earned on a U.S. Treasury bond for the same maturity. The lower the spread, the more people feel comfortable with the company’s likelihood of paying off the debt. If the spread is high, that means people are concerned.The U.S. Treasury rate is your risk-free rate. There is very little chance of Treasuries defaulting. Investors use that as a starting point and then add premium to the rates depending on the chance of a company going bankrupt.By way of example, up until now General Electric (GE) usually has been able to issue bonds at a spread + 50 bps [basis points] to the Treasuries. So if the 5-year U.S. Treasury is yielding around 3%, then GE is able to sell their bonds at a yield of around 3.5%. On the other hand if you are looking at General Motors (GM), then the spread may be +400 bps to the Treasuries.As investors feel uncomfortable about a company, the yield spreads on their bonds start to rise. So right now financial companies yield spreads are shooting up.I was offered a bond issued by Citigroup (C) that will mature in 5 months and it is yielding around 6.3%. For comparisons sake, 6-month Treasuries are yielding around 1.5%. So the spread is around 480 bps. That is junk bond territory. It does not have to be Citigroup -- you can take a look at Bank of America (BAC), Merrill Lynch, Morgan Stanley (MS), etc. The yield spread on all of the financial company bonds have gone up. Consequently, if these companies want to borrow money, they have to pay obscenely high rates.How about mortgage-backed securities?Most of the MBS paper that I have dealt with has been issued by Fannie Mae (FNM) or Freddie Mac (FRE). Since the U.S. Government took over the agencies, their debt has been trading very well. There are going to be some mortgage defaults within the bond, but with the U.S. Government basically guaranteeing the principal and interest payments, investors have felt a lot more comfortable with the product. Remember, there are still actual homes/mortgages backing the bonds and a majority of them are still paying on time.I can save you time and tell you about some of the other components. The Leveraged Buyout Bond Market is basically shut down right now. No one is willing to buy debt of companies that were bought out by private equity companies.The Credit Default Swap (CDS) market has also slowed down quite a bit as investors don’t know if the company on the other side of the trade is going to be around or not. OK, so knowing all this, how would you recommend investors proceed?Just because a security has stopped trading does not mean that the security is worthless. Unless the underlying investment is completely worthless, the bond will have some value to it. Even Lehman’s bonds are trading around 15 cents on the dollar right now.What does it mean for investors? Stay with companies with strong characteristics in terms of balance sheet, profitability, market share, etc. Right now investors are scared and running towards the only thing that they consider safe -- U.S. Treasuries. They are selling bonds of any company that they consider unsafe. As a result, the yield on U.S. Treasuries has come down significantly and the yields on bonds that people don’t want to buy are soaring.For investors with patience and an appetite for risk, this market is presenting a tremendous amount of opportunities. As I indicated above, Citigroup bonds are paying around 6% for going out 5 months. If you believe Citigroup is still going to be around at that time, then that is an excellent yield to capture. The key things to remember are individual company exposure as well as sector exposure. Don’t load yourself up with financial company bonds because they are offering the highest yield. Just like equities, diversification is the name of the game here.Manish Jain is the Fixed Income Portfolio Manager for Zacks Investment Management.Editorial Disclosure: Any personal views and opinions expressed by the author in this article are the author's own and do not necessarily reflect the viewpoint of GET.com. 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