Equity Strategy March 31, 2008:

It seems that the credit markets are going to be in turmoil for a while longer. The recent JP Morgan take over of Bear Stearns is just one more in the continuing series of dramatic consequences of the excessive creation of credit over the past decade. The best and brightest on Wall Street and Bay Street have been working over time to try and control an out of control market, so far with very little success.

The Bear Stearns story points out the huge amount of risk currently in the credit markets and just how incredibly opaque the system has become. When Bear Stearns closed on Friday March 14th it was valued at $30.00 a share and on Monday March 17th it was sold for $2.00 a share and the deal could only be done if the Federal Reserve would commit to funding $29 billion of the loan portfolio, while JP Morgan the buyer put in $1 billion.

If this doesn’t scare everyone out of the financial services sector I don’t know what will. This points out just how little anyone knows about the value of these firms, it could be x amount a share or zero, depends on the amount of faith investors have that the loan portfolio will be repaid. So really who knows!

The uncertainty created by the surprising and dramatic decline in the value of Bear Stearns will keep the financial services sector under pressure for quite some time. The fact that the Federal Reserve was required to fund the buy out taking steps that have not been required since the 1930’s should send a signal to investors that the credit market is in far worse shape than previously forecast. The unprecedented expansion in credit over the past few years will take a considerable amount of time to unwind and in the process it would not be surprising to see more Bear Stearns type of takeovers arise.

The Canadian credit market is struggling to finalize a deal in the Asset Backed Corporate Paper sector where $35 billion has been frozen since last August when the secondary market stopped functioning. So far it appears that the major institutions holding these securities have come to an agreement and will accept longer term bonds in exchange for the short term corporate paper they currently hold. The remaining hurdle to finalizing a deal is to convince the retail investor that this is a reasonable solution to the problem. This is likely to be an uphill battle as many of these investors will not be in a position to wait for the bonds to mature in order to realize on their investment. If the retail investors do not go along with the arrangement then it will be back to the drawing board.

A major concern in the credit markets is if the Montreal Accord fails how will these securities be traded and how will they be valued. There could be a huge loss in this sector and nobody can say with certainty what value there will be in the end adding considerable risk to the Canadian market.

We are only at the very beginning of an economic slowdown that has the potential to be the worst in decades. All of the recent economic news out of the US is indicating a recession is currently underway and that the data is in many cases similar to the recession seen in 1972-1974 which was the most severe down turn in the past 5 decades. If the current slow down becomes that severe corporate profits will be exceedingly hard to come by and the potential for more negative surprises similar to the Bear Stearns situation increases dramatically in both the US and Canada.

Investors looking for income should be very cautious regarding the issuer of any notes or bonds being considered for investment. The bulk of an income portfolio should be invested in securities issued by the Government of Canada or the Provinces. The uncertainty in the corporate sector is high enough that investors should avoid this sector; the increase in yield may not be reflecting full degree of risk attached to corporate bonds. Investors looking for a diversified position in the bond market have a number of Exchange Traded Funds to choose from.

Barclays Global Investors markets their Exchange Traded Funds as the ishares funds, in this group there are three ETF’s that could be considered for investors looking for regular income in a diversified portfolio.

The Short Term Bond index fund (XSB-T) is designed to track the Scotia Capital Short Term Bond index net of fees which have been set at a very low 0.25% of net asset value. The fund currently holds 94 bonds with an average term to maturity of 3.21 years with an average weighted yield of 3.64% and duration of 2.81 years. The fund does hold some corporate bonds as set out in the index but the majority of the assets are invested in Government issued bonds.

The Canadian Government Bond Index Fund (XGB-T) tracks the Scotia Capital Government Bond index. The fund currently holds 57 Government bonds with an average weighted term of 10.53 years, duration of 6.92 years and an average yield of 3.67%. The units have a very low MER of only 0.35% and pay a quarterly distribution in March, June, September and December.

The Canadian Long Bond Index Fund (XLB-T) tracks the Scotia Capital Long Bond Index. The fund currently holds 88 bonds with an average weighted term of 22.25 years, duration of 12.49 years and an average yield of 4.62%. The fund pays a quarterly distribution and carries a maximum MER of 0.35%.