Encore Please?

09.09.20 - campeonato de wu shu 185

A strong September helped put the exclamation point on an impressive quarter for the bond market. All segments of the bond market finished in positive territory and the Barclays Aggregate Bond Index posted one of its best quarterly performances of the past six years. Credit sensitive sectors, such as corporate bonds, had a stellar quarter again even if they fell short of the second quarter’s record performance [Table below].

In Q3, bond investors benefited from both lower overall interest rates and continued price improvement on non-government bond sectors such as corporate bonds and high yield bonds. Treasury yields declined 0.10% to 0.28% during the third quarter. While the drop in Treasury yields did not seem like much, it provided a favorable tailwind for the bond market in the form of higher prices. Since Treasuries form the backbone of the bond market, the drop in yields was certainly positive.

encore bonds

Yields on the Decline

Yields declined faster and farther outside Treasuries, as investors took advantage of sizeable yield advantages to Treasuries. Prices on non-Treasury sectors, therefore, received an added boost from the strong demand for yield. Yield spreads to Treasuries steadily narrowed in response. Going forward, lower yields and narrow yield spreads suggest bond investors should temper expectations and we expect performance to slow. The decline in bond yields means that income will be less of a performance driver going forward. Even corporate bond yields have declined to their lowest levels since 2005 and top quality short and intermediate municipal bond yields dropped to historic lows.

Narrower yield spreads provide less of a buffer against higher Treasury yields. The 10-year Treasury yield has declined to 3.2%, slightly below the low end of our expected 3.3% to 4.0% trading range. We do not expect Treasury yields to rocket upwards but a return to the mid-point of that range would lead to price declines that might impact the broader bond market. This is particularly true with mortgage-backed securities (MBS) where yield spreads are near historic lows and any increase in Treasury yields may translate directly through to lower MBS prices.

We still find investment grade corporate bonds attractive based on valuations. The average yield spread of 2.3% is still above the long-term average of 1.5%. However, as we approach the average, investors will likely wait for signs of more concrete improvement. We believe that will occur but will likely take place over several quarters. Through the end of September, the Barclays Aggregate Index is up 5.7% for 2009, firmly within our base case expectation of a mid-to high single-digit return for the full year. If the overall level of yields and yield spreads does not change over the 4th quarter, the Aggregate Index would generate another 1.2% from interest income. If so, that increase would reflect the slower pace of performance but still make for a good year overall for bonds.

High Yield Spread is High

Given the slower pace of improvement we recently increased exposure to high yield bonds and established a position in emerging market debt (EMD). The average spread on high yield bonds is still relatively wide to historic norms and the overall yield is roughly inline with the 10-year average. EMD yields are also lower and not far above 2007 levels but yield spreads, at 3.4% above comparable Treasuries, are higher than their five year average and offer a greater buffer against the possibility of higher interest rates. Keep in mind, the lower average yield of 6.6%, according to JP Morgan index data, also reflects the improving credit quality trend as EMD possesses an average BBB rating, up from BB ten years ago. Improving fundamentals suggest the favorable rating trend can continue.

The third quarter of 2009 was certainly good to bond investors. We expect a range bound interest rate environment to persist over the near-term and are optimistic that the bond market can generate additional incremental return for investors. Our focus has shifted towards high yield bonds and we established a position in EMD where higher yields and wider yield spreads to Treasuries offer both better total return opportunities and a buffer against the possibility of rising interest rates. However we believe bond investors should be prepared for a slower pace of return going forward and that an
encore performance of Q3 is unlikely. That is not necessarily a bad thing as a reduction by half would still be good for bond investors.

IMPORTANT DISCLOSURES

  • The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
  • Neither LPL Financial nor any of its affi liates make a market in the investment being discussed nor does LPL Financial or its affi liates or its offi cers have a financial interest in any securities of the issuer whose investment is being recommended neither LPL Financial nor its affi liates have managed or co-managed a public offering of any securities of the issuer in the past 12 months.
  • Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fi xed rate of return and fixed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
  • The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
  • Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
  • Mortgage Back Securities are subject to credit, default risk, prepayment risk that acts much like call risk when you get your principal back sooner than the stated maturity, extension risk, the opposite of prepayment risk, and interest rate risk.
  • This Barclays Capital U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fi xed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
  • GNMA’s are guaranteed by the U.S. government as to the timely principal and interest, however this guarantee does not apply to the yield, nor does it protect against loss of principal if the bonds are sold prior to the payment of all underlying mortgages.
  • High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversifi ed portfolio of sophisticated investors.
  • International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.

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