Treasury Supply Kicks off Second Half of 2009

Continuing a familiar 2009 theme, a fresh round of new Treasury issuance will greet investors this week as the bond market begins the second half of 2009.

Investor demand at this week’s auctions will provide insight into how far the recent Treasury rally may go as well as the potential path of bond yields.
The June Treasury rally helped the overall bond market return 1.9% year to- date through the midpoint of 2009, but total returns varied greatly by sector.
We believe investors are still better served by maintaining exposure to non-government bonds, such as investment grade and high yield corporate bonds, although we expect the pace of improvement to slow going forward.

This week, the Treasury will auction $74 billion in new securities, including a 10-year Treasury Inflation Protected Security (TIPS), and new 3-year, 10-year, and 30-year conventional Treasuries. The event marks the first time ever the Treasury Department will auction four securities over four consecutive days.

Although the dollar volume of this week’s Treasury issuance is less than that of the last round of auctions two weeks ago, it is comprised of longer-term notes and bonds. The last bout of Treasury auctions during the week of June 22 consisted of $104 billion in 2-, 5-, and 7-year notes. The degree to which investors buy longer term bonds and take on more interest rate risk will help determine how much the recent Treasury rally may be extended, as well as indicating the potential path of bond yields.

Treasury Demand

Investor demand at Treasury auctions over June was relatively strong and truly evident at the recent 2-, 5-, and 7-year note auctions, when all three securities sold at lower than expected yields. Indirect bidders, a category that includes foreign central banks, took down over 60% of each auction versus an historical average of 30% to 35%. Given the hefty funding needs of the Treasury, healthy investor demand was needed to help stabilize the Treasury market. The auctions indicated that both foreign and domestic investors found value in higher Treasury yields. The Treasury market returned 2.1% from June 10 to June 30 and tacked on another 0.3% over the first two days of July, according to Barclays Index data.

The June Treasury rally helped the overall bond market return 1.9%, as measured by the Barclays Aggregate Bond Index through the midpoint of
2009, but total returns varied greatly by sector. Despite the late bounce in June, Treasuries still underperformed by a wide margin. Globally, the situation was similar, with government bonds under-performing. Emerging Market Debt, which is more sensitive to underlying economic conditions, bucked the trend as it benefited from improving economic data. Corporate bonds, both investment grade and high yield, outperformed by a wide margin. In sum, the first half of 2009 represented a sharp reversal of what investors experienced in 2008.

Where do we go from here?

We expect non-Treasury sectors to outperform over the second half of 2009 but expect the magnitude of out performance to be less and the pace of improvement to slow. If demand continues to stay elevated at the upcoming auctions, it would signify that the current level of Treasury yields is at equilibrium, given lingering weakness in the economy that was highlighted by last week’s employment report.

Even if Treasury yields do stabilize, non-Treasury sectors such as corporate bonds still possess an impressive yield advantage. For investment grade corporate bonds, that differential stood at 3.2% above comparable Treasuries as of July 2, according to Barclays data. That level is still above the 2.7% peak witnessed during the WorldCom and Enron induced corporate panic of 2002.

Corporate balance sheets, outside of financials, are better now than in 2002.For high yield bonds, the average yield advantage, or spread, was 10.2% as of July 2, according to Barclays data, narrower than the 11.1% peak of 2002 but still well above the 5.5% historical average. Rising defaults pose risks, but we believe the added yield compensates for this risk. Also, the market, always a forward looking mechanism, may begin to price in further improvements over the latter half of 2009. Furthermore, we believe High Yield bonds may benefit as yield-seeking investors rotate from Investment Grade to High Yield during the second half of 2009. However, we do expect the pace of Corporate Bond improvement to slow over the second half of the year. Although many issuers are actively engaged in de-leveraging and repairing balance sheets, much of the gains this year have come from better liquidity and investors taking advantage of overly cheap valuations. Further spread contraction will likely need to be accompanied by better underlying credit metrics, which we believe will come, but gradually.

Still Like Muni’s

We still find Municipal Bonds attractive, but as with Corporate Bonds, expect the pace of improvement to slow. New issuance is running at its slowest pace since 2006, and provides a favorable supply backdrop, unlike the backdrop in 2008. Over a longer-term horizon, the prospect of higher tax rates in 2011 will also provide support. Municipal valuations remain attractive by historical norms. Credit concerns may linger over the market and cause improvement to come in fits and spurts rather than the relative steady improvement witnessed so far this year.

Overall, we believe the bond market is on track to post a total return at the low end of our mid-to-high-single-digit return expectation outlined in the Base Case Scenario of our 2009 Market Outlook. While the 1.3% increase in the 10-year note yield was greater than we anticipated, spread contraction among non-Treasury sectors was also better than expected and helped offset the rise in Treasury yields. Ultimately, we expect further gradual improvement in the economy that will exert upward pressure on Treasury yields, and we maintain an underweight.

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.
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High Yield/Junk Bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors. 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.
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