Bond market performance in December is shaping up to be a microcosm of 2009: Treasuries under-perform while Corporate, High-Yield, and Emerging Market Bonds post strong out-performance. Also in keeping with the 2009 trend, Tax Exempt Municipal Bonds have out-performed Treasuries so far in December. Last week’s light volume was a sign the bond market has already entered holiday mode and Corporate, High-Yield, and Emerging Market Bonds are set to close out a record year of out-performance relative to Treasuries.
Bond market performance is set to finish the year at the upper end of our mid- to high-single digit total return forecasted in our 2009 Outlook. Year-to-date through Friday, December 18, the Barclays Aggregate Bond Index has returned 7.6% but this number masks very different performance under the surface. In December, the Aggregate index is down 0.6% through last Friday but, like the full year, also hides different undercurrents.
Higher Quality Bonds
Investment-Grade Corporate Bonds have posted marginally positive returns despite the rise in Treasury yields in December. As Treasury yields increased, corporate yields moved higher as well but to a much lesser degree. Through December 18, the 10-year Treasury yield increased from 3.20% to 3.55% while the average 10-year A-rated corporate bond yield increased by only 0.16%, or less than half the yield increase witnessed by the same maturity Treasury. As a result the yield differential, or spread, between Treasuries and Corporate Bonds narrowed further and reflected the better price performance of corporate bonds. Corporate Bonds are set to post another impressive monthly performance result versus Treasuries.
Performance has been most impressive among High-Yield Bonds which witnessed lower yields (higher prices) despite the rise in Treasury yields in December. Higher income has also played a role. With an average current yield of 8.8%, interest income can assist performance going forward as the pace of price improvement is likely to slow.
Economic data so far in December has also been a reflection of 2009 with reports surpassing consensus expectations. The November jobs report (released Dec. 4) and November retail sales (released Dec. 11) in particular stood out and caused investors to rethink the trajectory of the economy. The retail sales report led to upward revisions of fourth quarter GDP estimates to near 4%. These two reports were key drivers of higher Treasury yields in December.
Sovereign credit worries has led to a challenging December for Emerging Market Debt (EMD) but the asset class has still followed the trend of December reflecting the full year. As mentioned in last week’s Bond Market Perspectives publication we believe sovereign credit risks will ultimately result in a shift within emerging markets. With trading volumes already down noticeably in U.S. bond markets, the most liquid in the world, poor liquidity has likely exacerbated challenging conditions in EMD and the reason the sector could not keep pace with municipal bonds which are rebounding from a difficult October and November.
More from GFC, Below
We believe credit sensitive bonds such as investment grade corporate bonds, high yield bonds, and emerging market debt will maintain momentum and continue to outperform Treasuries to start 2010. In the municipal market, the Build American Bond program will continue to siphon bond issuance away from the traditional tax-exempt market. This favorable supply dynamic bodes well for the tax-exempt market. However, with yields now much lower and yield differentials to Treasuries much narrower, the capacity to outperform is reduced. Therefore, investors should expect lower returns from the bond market in 2010. Later in the year, corporate yield spreads may widen as headwinds pressure the market but we still expect non-government sectors to outperform in 2010.
For 2010, we see high grade bonds posting flat to mid-single digit total returns. The key factor will be our expectation of higher interest rates as Treasury yields rise by 0.50% to 1.00%. While inflation is expected to remain low throughout 2010, we expect the Federal Reserve to gradually remove stimulus and hike rates later in the year. Furthermore, the fact the Fed will not be a prodigious buyer of Treasuries, agency bonds, and Mortgage-Backed Securities means that heavy Treasury new issuance will pose a greater challenge to the bond market in 2010. Our 2010 Outlook provides more detail on our bond, stock, and economic outlook.
- 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.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed 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.
- High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
- International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.