The bond market keeps going and going in 2010. The high-quality domestic bond market delivered another quarter of good performance with the Barclays Aggregate Bond Index returning 2.5% for the quarter and 7.9% year-to-date through the end of September. We expect performance to slow during the fourth quarter as the now even lower level of yields implies lower returns going forward. However, the Federal Reserve (Fed) may provide an additional catalyst should the central bank expand bond purchases in an attempt to stimulate the economy and we see limited bond market weakness over the fourth quarter.
A Rising Tide Lifts All Boats
Virtually all sectors of the bond market benefited from the decline in bond yields and corresponding rise in bond prices. A steady decline in interest rates provided the bond market with a nice tailwind over the third quarter. Intermediate and long-term bond prices benefited most from the decline in yields while short-term bond returns were more muted due to already rock bottom short-term interest rates that failed to match the decline in intermediate and long-term yields. Among government bond sectors, Mortgage-Backed Securities (MBS) lagged as fears over a refinancing wave led to price weakness later in the quarter.
More economically sensitive High-Yield Bonds and Emerging Market Debt (EMD) outperformed high-quality bonds during the period. Credit quality fears from the European debt problem subsided over the summer prompting investors to refocus on strong underlying fundamentals and attractive valuations. Demand from income-seeking investors also benefited both sectors. Foreign bonds, un-hedged for currency movements, performed well as the Euro rebounded and debt fears subsided.
Performance in the municipal bond market paralleled that of the taxable bond market. High quality intermediate and long-term bonds outperformed short-term bonds while municipal high-yield bonds outperformed high-grade tax-free bonds. Even though the drumbeat of warnings about municipal credit quality continued, investors recognized the high-priority status of most municipal bond interest payments. Attractive valuations also benefited tax- exempt bonds.
As we look to the fourth quarter, we expect bond market performance to slow. The benign Federal Reserve and low inflation environment that benefited bonds during the third quarter looks set to continue; however, we believe the now lower level of high-quality bond yields already reflects this favorable backdrop. Bond prices may remain relatively range-bound as Fed policy and economic data unfolds. Interest income, and not price appreciation, therefore will be a greater driver of bond returns over the fourth quarter in our view.
High Yield Bonds Still in Favor
We continue to favor more economically sensitive bond sectors such as High-Yield Bonds, investment-grade corporate bonds, and EMD. Domestically, second quarter earnings reports revealed that debt issuers continued to improve key credit quality metrics. On average S&P 500 companies increased their interest coverage ratio and reduced leverage further. Late in the quarter Moody’s Investor Service reported that U.S. corporations have been actively refinancing existing debt maturities. The amount of high-yield and investment-grade corporate debt due between mid-2010 and the end of 2012 declined 37% and 18%, respectively. Not only does refinancing higher interest debt potentially bode well for improving the ability to service debt, but it also gives corporations the ability to avoid volatile markets and issue debt with uneconomical terms.
The high-yield market continued to benefit from a sharp decline in defaults, a trend we expect to continue over the fourth quarter. The Moody’s 12-month trailing default rate declined to 5.0% at the end of August with Moody’s forecasting a further decline to 2.7% through year-end 2010. With an average yield advantage of 6.4% above comparable Treasuries as of September 22, 2010, we believe valuations more than compensate investors for the risk of default. Additionally, the average 7.9% yield-to-maturity is attractive in what could be a very low return environment for bonds.
Emerging market countries continue to exhibit stronger economic growth. Stronger economic growth bodes well for continued credit quality improvement and an enhanced ability to service debt obligations. The International Monetary Fund (IMF) forecast that EMD issuers on average will continue to reduce their debt burdens relative to the size of their economies, as measured by debt-to-GDP ratios, through 2015. Not surprisingly, the IMF forecast debt burdens of developed countries would continue to increase over the same period. The stronger fiscal position bodes well for EMD. However, similar to high-quality bonds, we expect the bulk of future performance to come from interest income generation as we find valuations attractive but close to fair value.
A double-dip recession is a risk to our preference for more economically sensitive bonds. A return to recession would likely lead to still higher high- quality bond prices and additional gains. However, a double-dip recession would likely lead to underperformance of more economically sensitive bonds such as high-yield bonds and EMD.
More from GFC, Below
Conversely, a sharp rise in interest rates could lead to bond price declines and the possibility of negative total returns. We place a low probability on such a scenario as the Fed remains committed to keeping interest rates low for an “extended period” and may err to the side of providing additional stimulus via expanded bond purchases. Even if the Fed does not announce additional bond purchases at its November policy-making meeting, it will likely state that they stand ready to take additional action as necessary to stimulate the economy which will keep the prospect of bond purchases alive. Although a decline in yields in response to Fed buying is far from certain, the prospect of Fed purchases, slow growth, and low inflation will likely keep any bond price weakness limited.
Like high-quality taxable bonds, we believe high-quality municipal bond performance may slow as average AAA-rated municipal bond yields are near historic lows. Signs of weakness appeared late in the quarter as a surge in new issuance met lukewarm demand. Low yields caused investors to hesitate and if bond dealers cut prices to move recent new issues, a modest sell-off may ensue. On a positive note, valuations relative to Treasuries remain attractive with longer-term AAA-rated Tax-Free Bonds yielding more than taxable Treasuries. On a longer-term view, a supply-demand imbalance remains in effect with tax-exempt bond issuance on pace to finish 2010 at the lowest level in almost a decade.
- The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- Mortgage-Backed 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.
- 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 a fund shares is not guaranteed and will fluctuate.
- Treasury inflation-protected securities (TIPS) help eliminate inflation risk to your portfolio as the principal is adjusted semiannually for inflation based on the Consumer Price Index – while providing a real rate of return guaranteed by the U.S. Government.
- High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
- 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.
- Preferred Stock investing involves risk, which may include loss of principal.
- International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors.
- Investing in foreign securities involves special additional risks. These risks include, but are not limited to, currency risk, political risk, and risk associated with varying accounting standards. Investing in emerging markets may accentuate these risks.
- Municipal bonds are subject to availability, price, and to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise. Interest income may be subject to the alternative minimum tax. Federally tax-free but other state and local taxes may apply.
- Bank Loans are loans issued by below investment-grade companies for short-term funding purposes with higher yield than short-term debt and involve risk.
- Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) is essentially net income with interest, taxes, depreciation, and amortization added back to it, and can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing and accounting decisions.
- This Barclays Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.