Fixed Income

Confidence Came Back
Fixed income markets performed beyond everyone's expectations during 2009. At the end of last year, investors showed a voracious appetite for the safety of Treasury bonds and little demand for anything else. But then things started to change. Business and consumer confidence increased. Housing prices appeared to stabilize at mid-year. Market liquidity improved as bid-offer spreads significantly contracted. The spread between the London Interbank Offered Rate (LIBOR) and U.S. Treasuries, a measure of investor anxiety, dropped from more than 200 basis points to 20 basis points. Government intervention in the form of sponsored hedge funds or direct purchases loosened up the market for securitized bonds, such as asset-backeds and commercial mortgage-backeds. Large numbers of buyers for newly issued bonds emerged.

The movement away from risk-aversion to active risk-taking had a profound impact on the fixed income market as a whole. In the Treasury sector, yields on all but the shortest notes increased. Yields and yield spreads on corporate, asset-backed and mortgage-backed bonds plunged, providing substantial returns for investors who underweighted Treasuries. For example, since November 2008 yields on corporate bonds have declined from near 8% to around 4.5% and yield spreads have dropped from close to 550 basis points to below 200 basis points. (See chart below.) The performance of high yield bonds has been even more impressive, returning more than 50% since the end of the year.*

What to expect in 2010
The Fed will likely keep short term rates near zero for most of 2010. Funding the massive deficit will ensure an excessive supply of Treasury debt. As a result, rates on longer Treasury debt should rise and the yield curve should steepen.

Agency-backed residential mortgages have become very overvalued due to government purchases intended to keep mortgage rates low.

Similarly, the Term Asset-Backed Securities Loan Facility (TALF) has proven to be partially successful. Bonds backed by credit card debt and automobile loans have been bid up to fair value as a result of very attractive government financing. However, spreads on bonds secured by commercial-mortgage-backed loans remain significantly higher than normal. Despite an expected increase in credit losses and decreasing recovery values, well-structured bonds are attractive at yields currently exceeding 7%.

While spreads on corporate bonds have decreased, they are still higher than long-term historical averages. We still find value in high-quality non-cyclical entities with strong balance sheets and financial flexibility, and without near-term financing needs. High- yield bonds are less attractive on a risk-adjusted basis after their spectacular rally earlier this year.

During 2009, bond market returns were dominated by falling risk premiums. Today, with the market seemingly split between those looking for deflation and those fearing runaway inflation, Treasury rates could be particularly volatile. Bond market returns in 2010 will be heavily influenced by the direction of interest rates.

 

*Past performance is not necessarily indicative of future results.