Quarterly Market Update
Fixed Income Outlook
Fixed income performance for the third quarter was largely bookended by Federal Reserve (the Fed) Chairman Ben Bernanke’s June announcement of first the intent to begin, followed by the September decision to delay, tapering of the great bond-buying program which commenced in 2008 as a means of putting downward pressure on borrowing costs.
Corporate Bonds Brush off Taper Postponement
The Fed’s original announcement in June with its perceived threat of rising rates knocked a bit of luster from the 10-year part of the corporate yield curve. Investors moved into intermediate maturities and spreads tightened relative to those of longer maturities. There was noticeably less corporate market response to the Fed’s mid-September announcement to postpone tapering. While the eventual start date may be an unknown, it is a given that the tapering process will begin eventually.
Corporate bond performance benefited from the equity market rally during the quarter. Clearly corporate balance sheets are in good shape, earnings are at least meeting if not exceeding expectations, and both factors improve the perception of the quality of corporate debt. Corporate bonds as represented by the Merrill Lynch U.S. Corporate 1 -10 Year A-AAA Index posted a slight negative return, but outperformed Treasuries, Agencies and Municipals for both the quarter and the year-to-date. Shorter maturities outperformed longer ones, and financials outperformed industrial bonds.
Treasuries and Agencies Rally on Taper Delay
U.S. Treasuries and Agencies racked up most of their positive performance in late September after the Fed announced that it would continue the previous $85 billion monthly bond-purchasing program for the time being. Treasuries also benefited from something of a safe haven rally after the threat of chemical weapons emerged in Syria and the looming instant replay of the last Congressional budget and debt ceiling impasse became apparent. The financial markets viewed both events as a threat to economic growth.
Figure 1. Investors focused on the intermediate part of the curve and spreads tightened.
Chairman Bernanke’s term is set to expire on January 31. The decision by Lawrence Summers, who had been tapped as a possible replacement, to withdraw from consideration for the position also played a last minute role in the asset class’ performance. Mr. Summers had been perceived as more hawkish, and thus more likely to allow interest rates to rise, than Janet Yellen, the other leading candidate for Chairman Bernanke’s job who was ultimately nominated by President Obama a few days after quarter-end. The yield on the 10-year Treasury which had drifted up to 3.0%, fell to 2.65% by the end of the quarter.
Municipals Move in Sympathy with Treasury Market
The municipal bond market sold off in July and August in sympathy with U.S. Treasuries and in response to heavy mutual fund outflows, making taxexempt bonds cheap relative to taxable bonds. But in mid-September the Fed’s decision to postpone tapering combined with an oversold market and very limited supply benefited the municipal market. The Bank of America 1-10 Municipal Index rallied 114 basis points and the 10-year yield on AAA-rated general obligation debt which had peaked at 3.04% on September 5 rallied back down to 2.55% by the quarter’s conclusion.
Once the fiscal budget and debt ceiling issues are under control, then our expectation is that the Fed will begin to unwind the quantitative easing that has been the bond market’s best ally for over five years.
Figure 2. Total returns by fixed income asset classes – Treasuries, Agencies, Corporates and Municipals over the third quarter in comparison to year-to-date.
We anticipate large-scale macroeconomic factors to drive the financial markets for the remainder of the year. The government shutdown has thrown a wrench into the economic expansion, but we anticipate that the Washington crisis will be resolved in some fashion which will eliminate a fair amount of the fear and flight rally that has hurt equities and helped U.S. Treasuries and bonds in general over the last couple of weeks. Resolution of the Washington crisis and continued improvement in the global economy will likely push the yield on the 10-year Treasury toward 3.0%, the previously defined high-end of the range.
The longer-term outlook for bonds is tepid at best as the Fed confronts the challenge of unwinding unprecedented levels of bond buying. The timing and amount of tapering, while tabled for the time being, will be the next thing on which the market starts to focus. There is a possibility that the Federal Open Market Committee could delay the reduction of quantitative easing until Chairman Bernanke’s replacement is onboard. Regardless, investor perception of Janet Yellen as Fed Chairman may soon become evident based on the movement of bond yields. However, Yellen is thought to be the least disruptive of all the candidates mentioned.
On a positive note payroll gains will likely continue to run around the high 100,000’s to low 200,000’s, the equivalent to 2.0 to 2.5% GDP growth which supports lower levels of wage or general inflation, easing some of the pressure on bond prices.
Municipal supply has been light and while there are some reports that the supply calendar could be building into the fourth quarter, that should not pressure the market inordinately given the high level of demand. Beginning in 2013, certain investment income will be subject to an additional 3.8% surtax, enacted as part of the Affordable Care Act. The so-called Medicare Surtax excludes tax-exempt municipal bond interest which supports demand for municipals relative to other fixed income investments.
We have been in a low-interest rate environment for some time and although rates have edged higher, we have not seen a flood of new issuance. But if there is a widespread perception that rates are going up permanently, then supply will likely become an issue for the municipal and corporate bond markets alike. City managers and corporate CFOs may be inclined to go ahead and lock-in financing as low as possible for as long as possible if they have not done so already.
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Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
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Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).