2012 Fourth Quarter Fixed-Income Market Review

William Martin, Head of Fixed-Income Portfolio Management

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Higher risk favored in year and in fourth quarter

Fixed-income markets realized moderately positive returns for the year and during the fourth quarter, reflecting improving economic conditions and a perceived reduction in global risks. While uncertainty surrounding the November 2012 elections and the impending “fiscal cliff” caused concern as the year drew to a close, improvements in the broader economic backdrop were reflected in a continued recovery in housing markets, strong vehicle sales, improving consumer sentiment, and stable employment trends.

The Federal Reserve continued to support U.S. economic growth by maintaining accommodative monetary policy, with the most recent round of quantitative easing (QE3) focused on open-ended purchases of mortgage-backed securities (MBS) as well as additional purchases of long-term U.S. Treasuries. The Fed also stated that it will not raise short-term interest rates until unemployment drops to at least 6.5% and inflation remains below 2.5%.

Article Highlights

  • Improving economic conditions lead to moderate gains in fixed income markets for Q4 and 2012.
  • Rising intermediate and longer-term interest rates drove slightly negative returns for Treasuries during Q4, capping a lackluster year for Treasuries.
  • Total returns for non-Treasury credits were positive, as investors sought out incremental yields over Treasuries.
  • We do not anticipate a rapid rise in interest rates in 2013, though current valuations will limit the potential for outsized returns.
  • We believe fixed income will experience positive total returns in 2013, though there may be material variations in returns among the different sectors.

Rising intermediate and longer-term interest rates drove slightly negative returns for Treasuries during the fourth quarter, capping a lackluster year of performance for Treasuries and other high-quality fixed-income securities. Total returns for non-Treasury, “spread-sector” credits were positive, as a large volume of corporate bond issuance was readily absorbed by investors seeking incremental yields over Treasuries. Spreads for lower-quality bonds narrowed during the quarter and for the year, in part as investors viewed default risks to be increasingly benign. Lower-quality securities such as high-yield corporate and emerging-market bonds, which returned more than 3% in the fourth quarter, benefited in this environment, as did certain structured sectors such as commercial mortgage-backed securities (CMBS) and non-agency-issued residential mortgage-backed securities (MBS).

Fixed-income markets nearing an inflection point?

As we enter 2013, we are mindful of changing conditions in the global economy and capital markets that may hold implications for fixed-income markets in months to come. Since 2009, real (inflation-adjusted) yields on fixed-income securities have been in persistent and dramatic decline, indicating investor willingness to accept increasingly lower expected returns on fixed-income investments. For the past several years, sluggish economic growth, the presence of global “tail” risks (such as a potential breakup of the eurozone), and accommodative Fed policy has allowed these low real rates to persist.

However, in ways that we have not seen previously, there are palpable signs that these factors are likely to change in the coming year. Momentum in the housing market recovery has caused housing to switch from being an inhibitor of economic growth to being a positive contributor to growth. Housing market gains, which add substantially to individuals’ net worth and drive increased consumption, should also contribute greatly to improved employment and greater industrial production. While global risks remain in the form of European sovereign debt issues and U.S. debt ceiling and sequestration concerns, we view these risks as greatly reduced from previous levels and less likely to disrupt economic growth going forward. As more stable economic growth takes hold, we believe the Fed may be more likely to adjust policy than previously thought, changing the technical dynamics that have influenced investment patterns within fixed-income sectors over the past year or more.

Although we do not anticipate a rapid rise in interest rates, current valuations across fixed-income sectors will limit the prospect of outsized returns even if interest rates remain within a stable range. Moreover, as earnings-based yields on equities have reached levels that are historically attractive relative to bonds, fixed-income markets are increasingly vulnerable to shifting investor preferences.

The outlook for fixed income in 2013

Following 3.1% real GDP growth in the third quarter of 2012, the advance estimate of fourth-quarter growth, released in late January, was surprisingly negative (-0.1%). In our view, this headline number is an anomaly driven by fiscal cliff uncertainty, which took a disproportionate toll on government spending and business inventory growth during the quarter. On balance, we think GDP growth will begin moving slowly back toward its underlying rate, which we continue to forecast at 2.5%, on average, for the year.

While we anticipate that fixed-income securities will produce positive total returns over the next year, we expect this will result more from current income than from gains due to declining interest rates and tighter yield spreads such as we have seen over the past few years. Positioning within sectors will likely play an important role in performance, as there may be material variations in returns among sectors. Treasuries and agency-issued MBS may come under pressure as the Fed weighs policy options that lean toward being less accommodative, and quantitative easing programs are eventually curtailed.

In this environment, we believe spread products will maintain an edge over lower-risk bonds. With the benefit of relatively healthy corporate balance sheets, stable economic fundamentals, and a benign default environment, lower-quality, higher-yielding credits will likely outperform other fixed-income securities, while offering greater resilience in the face of possible interest-rate increases. Such securities may include high-yield domestic corporate bonds or government agency and corporate emerging-market-based bonds that would benefit from an improving global economy.