David Brown, Senior Managing Director , Global Public Markets
U.S. Treasuries remained the safe haven of choice for many investors during a tumultuous third quarter. As global economic growth slowed and the European sovereign debt crisis worsened, investors gravitated to the perceived relative safety of U.S. government debt. They focused most of their buying on Treasuries of 10 years or longer pushing up prices and driving down yields. (Yields move in the opposite direction of bond prices.)
Overall, fixed income outperformed equities during the third quarter. The Barclays Capital U.S. Aggregate Bond Index (an index of U.S. investment-grade bonds) was up almost 4%, while the S&P 500 Index (a broad measure of the U.S. stock market) fell approximately -14%.
Events in Europe Rattle Bond Investors
The European debt crisis dominated investor sentiment during the period. Bond markets were volatile as investors contemplated the looming possibility of a Greek default and the potential implications for the European Union (EU). EU policymakers responded with a number of actions that seemed to calm the markets. Greece approved additional austerity measures that allowed the country to receive bailout funds, and the EU, European Central Bank (ECB) and International Monetary Fund agreed on an additional bailout plan. However, EU nations did not reach a consensus on a long-term solution to their debt problems—one that would keep Greece from defaulting on its sovereign debt obligations and would satisfy both the EU and the interests of stronger EU member nations such as Germany and France. The EU’s fiscal problems also threatened the stability of financial institutions holding European sovereign debt.
Also fueling turmoil in the fixed income markets was a heated debate in Congress that seemed to take the United States to the brink of default. Although lawmakers ultimately raised the debt ceiling at the 11th hour, their deliberations were less than constructive. In fact, their reluctance to address the nation’s fiscal challenges was cited by Standard & Poor’s Ratings in its downgrade of the U.S.’s long-term AAA credit rating to AA+. Interestingly, after the downgrade, investors responded not by selling Treasuries but by purchasing them. They also retreated from stocks and riskier fixed income assets, such as high yield bonds and emerging markets debt.
Economic Growth Weakens in Europe and the U.S.
During the third quarter, the EU as a whole appeared to be slipping into recession. (The peripheral nations of Greece, Italy, Spain, Portugal and Ireland were already in the midst of painful recessions.) Some observers suggested that an EU recession would be mild if policymakers were successful at restructuring Greek debt and stemming contagion.
In the U.S., the Department of Commerce reported second-quarter GDP growth of just 1.3%, putting the nation on a trajectory for less than 2% GDP growth in 2011, largely as a result of sluggish consumer spending, weakness in durable goods orders and slowing home sales. The Federal Reserve also acknowledged that the U.S. economic slowdown was likely to persist for another year or more and pledged to keep short-term interest rates near zero through at least mid-2013.
In addition, the Fed indicated it would attempt to boost economic activity by pushing down longer-term interest rates. Through “Operation Twist,” the Fed plans to extend the maturity of its portfolio of securities by selling some of shorter term holdings and buying longer-term bonds. Some Fed governors opposed the measure, fearing that it—along with previous policy moves such as the Fed’s quantitative easing programs—might lead to a significant increase in inflation. As interest rates declined during the quarter, inflation-linked bonds continued to perform well.
High Yield and Emerging Markets Decline, Municipals Outperform
High yield bonds, as represented by the Barclays Capital U.S. Corporate High Yield Bond Index, dropped -6% during the quarter. Although market fundamentals were favorable, many investors reduced their high yield holdings, sending prices down and yields up. Historically, yields tend to rise when investors expect high yield defaults to increase. However, during the quarter, the high yield default rate was low (between 1% and 2%) and corporate balance sheets were relatively healthy. The market also saw some new issuance. Under the circumstances, the selloff in high yield bonds largely reflected broader concerns stemming from the global economic slowdown, the U.S. debt ceiling debate and Europe’s financial woes.
Emerging Markets debt also realized steep declines in the quarter, reflecting the anticipated impact of declining global demand on Emerging Market economies. Heavy selling in September reversed more favorable performance that had persisted for much of the year, as declining commodity prices impacted export-dependent countries such as Russia and Argentina. Emerging Markets returns were further pressured during the quarter as local currencies weakened relative to the U.S. Dollar.
In the tax-exempt bond market, a robust rally continued even during the debt ceiling debate when some investors may have wondered how a downgrade of U.S. government debt might affect municipal credit ratings. Municipal bonds outperformed largely as a result of supportive supply and demand dynamics. Since the beginning of 2011, when the wave of municipal defaults predicted by some pundits failed to materialize, investors have steadily returned to the tax-exempt market. State and local governments continued to make progress with their fiscal challenges. Many have cut spending and reducing their need to issue debt. As a result, there was little new issuance during the quarter. Tax-exempt bond prices benefited from strong demand for the existing limited supply.
The Road Ahead
Looking forward, global economic conditions and the European debt crisis are likely to weigh on market sentiment. Long-term interest rates were extremely low at the end of the quarter, suggesting that bond investors expected a prolonged period of economic weakness. Periods of heightened volatility will likely persist until more stability and durable solutions emerge.
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