2012 First Quarter Fixed Income Review

Lisa Black, Head of Global Public Fixed-Income Markets

Click here for the downloadable version. (PDF)

During the first quarter of 2012, fixed-income markets posted modestly positive returns as the outlook for U.S. economic growth improved and concerns over the European debt crisis eased. Interest rates increased steadily during most of the quarter, driving declines in the value of medium- and long-term Treasury bonds, while higher-yielding, lower-quality sectors of the market (known as “spread sectors”) realized strong gains as a result of the improving economic climate and reduced likelihood of defaults.

Improving economy lifts returns for non-Treasury sectors
Among U.S. fixed-income sectors, high-yield corporate bonds led the market, returning 5.3% for the quarter. Other sectors that are particularly sensitive to changes in the economic cycle also did well: U.S. commercial mortgage-backed securities and global emerging markets bonds, for instance, returned 3.5% and 5.9%, respectively. Various other U.S. sectors, including residential mortgage-backed securities and investment-grade corporate bonds, produced positive returns ranging from 0.6% to 2.1%, while U.S. Treasuries declined 1.3% on average, with longer-dated securities losing the most (-5.8%). (All returns are based on Barclays indexes.)

The rally in non-government sector bonds was driven largely by a steady stream of data indicating that the U.S. economy was gaining a more solid footing. In January, two key elements of a sustained economic recovery — consumer spending and housing — showed signs of life, indicated by increased consumer credit and improvements in the National Association of Homebuilders’ sentiment gauge. U.S. labor markets also picked up steam, with a substantial upside surprise in February’s nonfarm payroll employment further bolstering optimism about the economy.

Easing of European debt fears calms markets early in the quarter
Outside of the U.S., the threat of negative shocks from Europe remained a constant, as Greece negotiated a restructuring of its sovereign debt and Italy and Spain addressed budgetary and debt funding issues. However, investors found some comfort during the quarter as the European Central Bank made approximately €1 trillion (approximately $1.35 trillion) in funding available to 800 regional banks through its Long-Term Refinancing Operation (LTRO). Although the LTRO’s injection of liquidity is not a solution to long-term structural issues, it gave European financial institutions sufficient breathing room and offered hope that more permanent solutions could eventually be put in place.

In response to these encouraging developments, U.S. Treasury yields rose substantially, with the bellwether 10-year yield climbing from 1.89% at the beginning of the quarter to 2.39% in mid-March, while the yield on the 30-year Treasury increased from 2.89% to 3.46% over a similar timeframe. These increases represented a steepening of the Treasury yield curve, reflecting expectations for improved future growth and anticipation of increased inflation. This led many fixed-income investors to rotate out of safe-haven Treasuries, seeking higher returns in lower-quality, riskier types of bonds. Although prices of nominal Treasury bonds declined sharply over the quarter, returns of Treasury-issued, inflation-protected bonds fared well as investors sought protection from expected higher inflation.

In the closing weeks of the quarter, increasing signs of weakness in China’s economy, combined with worsening economic and debt funding troubles for Spain and other southern European nations, began to rattle investors’ nerves. As a result, 10-year and 30-year Treasury yields, which had spiked in mid-March, generally eased during the second half of the month. After some volatility in the first few days of April, yields resumed their steady decline, reaching levels that were approximately 35 to 45 basis points lower than their March highs.

Outlook: Continued economic growth, but global risks remain
Our view of the fixed-income markets is framed by an expectation of continued U.S. economic growth and by the recognition that global risks remain. With yields on corporate bonds and other non-Treasury credits generally falling over the course of the first quarter, prices for certain types of bonds have reached levels that leave little room for further gains. Although our expectation for continued economic growth leads us to maintain exposure to spread-sector investments in many of our fixed-income portfolios, on the margins we have increasingly shifted exposure to bonds at the higher end of the quality spectrum.

As interest rates have settled back down to low levels, we think the prospect of further yield declines is limited. We also believe the likelihood of further quantitative easing or other monetary stimulus by the Federal Reserve has been greatly reduced, but we remain cognizant of the Fed’s willingness to take further stimulative action in the event of further economic weakening. For this reason, we have maintained exposures within some of our portfolios to fixed-income securities that are likely to be the target of Fed purchases, such as lower-coupon mortgage-backed securities, which the Fed may focus on to help counter weakness in the housing market.

In our view, prices across a range of fixed-income sectors are currently in a reasonable range. While we continue to view spread-sector bonds as offering favorable relative value, we do not expect further spread compression to be the primary driver of total returns going forward. In the low-interest-rate environment, the need to seek yield remains pressing. Our focus is on securities that should provide attractive “carry” (interest income) and that will retain liquidity and resiliency under potentially volatile conditions. We believe that positioning our fixed-income portfolios in this way is a sound strategy for the unsettled economic and market environment that is likely to prevail over the coming months.