Lisa Black, Head of Global Public Fixed-Income Markets
Fixed-income markets realized positive returns in the third quarter of 2012, as investors perceived an easing of global risks based on measures taken to address European sovereign debt concerns and an announced third round of quantitative easing (QE3) by the Federal Reserve. The Barclays U.S. Aggregate Bond Index, a broad measure of investment-grade fixed-income performance, returned 1.58% for the quarter.
ECB comments spark “spread sector” rally
Early in the quarter, fixed-income markets were gripped with concern over slowing U.S. economic growth and the lack of a coherent plan to address Europe’s sovereign debt crisis. These factors led fixed-income investors to favor U.S. Treasuries, causing the yield on the 10-year Treasury to close at a record low of 1.43% on July 25, down from 1.67% at the end of the second quarter.
Market sentiment changed abruptly the following day, after European Central Bank (ECB) President Mario Draghi provided assurances that the ECB was prepared to do “whatever it takes” to preserve the euro. These comments sparked a rally in “spread sectors” (higher-yielding, non-Treasury fixed-income investments), particularly developed- and emerging-market sovereign debt issues. They also gave a boost to lower-quality credits such as high-yield corporate bonds and commercial mortgage-backed securities (CMBS). In the weeks that followed, long-term Treasury yields steadily rose, resulting in a steepening of the yield curve, albeit with a decline in yields for short- to medium-term Treasuries.
Fed’s QE3 announcement drives investors to search for yield
Despite encouraging signs of improvement in the housing market, economic growth in the quarter remained sluggish. Businesses remained cautious and reluctant to hire and spend in an uncertain environment, leading to weak business activity and disappointing employment growth.
To counteract these conditions, the Fed announced QE3 in mid-September, providing further support to non-Treasury fixed-income markets. The Fed’s plan includes purchasing $40 billion per month of agency mortgage-backed securities (MBS), representing about 60% of monthly MBS production. The effect of these open-market purchases during the quarter was to drive investors to other types of fixed-income securities—including investment-grade corporate bonds and structured securities—in search of assets that could offer incremental yield over Treasuries.
Third-quarter performance varies by sector
During the period, fixed-income returns varied considerably by sector. In the case of A-rated bonds, the margin of incremental yield, or spread, over Treasuries narrowed by 50 basis points (0.50%) during the quarter, from 1.85% to 1.35%. This spread compression drove gains of close to 4% for both investment-grade corporate bonds and CMBS.
In spite of economic growth that was expected to remain slow for an extended period, investors showed sustained interest in corporate bonds as a preferred sector, due in part to relatively low anticipated default rates and the Fed’s stated intention to maintain low-rate policies through 2015. Strong returns for CMBS reflected investors’ expectations that Fed easing would boost prospects for employment and business activity in retail centers, hotels and other commercial real estate properties.
Meanwhile, sovereign credits and high-yield corporate bonds both returned approximately 4.5% in the quarter. High-yield bonds outperformed based on compelling yields and greater investor comfort with default rates, which have remained well below long-term averages. Moreover, with primary high-yield issuance on pace for a record year, corporations have been aggressively extending their debt maturities, which further mitigates default risk.
Treasuries realized among the lowest returns for the quarter, about 0.6%, while asset-backed securities, MBS and U.S. government agency securities returned just over 1%. The relatively flat Treasury returns reflected a rotation out of safe-haven assets and into spread sector credits, as investors sought higher yields. While MBS benefited from the Fed’s open market purchases, gains were largely limited to current-production MBS bearing coupons in which Fed purchases were concentrated.
Although we expect uncertainty to persist amid risks associated with Europe and possible disruptions from the looming U.S. “fiscal cliff,” we think continued slow economic growth is the most likely course going forward. Against this backdrop, we maintain a favorable view toward non-Treasury assets. Although credit spreads have narrowed considerably during the past several months, prices of spread sector securities remain in a reasonable range relative to historical levels. Given the current low-interest-rate environment, there may be a practical limit to the degree of additional spread compression that can be expected, even if conditions remain stable or improve.
With respect to valuations across sectors, recent gains in some pockets of the market may have caused prices to fully reflect future upside potential for certain securities. As the Fed’s open market activities continue to play a significant role in shaping fixed-income market dynamics, we are mindful of the need to trade on technical rather than fundamental factors in some cases, particularly with respect to MBS holdings.
We believe investment-grade corporate bonds can offer a dependable source of yield and value in the coming months, as investors face increasingly limited opportunities due to the dramatically larger share of outstanding securities that U.S. government-issued securities have come to represent within fixed-income markets over the past several years. On this basis, our focus remains on high-quality alternatives to Treasuries that offer compelling yields.
This material is for informational purposes only and should not be regarded as investment advice or a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons.
Past performance does not guarantee future results.
Please note fixed income investing involves risk.
TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association® (TIAA®). Teachers Advisors, Inc. is a registered investment advisor and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA).