2013 First Quarter Fixed-Income Market Review

Lisa Black, Head of Global Public Fixed-Income Markets
Bill Martin, Head of Fixed-Income Portfolio Management

May 9, 2013

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Improving outlook tempered by increased caution

Fixed-income markets realized slightly negative returns during the first quarter, as better-than-anticipated U.S. economic growth resulted in modest increases in intermediate and long-term interest rates, while short-term rates remained stable or increased only slightly. Growth was supported by resilient consumer spending in the face of payroll and other tax increases. Additionally, home sales and home prices rose more than expected and employment growth was more consistent, all of which underpinned an improving domestic outlook.

Spreads — incremental yields over U.S. Treasuries offered by lower-rated, higher-yielding assets (“spread products”), such as investment-grade corporate and structured securities — widened somewhat after narrowing in January, as fixed-income markets grew more cautious amid worries about Europe. Among the concerns were political uncertainty following failed elections in Italy and a bailout of Cyprus’ financial system that was paid for in part by imposing a levy on bank deposits — an unusual and controversial step that rattled markets and fanned fears of bank runs in southern eurozone countries.

Fixed-income sector performance negative to flat

Most fixed-income sector returns were slightly negative to flat during the quarter, reflecting higher valuations that left little room for upside gains. Treasury returns were negative, with longer-term issues struggling the most in the face of a steepening yield curve. Investment-grade corporate bonds also posted losses, reflecting wider spreads and heightened sensitivity to interest-rate risk. Returns for agency residential mortgage-backed securities (MBS) were negative due to concerns that the Federal Reserve may taper purchases of these securities because of an improving U.S. labor market outlook, among other factors.

In contrast to other sectors, below-investment-grade corporate securities performed well. U.S. high-yield returns approached 3% for the quarter, as spreads narrowed considerably amid low default rates and continued investor demand for yield.

Heightened LBO risk buffets investment-grade corporates

The prevalence of low interest rates coupled with high equity valuations led to increasing leveraged buyout (LBOs) activity during the quarter, with transactions involving Heinz and Dell Computer among the most prominent. The prospect of continued LBOs represents a headwind for investment-grade credits that are viewed as potential buyout targets. In this environment, TIAA-CREF has tended to favor financial-sector securities over industrial bonds due to protection from LBO risk that financial institutions enjoy as regulated entities. As the risk of LBO activity persists, the market may continue to favor bonds with change-of-control features, asset-backed securitizations, high-yield debt, or other securities that are less vulnerable to buyouts. This environment underscores the heightened importance of fundamental credit research and security-specific analysis.


As the first quarter drew to a close, we began to see less consistency in economic indicators, as well as signs that consumers may be retrenching more than expected due to higher payroll taxes and the effects of the federal budget sequester. Additionally, Japan’s aggressive monetary easing efforts, which are being implemented on a very large scale relative to the size of the Japanese economy, have the potential to place downward pressure on U.S. Treasury yields as Japanese investors look to invest in safe assets abroad.

Counterbalancing these effects are factors including new home construction, more domestically-sourced energy production (based on development of natural gas and shale oil), and on-shoring of manufacturing operations due to rising labor costs in China and changing global production preferences. These trends, along with continued loose monetary policy across most major developed and emerging markets, will likely drive continued growth in the second half of the year and result in improving employment. Overall, we believe the U.S. remains better poised than Europe and many emerging-market economies for a marginal upturn in growth at this stage. While our constructive outlook warrants continued exposure to spread sectors, security selection within investment-grade and below-investment-grade credits has never been more critical.