Asset Management

2011 Fourth Quarter Fixed Income Market Review

David Brown, Senior Managing Director and Head Portfolio Manager, TIAA General Account

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The bond markets performed well during the fourth quarter of 2011 in response to falling interest rates and a favorable view of U.S. economic developments that fueled demand for securities in higher-risk fixed-income sectors. The Barclays Capital U.S. Aggregate Bond Index, a broad measure of the U.S. investment-grade bond market, returned 1.12% for the quarter and 7.84% for the year.

Macroeconomic forces generally drove performance, with the European debt crisis at center stage, along with U.S. economic and political news—both positive and negative. In this environment, high-yield bonds, tax-exempt securities and inflation-linked bonds outperformed investment grade corporate bonds and nominal U.S. Treasury securities. (Nominal Treasury securities provide “before-inflation” returns.)

The Treasury Market Remained a Safe Haven
Although they underperformed on a relative basis during the fourth quarter, nominal Treasuries posted a third consecutive quarter of gains. Through much of 2011, the U.S. Treasury market benefited from a flight to quality as investors sought refuge from the volatile equity markets. Treasuries remained the safe haven of choice even after the August 2011 downgrade of the U.S. government’s credit rating by Standard & Poor’s Ratings. During the fourth quarter, the Barclays Capital U.S. Treasury Bond Index returned 0.89%. It was up 9.81% for 2011 as a whole.

Meanwhile, corporate bonds finished 2011 on a strong note, with the Barclays Capital U.S. Corporate Investment Grade Index rising 1.93% in the fourth quarter for a gain of 8.15% in 2011. For both the quarter and the year, corporate bonds in the Industrials and Utility sectors were highly favored over bonds issued by Financials. Prices of mortgage-backed securities (MBS) were supported by “Operation Twist”—the Federal Reserve’s effort to lower long-term interest rates by selling $400 billion in short-term securities and using the proceeds to purchase an equivalent amount of long-term securities—and at the same time, threatened by prospective refinancing initiatives that were designed to prop up the sagging housing market. Nevertheless, MBS recorded positive returns of 0.88% for the quarter and more than 6% for 2011 as a whole.

Higher Yielding Sectors Posted Strong Gains
With interest rates hovering near historic lows and the markets showing an increased appetite for risk, investors generally favored higher-yielding securities, such as corporate high-yield bonds. During the fourth quarter, in fact, high-yield bonds outperformed every other fixed income asset class. The Barclays Capital U.S. Corporate High Yield Bond Index, a measure of high yield bond performance, rose 6.46%. Risk was generally rewarded, with the returns of BB-rated bonds lagging those of B-rated and C- to CCC-rated bonds. Market fundamentals remained positive—the high yield default rate was low and corporate balance sheets were relatively healthy.

Meanwhile, the rally continued in the municipal bond market. Tax-exempt securities, as represented by the Barclays Capital 10-Year Municipal Bond Index, returned 3.23% during the fourth quarter and 12.32% during the calendar year. The three drivers of 2011 municipal bond performance were fear, supply and value. Early in the year, there were dire—and ultimately unfounded—predictions of rampant municipal defaults. Fears about a wave of municipal defaults dissipated as the year progressed, only to be replaced by fears of calamity in the European bond markets. As a result, in the third quarter, investors focused on higher-quality bonds, including tax-exempt securities, with shorter-term maturities. Municipal bond prices also benefited from tight supply conditions; for most of the year, there was little in the way of new supply. In the fourth quarter, significant new issuance was met with strong demand and was quickly absorbed by the market.

Inflation-Linked Bonds Attracted Investors
Inflation-linked bonds, such as U.S. Treasury Inflation Protected Securities (TIPS), posted strong results. The Barclays U.S. Government Inflation-Linked Bond Index, a measure of U.S. TIPS performance, was up 2.69% in the fourth quarter and 13.56% for 2011 overall. Although inflation was relatively benign during the fourth quarter, the Fed’s implementation of “Operation Twist” raised concerns about the program’s impact on inflationary trends. Reflecting these concerns, investor demand increased for longer maturity inflation-linked bonds, leading to their outperformance relative to nominal Treasuries.

European and Emerging Market Bonds Muddled Through
In Europe, sovereign bonds—those issued by national governments—had a difficult fourth quarter, reflecting the turmoil that has prevailed in the region as fiscally challenged nations continue to grapple with enormous debt loads and budget deficits. The Barclays Capital Euro Treasury Index, which measures performance of eurozone government bonds, returned –3.73% for the quarter and 0.09% for the year. In the emerging markets, returns were broadly positive, with the Barclays Capital Global Emerging Markets Bond Index gaining 3.93% and 5.77% for the quarter and year, respectively. On a regional basis, emerging markets in Latin America and Asia generally fared better than their counterparts in developing Eastern European markets.

The Road Ahead
Looking ahead, the competing influences of positive U.S. economic news and Europe’s ongoing debt situation are likely to dominate investor sentiment and market direction during 2012, just as they did during 2011. The Fed continues to reiterate its intentions to keep short rates at historical lows, indicating that the federal funds rate may stay at between zero and 0.25% until at least late 2014. During the fourth quarter, yields remained exceptionally low on maturities of up to three months for Treasuries, agency securities, and corporate bonds. Long-term interest rates were also extremely low. We expect them to rise somewhat during 2012, though not dramatically.

Meanwhile, we believe a number of factors will keep Europe’s economic fundamentals weak, at least in the short term. European banks, hurt by the region’s debt crisis, will continue to deleverage (pay down existing debt on their balance sheets) and seek to meet stronger capital requirements, thus reducing their lending activity and putting a drag on economic growth. In addition, austerity measures implemented by debt-saddled governments will mean less spending to help stimulate their economies. Moreover, efforts to achieve closer fiscal integration among European Union member nations—widely seen as essential to resolving the debt crisis—will take time. Despite the challenges, we think progress will be made, albeit slowly, and we expect slightly better conditions in Europe during the second half of 2012. This would be supportive of improved performance by European bond markets.

Overall, we consider the current slow-growth, low-inflation environment favorable for “spread” fixed-income sectors (that is, higher-yielding non-Treasury securities), and we anticipate that corporate bonds and other spread-sector credits will likely outperform in the coming year.