Asset Management

2012 Second Quarter Fixed Income Review

Joseph Higgins, CFA, Portfolio Manager
Global Public Fixed-Income Markets

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The second quarter of 2012 represented a reversal of trends that had begun to take hold earlier in the year. During the period, renewed fears over Europe’s ongoing sovereign debt crisis and mounting evidence of an economic slowdown in the U.S. and Asia became dominant forces influencing fixed-income markets. Fears of an imminent Greek eurozone exit early in the quarter diminished somewhat as the period wore on, only to be replaced by an intensified focus on Spain’s difficulty in accessing debt markets to support its troubled banking sector. Italy and other European nations joined Spain in the unfavorable spotlight, wrestling with declining GDP growth partly as a result of austerity measures.

Later in the quarter, the impact of Europe’s problems began to be felt more strongly in the U.S., as reflected in declining retail spending, a slowdown in manufacturing and disappointing employment growth. Housing emerged as a bright spot during the quarter: Favorable readings on new and existing home sales, housing starts, building permits and median home prices allowed for a degree of optimism regarding future growth.

Returns are broadly positive across fixed-income sectors

While increasing global concerns drove investors to safer bond market sectors, fixed- income securities across a range of sectors realized positive returns during the quarter, benefiting from declining interest rates and fairly stable credit conditions for U.S. issuers. U.S. Treasuries outperformed "spread sector" credits (lower-rated, higher-yielding non-Treasury securities), as 10-year Treasury yields declined from 2.23% to 1.67% during the quarter, and 30-year Treasury yields fell from 3.35% to 2.76%, touching a three-year low of 2.53% on June 1.

These yield declines resulted in nominal and inflation-protected Treasury bond returns of approximately 3% (with double-digit gains in longer-dated Treasuries). Other fixed-income sectors—including investment-grade and high-yield corporate bonds, mortgage-backed and asset-backed securities, and U.S. dollar-denominated emerging-markets debt—realized positive second-quarter returns in a range of approximately 1% to 2.5%. Investment-grade bonds outperformed other spread-sector credits.

Search for yield lifts corporate bond sectors

The margin of incremental yield, or spread, between non-Treasury bond sectors and Treasuries widened somewhat during the quarter but did not revert to levels seen at the beginning of the year. As investors came to terms with a low-yield environment that is likely to persist for some time, demand remained robust for fixed-income securities that offer compelling yields relative to Treasuries. Corporate bonds, in particular, drew investor interest, as issuers have improved their ability to withstand challenging economic conditions by maintaining debt levels that are low and cash positions that are high by historical standards. Along with these positive factors, a slowdown in leveraged buyout activity (which can hurt corporate credit profiles by adding significantly to debt levels) created somewhat of a "Goldilocks" scenario for the investment-grade market in which circumstances were just right for their performance.

Within high-yield corporate bond markets, higher-quality issues outperformed relative to lower-quality CCC-rated bonds, based on stable default rates and attractive spreads. Some investors tilted away from emerging-markets issues in favor of U.S. high-yield corporate bonds for greater perceived protection, given the pronounced slowing of economic growth in China and Europe. Many emerging market countries are dependent upon exports to Europe for growth.

Although returns for structured securities fell short of corporate returns, certain sectors— including commercial mortgage-backed securities (CMBS), asset-backed securities (ABS) and non-agency mortgage-backed securities (MBS)—performed well. These sectors benefitted from strong collateral backing and also from a lack of net new supply that will likely support continued elevated levels of investor demand for such securities.

Looking ahead

Looking out to the remainder of 2012 and beyond, we expect the current environment—characterized by low interest rates, slow growth and relatively benign credit conditions—to persist. Despite prevailing macroeconomic headwinds, we continue to find value in U.S. corporate and structured securities, which we expect to perform well under a range of economic scenarios. Balancing this positioning, we believe that an emphasis on higher-quality assets within spread sectors, along with a bias favoring more liquid, recently issued securities, is prudent. Across a number of our portfolios, we have closed underweight positions in defensive sectors, such as MBS, that may outperform if conditions weaken—particularly if the Federal Reserve were to engage in another round of quantitative easing.

With current yields already reflecting investor expectations for continued economic weakening, and factoring in the possibility of further economic shocks, we expect further rate declines, if they occur, to have a more muted impact on bond market performance. Although we believe it is possible for interest rates to drift lower given weakening U.S. and global economic conditions, we are also mindful of rapid changes in investor sentiment that may easily cause rates to spike higher on signs of improvement. Accordingly, we feel that a relatively neutral exposure to interest-rate risk is warranted at this time, while maintaining a focus on earning excess returns through effective credit selection.