Asset Management

2013 Third Quarter Fixed-Income Market Review

WILLIAM RIEGEL, HEAD OF EQUITY INVESTMENTS

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The bond market rebounds

Major bond market indexes were generally positive for the third quarter, although most remained in negative territory for the year to date through September 30. Investment-grade and high-yield corporate bond yields fell as prices rose during the quarter, the result of investors returning to these segments after broadly selling them off in the second quarter.1 These sectors, along with emerging-market bonds, outperformed the broader market during the period. High-yield corporate bonds advanced 2.36%, while emerging-market debt rose 1.11% and investment-grade corporate bonds gained 0.89%. U.S. Treasury returns were slightly positive (+0.10%) for the quarter but negative (-2.01%) for the year to date through September 30. The broad investment-grade bond market, by comparison, returned 0.57% for the quarter and -1.89% for the year to date through September 30.2


Article Highlights

  • Returns were positive across most segments of the fixed-income market during the third quarter.
  • High-yield corporate and emerging-market bonds outperformed the broad U.S. fixed-income market and U.S. Treasuries, both of which posted modest gains.
  • Fixed-income performance benefited from the Federal Reserve’s surprise September announcement to keep its quantitative easing program intact until more convincing signs of economic growth and stability emerge.
  • A weak September jobs report and the effects of the U.S. government shutdown have increased the likelihood of a delay in Fed tapering.
  • With expectations for Fed tapering shifting to a 2014 timeframe, higher-yielding fixed-income sectors are poised to perform well into year-end.

Treasury yields are influenced by taper talk and economic data

For most of the quarter, the bellwether 10-year U.S. Treasury yield continued an ascent that began in mid-May. A surprisingly robust June employment report led investors to believe that the Fed would begin to reduce its asset purchases sooner rather than later. Additional positive economic signals later in the period increased the odds of Fed tapering as early as September.

This combination of “taper talk” and strong economic data helped push the 10-year Treasury yield from 2.50% on July 1 to a quarterly high of 2.98% on September 5. Then, on September 18, the Fed surprised investors by announcing that it would delay tapering until signs of economic growth are evident. This decision resulted in an immediate decline in fixed-income yields, and the 10-year Treasury ended the third quarter at 2.64%. (See Exhibit 1.)

Exhibit 1

The 10-Year Treasury generally trended higher in the quarter until mid-September. 

The yield curve steepens

Treasury yields for maturities from 7 to 30 years ticked up modestly during the period, while yields for maturities below 7 years stayed the same or moved slightly lower versus the end of the second quarter, resulting in a steeper yield curve. Rates were mostly higher across the curve by the end of September (as shown by the orange line in Exhibit 2) than they were at the end of June (blue line) and significantly higher versus one year ago (purple line), with the largest increases occurring in the “belly” of the curve (bonds with maturities between 5 and 10 years). The steepness of the curve reflects investor expectations of an eventual end to quantitative easing programs, which will likely lead to higher rates in the future. Astute security selection in particularly steep sections, such as the “belly,” may offer the opportunity for price appreciation as the bonds approach maturity.

Exhibit 2

Q3 fixed income yield curve

Some uncertainty remains

The decision to delay tapering, combined with increasing focus on the deficit and debt debate in Washington, added uncertainty for investors. However, markets were far less volatile than in 2011, during the last major debate over government spending, as underlying economic conditions are better now than they were then.

Meanwhile, lackluster economic growth keeps individuals and businesses on the defensive, making them reluctant to spend or hire. Job creation remains positive but not strong enough to prompt Fed action. The September jobs report, for example, was nowhere near what the Fed needs to see before it begins tapering. Consistent monthly payroll gains of 200,000 or greater would indicate stronger growth and provide a better foundation for the Fed to slow down its bond-buying program.

The recent nomination of Janet Yellen as Chairwoman of the Federal Reserve has provided some clarity on the path of future Fed policy. We are likely to see the Fed maintain its focus on job creation under Yellen, if she is confirmed next year, as expected. A close ally of Fed Chairman Ben Bernanke, Yellen is perceived to be “dovish” in her views on monetary policy, so under her leadership, we expect the central bank to proceed cautiously until clearer signs of economic growth are apparent and Congress develops a long-term plan to tackle federal spending and debt issues. In the meantime, fixed-income markets may find a tailwind due to the reprieve from upward pressure on interest rates.

Outlook

Barring any exogenous shocks or especially strong economic data, credit markets appear poised for a strong 2013 finish. We anticipate a continued U.S. economic recovery and sustained modest growth in the medium to near term. Additionally, significant credit-related problems in the broad bond market are not likely, and we expect bondholder-unfriendly actions, including merger and acquisition activity, to stay at subdued levels.

At the same time, investors recognize that the temporary hold on tapering is just that—temporary—and will eventually give way to a higher interest-rate environment in which the Fed begins to wind down its bond-buying program. In our view, such an increase in rates is likely to be gradual as inflation levels remain low and as the tepid pace of the job market recovery reduces the urgency of Fed tightening measures.

In terms of portfolio positioning, we remain cautious in certain sectors, including agency mortgage-backed securities, which in our view would be vulnerable to a reduction in the Fed’s asset purchases. In this environment, fixed-income investors may be well served by seeking value in less interest-rate-sensitive segments such as non-agency and commercial mortgage-backed securities, leveraged loans, and high-yield corporate bonds.

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