Bill Martin, Head of Fixed-Income Portfolio Management
After realizing positive returns in April, fixed-income markets declined broadly during May and June on fears that the Fed would begin to taper its quantitative easing (QE) asset purchase program sooner than previously anticipated.
While the U.S. economy continued to feel the effects of federal spending cuts, increasing momentum in the private sector—reflected in firming manufacturing, strength in housing markets, and improving consumer confidence—brightened the outlook for economic growth for the second half of the year. This prompted the Fed to begin to discuss an eventual exit strategy from accommodative monetary policies, with direct implications for fixed-income securities markets where the Fed has become a dominant force since quantitative easing programs were first implemented in late 2008.
Fed tapering talk results in spike in yields
The Fed’s public statements regarding possible tapering of asset purchases caused a swift increase in fixed-income yields in May and June, with the 10-year Treasury yield spiking by 86 basis points, from a May 2 low of 1.66% to 2.52% at quarter-end. Interest rate-sensitive sectors such as Treasuries and mortgage-backed securities (MBS) were negatively impacted, as were credit-sensitive sectors, where spreads widened and market liquidity rapidly diminished.
While credit fundamentals were not a primary point of investor focus, the speed of the rate rise nonetheless prompted investors to shed riskier assets, resulting in a rotation out of investment-grade and high-yield corporate bonds. Emerging-market bonds were particularly hard-hit, as yields on U.S. fixed income became more competitive relative to international securities and concerns about slower global growth took hold. Difficult conditions were exacerbated by diminished liquidity, with less capital from securities dealers being dedicated to maintain well-functioning markets in this and other recent periods of stress.
Bonds with durations between five and 10 years—a range referred to as the “belly” of the yield curve—were more severely affected than those at the shorter or longer ends of the yield curve. As such, yields on five- and 10-year Treasuries increased by about 50 basis points (0.50%) more than yields on three-year Treasuries, and approximately 15 basis points (0.15%) more than yields on 30-year Treasuries.
Fixed-income sectors characterized by shorter-duration securities, such as asset-backed securities (ABS), fared better relative to other sectors. On the other hand, sectors with medium- to longer-term durations—particularly those, such as inflation-linked bonds, that are sensitive to increases in real interest rates—suffered the steepest negative returns.
Assessing the path ahead
Following the second quarter’s rapid and dramatic changes in fixed-income markets, investors are attempting to assess whether this was a one-time adjustment or a sign of more volatility to come. In considering this, it’s important to bear in mind the still tepid pace of economic recovery, which we think limits the capacity for the economy to withstand further substantial rate increases without jeopardizing future growth. We view the prospect of further significant rate increases to be limited in the near term, due to the negative impacts that such increases would have on the housing market, business investment, and other economic activity needed to sustain economic growth.
In addition, the relative attractiveness of U.S. interest rates relative to lower rates available to investors abroad will likely maintain a level of demand for U.S. Treasuries, taking some of the upward pressure off rates. For these reasons, we believe interest rates will be range-bound over the next few months.
Federal Reserve policy, guided by the strength of economic data releases, will certainly be the biggest macro driver of fixed-income performance as we enter the second half of 2013. With the housing recovery on track and default rates at low levels thanks to ample corporate liquidity, accelerated economic growth may allow for the narrowing of spreads versus Treasuries and stronger relative performance by investment-grade and high-yield corporate bonds, as well as other “spread” sectors.
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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). Past performance is no guarantee of future results.