Overview of 2012 Bond Market Performance
The global bond markets delivered healthy returns in 2012, with positive performance across the board for the major asset classes and the eighteenth consecutive year of gains for investment grade bonds, as measured by the Barclays Aggregate U.S. Bond Index.
The primary driver of bond market performance was the policy of ultra-low interest rates being pursued by the U.S. Federal Reserve (“the Fed”) and other major global central banks, which depressed yields (and supported prices) of short-term securities and government bonds. The low yields on these safer investments, in turn, caused investors to search for alternatives in the higher-risk, higher yielding segments of the market.
The bond market was also supported by an environment of slow global growth, featuring sluggish economic performance in the United States, the onset of recessions in Europe and Japan, and decelerating growth in China. Together, these factors provided investors with the confidence that the world’s central banks would be able to go several more years without raising interest rates. The Fed, for its part, maintained a pledge for much of the year that it wouldn’t hike rates until 2015. At the same time, growth in the United States – while soft – remained in positive territory, providing investors with confidence in the underlying financial health of corporate and high yield bond issuers. In this sense, the environment was nearly ideal for bonds in 2012.
The 2012 returns of the various asset classes within the bond market are as follows:
- Investment-grade U.S. bonds (Barclays U.S. Aggregate Bond Index): 4.22%
- Short-term U.S. Treasuries (Barclays 1-3 Year U.S. Government Index): 0.51%
- Intermediate-term U.S. Treasuries (Barclays US Government Intermediate Index): 1.73%
- Long-term U.S. Treasuries (Barclays US Government Long Index): 3.78%
- TIPS (Barclays US Treasury Inflation Protected Notes Index): 6.98%
- Mortgage-backed securities (Barclays Mortgage GNMA Index): 2.42%
- Municipal bonds (Barclays Muni Bond Index): 6.78%
- Corporate bonds (Barclays Corporate Investment Grade Index): 9.82%
- Long-term corporate bonds (Barclays Corporate Long Investment Grade Index): 12.41%
- High yield bonds (Credit Suisse High Yield Index): 14.71%
- International government bonds (SPDR Barclays International Treasury Bond ETF, BWX): 5.66%
- Emerging market bonds (iShares JPMorgan USD Emerging Markets Bond Fund, EMB): 16.52%
Long-Term Bonds Outperform
Long-term bonds outpaced the returns of their short-term counterparts in 2012 amid investors’ continued search for yield. This relationship held true across the market, particularly within the corporate and municipal bond segments. Longer-term bonds have performed so well, in fact, that the risks are beginning to outweigh the upside potential. While there is nothing on the horizon to suggest an immediate jump in long-term rates, those considering long-term bond funds need to give the risks careful consideration.
U.S. Treasuries Register Modest Gains
After delivering outstanding returns in 2011, U.S. Treasuries generated only modest returns in 2012. Part of the problem was that yields were already so low – 1.87% for the 10-year note – coming into the year that there was little room for yields to fall much further. (Keep in mind, prices and yields move in opposite directions.)
Even with their low yields, Treasuries benefited from periodic flights to quality throughout the year. For example, TLT – the largest Treasury ETF – gained 10.48% in the second quarter when investors grew worries that European governments would be unable to prevent the debt crisis in Spain and Greece from spreading to the rest of the Continent. In this sense, Treasuries continued to function as a “safe haven” during periods of financial market stress.
Otherwise, performance was lackluster. From its peak on July 24 through December 21, TLT fell -6.5% as the yield on the 10-year note climbed in a choppy fashion from 1.40% to 1.75%. With investor sentiment improving in the second half, there was little demand for safe-haven investments. Investors’ appetite for Treasuries also was dampened by the stabilization in economic trends and improvement in the housing market. At the same time, however, any increase in yields was tempered by the Fed’s ongoing pronouncements that intends to maintain its policy of ultra-low short-term interest rates indefinitely.
TIPS Rise on Lower Rates, Inflation Fears
Treasury Inflation-Protected Securities outperformed plain-vanilla Treasuries in 2012. While TIPS are largely affected by the same factors as plain-vanilla Treasuries, the prospect of the Fed maintaining its ultra-low interest rate policy for another two-plus years led to increased demand for inflation protection. TIPS’ strong performance in 2012 means that the asset class has now delivered gains of at least 6% in each of the last four calendar years. A unique aspect of the TIPS market is that yields on five- and ten-year issues closed the period in negative territory. Find out why here.
Mortgage-Backed Securities Steady but Unspectacular
Mortgage-backed securities (MBS) finished the year with a gain thanks to falling government bond yields, the improving housing market, and the Federal Reserve's announcement its third round of quantitative easing would focus on this market segment. The Fed intends to purchase $40 billion of mortgage-backed securities per month, which removes a massive amount of supply from the typical supply-and-demand equation.
There is some downside to the rally: the yield advantage of mortgage-backed securities relative to Treasuries (the "spread") fell to its lowest level in history in the fourth quarter. While this indicates that mortgage-backed securities aren't offering as much value as they have historically, this is also an extremely unusual situation in that MBS investors have the biggest buyer in the world - the Fed - firmly on their side.
Municipal Bonds Strong Until December
Municipal bonds sustained more than their share of bad news in 2012, but the asset class nonetheless delivered decent returns. While states’ fiscal health is improving somewhat, local governments continue to face financial challenges. The main problem is expenses continue to expand faster than revenues, reducing local governments' flexibility - an issue that is being exacerbated by slow economic growth. These issues were underscored during the summer, when three California cities declared bankruptcy.
Nevertheless, municipal bonds generated solid gains thanks to low Treasury rates and a favorable supply-and-demand picture. Investors continued to gobble up municipal bonds to take advantage of their attractive yields, driving prices higher. In addition, the overall default rate continues to fall, creating a positive underpinning for municipal bonds. Not least, investors piled into munis during the second half in anticipation of higher tax rates for the wealthy in President Obama’s second term. High yield municipals generated particularly strong performance in 2012 – based on the 15.3% return of the Market Vectors High Yield Municipal Index ETF (HYD) through December 21 – amid investors’ continued search for yield.
This positive backdrop changed for the worse in December, when the fiscal cliff debate raised concerns that municipal bonds' tax-free status would be threatened. Policymakers are looking at new ways to reduce the debt, and one solution is to begin taxing the interest on municipal bonds in some form. Since munis’ tax exemption is their most important selling point, any tax on the interest would reduce demand and changed the way munis are valued. As of year-end, it remained to be seen what the fate of the municipal bond tax exemption would be in 2013, but the uncertainty began to take a toll on performance late in the year: in December, the largest muni ETF, iShares S&P National AMT-Free Municipal Bond Fund (MUB) declined 2.6%.
Corporate Bonds Deliver Outstanding Returns
Corporate bonds also provided stellar returns in 2012, for essentially the same reasons as high yield. One source of corporates' strong performance is obvious: they offer more yield than government bonds, providing investors with a chance to stay ahead of inflation. But another, equally important, reason the continued improvement in the health of U.S. corporations. Earnings came in well above expectations in the first half of the year, and companies have record levels of cash on their balance sheets (increasing the likelihood that bond investors will be paid back). Further, the odds that the Fed will maintain ultra-low interest rates for another two years made the bonds of higher-rated corporations more attractive relative to Treasuries. These factors caused a torrent of new cash flooding into the asset class, which helped drive prices on a steady, upward trajectory throughout the year. Investors were generally rewarded for taking higher risk, as the lower-rated and longer-term bonds within the asset class generally outpaced their higher-rated and shorter-term counterparts.
The outperformance for corporate bonds is nothing new, however: during the past decade, corporates have provided better returns than domestic large- and small-cap stocks, developed-market international stocks, or commodities.
Double-Digit Gains for High Yield Bonds
The backdrop for high-yield bonds was uniformly positive in 2012. The U.S. economy continued to exhibit modest growth, the stock market posted a double-digit gain, and high-yield issuers experienced the favorable combination of rising cash flows, lower debt, and reduced interest costs brought about by their ability to refinance existing debt at ultra-low interest rates. Together, these factors formed the underpinning for a continued decline in the default rate – or in other words, the percentage of issuers that fail to make interest or principal on time.
High yield bonds also gained support from their comfortable yield advantage over Treasuries. At a time in which investor sentiment was generally positive, investors were more than willing to take on the higher risk in the asset class in order to pick up extra yield. High yield bonds closed the year with absolute yields that were low on a historical basis, but their yield spread (or advantage) versus Treasuries remained above five percentage points, in line with the historical average.
Developed-Market Government Bonds Gain Ground
International government bonds provided respectable returns in 2012, finishing slightly ahead of U.S. Treasuries after lagging by a huge margin in 2011. Although the asset class continues to offer investors little in the way of yield – 1.84% at year-end, as measured by the J.P. Morgan Government Bond Index – the improving outlook for Europe nonetheless led to modest second-half price gains, particularly for the previously underperforming bond markets of Spain and Italy.
Emerging Market Debt Surges in the Second Half
Emerging market bonds were the best performer among the major market segments during 2012. The asset class benefited from the generally positive investment environment, the healthier economic fundamentals in the emerging world relative to their developed market counterparts, and their attractive yield and long-time upside potential.
The only true weakness in emerging markets bonds occurred in May amid heightened investors concerns about macroeconomic issues such as the European debt crisis. From the beginning of June onward, the market was almost straight up: from June 1 through year-end, iShares JPMorgan USD Emerging Markets Bond Fund (EMB) returned a blistering 15.6%.
Emerging Market Corporate Bonds Come of Age
Investors' search for higher-yielding investments was also a boon for emerging market corporate bonds in 2012. An area that received very little attention until just recently, emerging corporates have benefited from a flood of new assets so far this year. According to Reuters, the total value of the market rose above $1 trillion in mid-November, making it as large as the U.S. high-yield bond market.
One cause of this frenzy of activity is an extremely favorable relationship between risk and yield offered by bonds in this asset class. Since investors demand a higher premium for emerging-market corporates than U.S.-based issues, the bonds frequently offer higher yields than those issued by U.S. companies in similar financial condition. This can lead to compelling yield opportunities for longer-term investors and those who are comfortable with elevated volatility. Emerging market corporates aren't for everyone, but they are among the few investments left that can offer investors a yield more than four to five percentage points above the rate of inflation.
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