The first quarter brought an increase in U.S. Treasury yields (reflecting a fall in prices), but the bond market as a whole performed well thanks to investors’ improving appetite for risk.
Two factors helped fuel positive investor sentiment in the year’s first three months. First, U.S. economic data continued to come in above expectations, raising hopes that the country was on a sustainable growth path. Second, the European debt crisis began to fade into the background following aggressive steps by the region’s policymakers to alleviate the crisis. Sentiment began to deteriorate somewhat during March on concerns that China’s economy was on track for a “hard landing,” but on balance the environment was one of increased optimism.
U.S. Treasuries Slide on Improving Outlook
As is often the case, good news for the economy was bad news for U.S. Treasury prices. The yield on the five-year note rose from 0.83% to 1.04% as its price fell, while the 10-year rose from 1.87% to 2.22% and the 30-year from 2.89% to 3.35%. The bulk of this increase occurred during a very short period in mid-March, when yields soared due to as the improved outlook for Europe has led to a stampede into stocks and reduced the demand for “safe havens.” In addition, the evidence continued to mount that the U.S. economy is experiencing a substantial improvement in growth, making investors less confident that the Federal Reserve will hold rates at their current, ultra-low levels until 2014, as Fed Chairman Ben Bernanke pledged in January. The largest exchange-traded fund invested in U.S. Treasuries – the iShares Lehman 20+ Year Treasury Bond Fund (ticker:TLT) – finished the quarter with a total return of -7.03% after returning 31.53% in the second half of last year. Investors will undoubtedly be watching intently to see if this weak performance marks the long-anticipated bursting of the “bubble” in U.S. Treasuries.
Corporate Bonds Rally
Investment-grade corporate bonds continued to perform well during the first quarter, as gauged by the 2.34% return of the iShares iBoxx US Dollar Investment Grade Corporate Bond ETF (LQD). The asset class was helped by the combination of improved investor sentiment, the continued financial strength of U.S. corporations, and investors’ ongoing search for higher-yielding investments at a time of relatively low yields on government bonds. Corporates lost ground amid the jump in Treasury yields in the first half of March, but the otherwise strong performance of the asset class allowed it to finish ahead of U.S. Treasuries for the quarter.
Corporate bonds are still providing investors with higher yields than U.S. Treasuries, but the gap is falling. Improving investor sentiment has caused corporate bond yields to decline to yield levels that are low on a historical basis, as cash continues to gravitate away from lower-risk investments to those that offer more attractive yields. According to data from the Federal Reserve Bank of St. Louis, the Bank of America Merrill Lynch US Corporate Master Effective Yield stood at 3.44% on March 29, near its all time low of 3.39% (set on March 2) and well below its peak of 9.30%, registered during the depth of the financial crisis in 2008. View the chart here to get a sense of how low yields are now relative to the past 15 years. Keep in mind, falling yields indicate rising prices.
Corporate bonds are offering a yield spread over Treasuries that is low by historical standards. The 10-year note closed at 2.22% on March 20, indicating that corporates (at 3.44%) are providing a spread of just 1.22 percentage points. Does this mean the rally in corporates is over? Not necessarily. With the U.S. Federal Reserve maintaining its pledge to keep rates low indefinitely, the demand for higher-yielding assets is unlikely to abate barring an adverse news event (such as a revival in the European debt crisis). Indeed, investors continue to pour cash into the asset class, more than making up for the added supply of new issuance from companies that are coming to the bond market to issue debt at these low yield levels.
TIPS, Mortgage-Backed Securities, Municipal Bonds Finish With Meager Returns
Outside of corporate bonds, the domestic, investment-grade segments of the bond market produced returns that were slightly positive for the quarter:
- TIPS: iShares Lehman TIPS Bond Fund (TIP), 0.82%
- Mortgage-backed securities: iShares Lehman MBS Fixed-Rate Bond Fund (MBB), 0.44%
- Municipal bonds: iShares S&P National Municipal Bond Index Fund (MUB), 1.58%
TIPS held up relatively well against plain-vanilla Treasuries, as the prospect of the Fed maintaining its ultra-low interest rate policy for another two-plus years raised investors’ demand for inflation protection. Mortgage-backed securities and municipal bonds both began the quarter with strong performance, but gave back ground in March following the spike in Treasury yields. In addition, munis were pressured by a flood of new issuance (which brought an unfavorable imbalance of supply and demand) and renewed concerns about the condition of state and local finances.
High Yield Bonds Provide Handsome Rewards
Investors who have been willing to take on the added risk of high yield bonds were rewarded with another quarter of outperformance. After gaining 10.68% in the fourth quarter of 2011, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) returned another 2.61% in the first quarter of this year. In comparison, investment-grade bonds gained 0.14%, as measured by the iShares Lehman Aggregate Bond Fund (AGG).
The success of high yield has come with a price, however. Following its outstanding rallies of the past six months, HYG finished the quarter with a yield of 7.1%, in the bottom end of its three-year range. This indicates that high yield bonds are offering a much lower yield spread over U.S. Treasuries than they have historically. This is great news for investors who are already in high yield bonds, but those who are considering an investment now should be mindful that the asset class has less upside now than it did six months ago. Fortunately, the Fed’s low-rate policy is likely to cap the downside risk by fueling continued demand for higher-yielding assets.
Emerging Markets Stand Out Overseas
Outside of the United States, the improved investor sentiment regarding Europe helped the developed government bond markets produce a return of 2.20%, as measured by the SPDR Lehman International Treasury Bond ETF (BWX). The story was also positive in the emerging world, where the improvement in investor sentiment sparked a gain of 3.51% in the iShares JPMorgan USD Emerging Markets Bond ETF (EMB). With the concerns about Europe out of the picture, at least temporarily, investors felt comfortable taking on the added risk to pick up the incremental yield available in the emerging markets. Emerging market currencies also gained ground, leading to a gain of 7.52% for the Wisdom Tree Emerging Markets Local Debt Fund (ELD).
Yields by Asset Class
Finally, a look at where the yields of each of the ETFs mentioned here stood as of the end of the first quarter:
- iShares Lehman 20+ Year Treasury Bond Fund (TLT), 2.85%
- iShares iBoxx US Dollar Investment Grade Corporate Bond ETF (LQD), 4.18%
- iShares Lehman TIPS Bond Fund (TIP), 2.45%
- iShares Lehman MBS Fixed-Rate Bond Fund (MBB), 3.38%
- iShares S&P National Municipal Bond Index Fund (MUB), 3.13%
- iShares Lehman Aggregate Bond Fund (AGG), 3.02%
- iShares iBoxx $ High Yield Corporate Bond ETF (HYG), 7.10%
- SPDR Lehman International Treasury Bond ETF (BWX), 1.84%
- iShares JPMorgan USD Emerging Markets Bond ETF (EMB), 4.83%
- Wisdom Tree Emerging Markets Local Debt Fund (ELD), 3.01%
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