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Bond Market Overview, July-September 2012

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A hearty revival in investors’ risk appetites led to robust performance for higher-risk asset classes and flat performance for U.S. Treasuries during the third quarter.

The primary reason for the improvement in market sentiment was the coordinated actions of the world’s central banks. In the United States, the Federal Reserve announced its intention to extend its stimulative quantitative easing policy indefinitely, maintain its Operation Twist program through year-end, and keep short-term interest rates near zero through 2015. In addition, European Central Bank president Mario Draghi indicated that he would do "whatever it takes" to keep the euro-zone together and announced a plan for an aggressive bond-buying program (called Outright Monetary Transactions - or OMT) to stabilize the region’s troubled debt markets. These moves were the strongest sign yet that the region would be able to make it through the debt crisis without the worst-case scenario – a collapse of the region’s common currency – taking place. The news out of Asia was also positive, with Japan and China both announcing steps to address the slowing growth in their respective economies.

Together, these factors led to positive performance for the bond market. The third quarter and year-to-date returns for the various segments of the bond market appear below, as represented by the returns of the major bond ETFs for which tickers appear in parentheses:

Third Quarter:

  • Investment-grade U.S. bonds (BND): 1.57%
  • Short-Term U.S. Treasuries (IEF): 0.93%
  • Long-Term U.S. Treasuries (TLT): -0.14%
  • TIPS (TIP): 2.02%
  • GNMAs (MBB): 1.09%
  • Municipal bonds (MUB): 2.50%
  • Corporate bonds (LQD): 4.57%
  • High yield bonds (HYG): 2.81%
  • International government bonds (BWX): 4.57%
  • Emerging market bonds (EMB): 6.89%

Year-to-Date:

  • Investment-grade U.S. bonds: 3.97%
  • Short-Term U.S. Treasuries: 4.41%
  • Long-Term U.S. Treasuries: 4.66%
  • TIPS: 5.99%
  • GNMAs: 2.64%
  • Municipal bonds: 4.57%
  • Corporate bonds: 10.40%
  • High yield bonds: 8.13%
  • International government bonds: 6.24%
  • Emerging market bonds: 14.14%

Emerging Markets Lead the Way

Emerging market bonds were the best performer among the major fixed income asset classes during the third quarter. The emerging markets 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. With Treasuries yields at their current, ultra-low level, the consensus view is that investors are much more likely to see stronger gains from emerging market bonds in the next five to ten years, if for no other reason than their substantial yield advantage. It should be noted, however, that this advantage has narrowed following the strong performance of emerging debt during the past year. While long-term fundamentals remains strong, the smaller “yield spread” relative to U.S. Treasuries indicates that emerging market bonds could suffer some short-term volatility upon any weakening of investor sentiment.

High Yield Bonds Also Rally

Similar to the emerging markets, high yield bonds are a prime beneficiary when investor sentiment is positive. The asset class performed very well during the quarter, supported by a comfortable yield advantage over Treasuries, the low level of defaults in the high yield market, and investors’ willingness to take on risk in order to pick up yield.This rally marked a continuation of the move off of the autumn lows of last year: in the one-year period ended September 30, 2012, high yield bonds gained 19.61% based on the iShares iBoxx $ High Yield Corporate Bond ETF.

Again, the strong returns signal the need for caution among investors. Although high yield companies remain in strong financial condition as a group, absolute yield levels closed the quarter near all-time lows. Like the emerging markets, high yield is vulnerable to short-term volatility if any adverse headlines cause investors to lose their appetite for risk in the months ahead. In fact, both Morgan Stanley and Standard & Poor’s offered cautionary outlooks in the final week of the quarter:

Morgan Stanley: “Risk/reward for the asset class is less attractive today than at any other point this year. The main driver of our downgrade is unattractive total return prospects going forward… We think prices are topping out.”

Standard & Poor’s: “We expect to see diminishing credit quality … The U.S. speculative-grade bond market has strong technicals such as record-low yields, high issuance, and tight spreads, but we also see rising defaults, increasing downgrades, and companies facing potential macroeconomic headwinds.”

Investment-Grade Corporates Gain Ground

Corporate bonds performed very well in the third quarter, as the continued improvement in corporate earnings and profit margins attracted investors to the sector. The outperformance of corporates 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. Long-term corporates have performed even better: in the one- and two-year periods ended September 30, the Vanguard Long-Term Corporate Bond exchange-traded fund (ticker:VCLT) posted total returns of 15.62%% and 26.65%, respectively.

While all of the fundamental factors that have fueled the rally in corporates remain in place, investors should be mindful that the decline in the sector’s yield advantage makes it vulnerable to a rise in Treasury yields. According to a recent article in the Wall St. Journal, titled “As Corporate-Bond Yields Sink, Risks for Investors Rise,” some caution may be in order. The article stated: “Companies sold $75 billion of investment-grade corporate bonds in the U.S. last month, the busiest July ever for such sales, and the total for 2012 is on track to hit $1 trillion, according to ThomsonReuters. Corporate bonds sold last month pay an average interest rate of about 3.2%, an all-time low. Over the past 30 years, interest rates on those bonds averaged about 7.2%.”

While there is little to indicate that weakness could occur immediately, investors nevertheless should be mindful of the potential risks given that the market has gone only one way – up – in the past ten months.

Treasuries Flat, but TIPS Gain

The improvement in investor risk appetites caused U.S. Treasuries to produce the weakest performance of the major market segments. During the past three years, U.S. government bonds have benefited from the “flight to quality,” or in other words, investors’ search for investments free of principal risk as safe havens from the trouble in Europe and elsewhere. As a result of the various central bank actions, investors began to feel more confident moving out of Treasuries and into higher-risk investments with more return potential. As a result, Treasuries were largely flat during the quarter: the benchmark 10-year note closed the period with a yield of 1.64%, down slightly from 1.67% at the end of June. Its closing high was 1.87%, touched on September 14, while its low was 1.40%, hit on July 14.

Treasury Inflation-Protected Securities , or TIPS, had a strong quarter as investors displayed a preference for investments that could help provide protection against inflation. A unique aspect of the TIPS market is that yields on five-, ten-, and 20-year issues all closed the period in negative territory. Find out why here.

Fed Policy Shift Sparks a Rally in Mortgage-Backed Securities

Mortgage-backed securities (MBS) benefited from the Federal Reserve's announcement its third round of quantitative easing would focus on this market segment. According to Bloomberg, the purchasing program could result in the Fed buying $650 billion to $1 trillion of mortgage-backed securities – about half of the mortgage-backed debt that agencies such as Fannie Mae, Freddie Mac and Ginnie Mae sell each month. The result is that a massive amount of supply will be removed from the typical supply-and-demand equation. This was far more than investors had anticipated going into the announcement, and the MBS market benefited in kind. In the days following the Fed’s announcement, the yield advantage of mortgage-backed securities relative to Treasuries (the "spread") fell to its lowest level in history.

Municipal Bonds Rise Despite Investor Concerns

Municipal bonds were hit by a wave of bad news during that third quarter, but that didn’t impacted their performance results. Both investment-grade and high-yield municipal bonds posted solid gains even as investors have become concerned about rising municipal bankruptcies and increased credit rating downgrades, among other factors.

The reason why munis have continued to perform well is a positive 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 for municipal bonds continues to fall. According to Barrons.com, the total number of defaults fell 32% (from 57 to 39) in the first half of 2012 compared to the same period a year ago. What's more, municipal bankruptcies are rare events, and the problems in a handful of issuers don't translate to broader problems for all municipalities nationwide.

Learn more about other issues affecting the bond market:

Does China own too much U.S. debt?

How do elections impact bond returns?

What is the fiscal cliff?

Why are yields so low?

Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.

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