The past year was a tumultuous time for the world economy, and this was reflected in the performance of the bond market. While the ultra-low interest rate policy of the U.S. Federal Reserve sparked increased interest in the higher-risk, higher yielding areas of the market at various points throughout the year, this was offset by the overriding impact of the European debt crisis. In the end, the U.S. bond market produced a solid, mid single-digit return and outperformed U.S. equities.Click here for 2011 bond market return data.
Treasury Yields Move to All-Time Lows
U.S. Treasuries proved to be the standout area of the bond market in 2011. The benchmark 10-year Treasury came into the year yielding 3.31%, and it remained in the 3.5% range through early April in a reflection of an environment characterized by steady economic growth and general investor optimism. The outlook began to change in the spring, however, for two reasons. First, the end of the Federal Reserve’s quantitative easing policy brought with it evidence of slowing economic growth both in the United States and around the world, particularly in the emerging markets. Second, the European debt crisis began to move back into the headlines. The combination of slowing growth and the evolving crisis in Europe fed off each other in a vicious cycle as the year progressed, frightening investors and sparking a flood of cash into the relative “safe haven” of U.S. Treasuries.
This “flight to quality” caused the yield on the 10-year Treasury to fall to a low of 1.70% in September and ultimately close the year near 2%.(Keep in mind, prices and yields move in opposite directions.) Additionally, Treasuries with maturities of five years and less plunged below 1% in the second half due in part to the Fed's pledge to keep the short-term federal funds rate near zero until mid-2013. The extremely low level of government bond yields indicated that investors were willing to earn less than the rate of inflation just to keep their money safe from short-term market volatility.
Ironically, the strength in Treasuries occurred even though the ratings agency Standard & Poor’s downgraded the United States’ credit rating in August. The U.S. government continues to build up debt at an alarming rate through persistent budget deficits, but this concern took a back seat to investors’ quest for safety amid the tumult in Europe.
Plain-vanilla Treasuries weren’t the only area of the government bond market to perform well in 2011. Treasury Inflation-Protected Securities, or TIPS, also finished with double-digit return for two reasons: first, the flight to quality; and second, the concern that the stimulative policies of the world’s central banks will ultimately lead to inflation (thereby boosting TIPS’ prices.) Mortgage-backed securities issued by government agencies also delivered steady gains during the year.
Municipal Bonds: Worst Fears Go Unrealized
In late 2010, the analyst Meredith Whitney went on 60 Minutes and predicted that in 2011, “You could see 50 sizeable 100 sizeable defaults” in the municipal bond market, amounting to "hundreds of billions of dollars.” The basis for the prediction was that a number of states and smaller government entities suffered from perilous finances caused by the combination of declining revenues and soaring expenses. The warning roiled the markets, sending munis on a sharp downturn that took prices down by over 9% in the coming month.
Fortunately for investors, this dire prediction failed to come to fruition. While there were a few select defaults in the municipal arena in 2011, nothing close to Whitney’s prediction in fact materialized. As a result, the asset class recovered all of its December 2010 – January 2011 losses as the year progressed and ultimately closed above its level at the time of the 60 Minutes piece. Munis, which attracted investors with their attractive valuations and high yields relative Treasuries, and ultimately finished with a strong, high-single digit total return that outpaced the performance of taxable issues.
Corporate Bonds, High Yield, and Emerging Markets Follow the Risk Trade
In the “spread sectors” of the bond market – in other words, the areas that trade based on their yield advantage, or “spread” over Treasuries – the year was dominated by investors’ perception of risk. During the first part of the year, the environment of low short-term interest rates, sturdy economic growth and elevated investor risk appetites boosted the performance of corporate, high yield, and emerging market bonds. In the second half the year, however, the concerns about Europe and the state of the economy led to sharply elevated volatility and, in the case of high yield bonds, negative price performance. All three market segments finished the year on tract to produced mid-single digit returns but trail the return of U.S. Treasuries.
Somewhat surprisingly given the government debt problems in Europe, the developed-market international bond markets finished the year with positive returns. While some markets - such as Greece, Italy, and Spain - saw yields soar as prices plunged, the global government bond market as a whole gained support from investors' preference for lower-risk investments.
A Look Ahead
In total, it’s fair to say that the bond market exceeded expectations in 2011. Considering that the market was pressured by the U.S. debt downgrade, a crisis in Europe, and apocalyptic predictions regarding municipal bonds, bonds delivered investors with a solid 12-month return – and with much lower volatility than what occurred in the stock market. For a look at what may be in store in the year ahead, see my 2012 Bond Market Outlook.
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.