Fixed-Income Market Monitor Archive

January 2008

Overall though, December was pretty tame as the biggest move was less than 10 basis points. But what a wild ride it has been for the benchmark 10-year Treasury in 2007. It began the year with a yield of 4.70%, hit a high of 5.29% in June, plunged to a low of 3.84% in November, before ending the year at 4.02%. In terms of total return, The 10-Year had a modest loss of 0.20% for December but a rock solid gain of 9.72% for the year.

The Year in Review

• The Fed was active again this year, but this time around they were taking interest rates in a different direction - lower. Chairman Bernanke was forced to reduce short-term borrowing costs three times in response to a near crisis situation. The 100 basis point reduction in Fed Funds may end up being more symbolic than anything else though, at least where housing is concerned. As I’ve noted in previous reports, high borrowing costs were not what was troubling the housing market, over-priced homes combined with loose lending standards were.

  Sticking with housing, the market and participants re-learned a lesson that many apparently forgot. While financial engineering has enabled the creation of all sorts of nifty derivative products, those products don’t eliminate risk. They merely transfer the risk off one party’s books and onto another’s. The low costs associated with this maneuver sometimes led to taking on more risk and introducing even riskier mortgage products. Keeping it simple sometimes really can be the best option.

• Summarizing what is perhaps the quote of the year in bond-land and spoken by many that we have heard: … “but we only hold the highest-rated tranches…” One day in December, S&P laid that claim out cold and proved how fleeting a “AAA” rating can be when they cut the rating on a “AAA” rated derivative CDO all the way down to “CCC-”.



• Looking to our Fixed-Income Index box below we can see that the best performing sector of the year was U.S. Treasury Inflation Protected Securities or TIPS. This marks quite a nice turn-around from 2006 when TIPS (inflation-linked securities) just barely broke even. Part of the reason for the outsized performance in this sector was the flight to quality that occurred as a result of credit market concerns. Add in the fact that oil, gold and other commodities were rising sharply and it’s not too much of a stretch to see inflation brewing down the road so bonds linked to inflation had a special appeal. The performance of this asset class once again demonstrates how last year’s dogs can quickly become next year’s darling.

The broader U.S. Treasury index performed well for much the same reason as TIPS – fear in the rest of the market. This performance helped drive the total return on the widely used Lehman Aggregate Bond Index. We dissect this index regularly and it’s roughly 36% weight in Treasury and other Government securities helped lead it to a return of 6.97%, besting the 5.53% total return of the S&P 500 in 2007.

The final story in the Treasury sector has to be T-Bills. Although the return of 5.01% is only 19 basis points better than 2006’s return, it does not tell the story of what occurred here. Since July we have seen amazing price swings and volatility in what is usually a relatively calmly traded security. Three month Bill yields ranged from 5.02% on July 24th to 2.75% intra-day on December 13th. This was mostly in response to frenzied buying by money market and other short-duration managers who lost confidence in the commercial paper market. That lost confidence is the result of the credit crunch and investors questioning just about everything other than Treasuries that went into money market funds. Managers needed the safety and liquidity that only T-Bills in this case could provide.

In High Yield we can once again see how one year’s extreme performer becomes the next year’s extreme in the opposite direction. The more risky “Caa” component of the HY index went from first to worst as the credit crunch and concerns of weakened economic activity going forward harmed this sector. Moody’s cautions that default rates will quadruple in 2008 because “the era of easy credit comes to an end and economic growth slows.” To be fair, the default rate was only 1% in 2007 – the lowest it has been since 1981. One can rationally argue that it had nowhere to go but higher.

Emerging Market debt continued perform okay, but well off its pace of the past few years. One theory says that a “decoupling” has occurred and that an economic slowdown in the U.S. does not necessarily translate to a slowdown elsewhere – thus the power and benefit of globalization. Others are not so sure. That theory has yet to be tested according to one famed equity manager. Either way, EMD spreads did widen out by about 60 basis points as the year drew to a close in November and December. That might not be a terribly significant widening, but it is a reversal in direction.

You’ve just got to love the Municipal bond market and how independent it is of the rest of the bond market. The muni indices we follow here are higher-quality and all investment-grade-rated. Yet unlike the Treasury market, where the longer the duration the better the return, in munis it was actually shorter duration securities that outperformed, and by a fairly substantial amount at that. There are a few reasons, such as Tender Option Bond programs unwinding and the fractured nature of the muni market in general, that we won’t get into in detail at this time, but once again we saw munis marching to the beat of their own drummer. Municipal bonds end the year being very cheap relative to Treasuries as muni yields are now very close to 100% of the treasury yield. And the muni income, of course, is tax-exempt.

Christopher Keith
Fixed-Income Manager