Fixed-Income Market Commentary Archive

April 2009

March Fixed-Income Review

• March was a rebound month for the markets and it was nice (relieving) to see that equities and bonds got back on the positive performance track. That, of course, is something I like to see from both.

• Throughout the month, the Treasury market continued to absorb huge amounts of new issues ($98B in just the final full week of the month) as government spending soars. At times it seems as though the market pauses and wonders about the demand for all these new Treasuries. This has led to some negative performance around the auctions, but when all was said and done, the Treasury index closed in positive territory for March, up 2.1%. Inflation-linked Treasuries (TIPS) were also strong performers and the index that tracks them returned 5.8%.

• I believe part of the reason for the good performance in TIPS centers around the intensifying inflation-or-deflation debate. On the deflationary side you have the argument that job destruction, wealth destruction and the combined pullback in consumer and corporate spending more than offset the growth in the government's balance sheet. On the inflationary side we have the liquidity measures, government / stimulus spending and the resulting massive federal deficits that eventually will catch up and quite possibly lead us into an elevated level of inflation. This could also leave us and others around the globe fearful of a sharp devaluation in dollar-denominated assets. We are warned that this is what happens when governments (such as ours) use a fiat based currency. A fiat based currency is a system where a government issues legal tender, however it is not backed by anything (gold or silver) other than that government's word.

• I sat down recently with JP Morgan economist and Chief Market Strategist, Dr. David Kelly and asked him what might be early warning signs of inflation. He urged us to have protection (we strongly agree!) and suggested that at some point we will see growth in the economy. When that occurs the unemployment rate begins to drop and then, should it drop rapidly, that could be a signal.

• There are a few ways to add inflation protection and among the ones we like is the use of a TIPS fund. We like TIPS for their high quality, but you also get this added benefit of an inflation guard. Internally we measure the attractiveness of the asset class by following the "break-even-inflation" spread on 10-year TIPS versus conventional 10-year Treasuries. This spread is the yield difference between these two securities. Using it as our proxy, we have seen inflation expectations rise over the past couple of months. At month's end, the BEI spread was 1.31%. In simplest terms, this means that investors are predicting an inflation rate of only 1.31% over the next ten years. By way of comparison, at year-end 2008 the BEI spread was only 0.12%. Even though there are times when TIPS move lock-step with conventional Treasuries, in an inflationary environment they should perform better than nominal Treasuries.

• The Federal Reserve is becoming even more involved in shaping the landscape with the commencement of their program to buy U.S. Treasuries. This is being done in an effort to control the longer end of the yield curve, which, in theory, would drive rates lower for home mortgage and consumer loans. The program is part of the "quantitative easing" policy (akin to money creation) and is just one more way the Fed is being innovative as they do their part to try and help stimulate economic growth. A brief from a Bloomberg News story says that the government and the Fed "have spent, lent or committed $12.8T, an amount that approaches the value of everything produced in the country" (GDP) last year.

• I was a bit surprised by the High Yield market's performance in March. Not that I didn't expect positive returns (we are on the record as recommending a modest allocation here), but it was that the "junkier", lower rated component fared so well. The "Caa" component handily beat the higher rated "B1" component. I found this unusual because default expectations are rising and recovery rates are falling. For our part, we are sticking with the more conservative exposures.

Christopher Keith
Fixed-Income Manager