July 2010
Fixed-Income Review
At the Half
 Key Points:
• First-half review shows positive returns across the board
• Treasury investors continue to benefit from global economic weakness concerns
• Inflation continues to decline
It's time for my mid-year review of the fixed income markets and I am pleased to see positive returns across the board. When the year began there were a lot of market observers predicting that it would be a difficult year for fixed income because rates were so low to begin with and the economy was showing signs of improvement. We still have another half of the year to go, of course, but there have been no negatives in the indices we track through the first half.
One area that stands out is the strong overall performance out of Treasuries. I did not anticipate the Treasury market performing as well as it has in my initial 2010 outlook. I expected a period of modestly rising rates on U.S. Government debt due to the nascent economic recovery, the search for higher yielding assets and further easing of the effects of the credit crisis. For a while I was right in my expectations as the yield on the benchmark 10-year hit 4.00% intra-day in early April. The yield on the 30-year Treasury reached 4.84% around the same time.
A sharp rally in the Treasury market began shortly after hitting those levels and lasted right up until the last day of June. The first half closed with yields of 2.93% on 10s and 3.88% on 30s. They started the year at 3.83% and 4.64% respectively. As I wrote in the recent past, the flight to quality / flight to liquidity has been on since shock waves out of Greece rattled investor confidence. The concern that some sovereign debt is now at a higher level of risk due to higher debt loads and a weakened global economy that was spurred on by that excessive debt is the driving force. When the first half of the year ended, the Treasury index we follow in our data box below returned 5.86%. Not bad at all from a “risk-free” sector.
A quick review of the yield curve in the diagram below shows that, with the exception of T-Bills, rates are lower. Clearly Treasury bonds are benefiting from declines in other markets and asset classes around the world.
TIPS (inflation-linked bonds), which are Treasuries, but not part of the nominal Treasury index (TIPS have their tracking index) performed well too. The TIPS index was up 4.41%, but I believe a good part of that return was based on their riding the coattails of Treasuries, not due to excessive inflation concerns. The government's inflation index (Core CPI) now shows an annualized inflation rate of only 0.9%. This is as good a time as any to repeat my recommendations on Treasury / TIPS debt. My first point is that if you want the safety of Treasury debt, then why not select the inflation-linked component of it? Secondly, the time to buy insurance is before the house burns down, not after. Investors should think of TIPS as offering a level of inflation insurance.
The Aggregate Bond index, which used to be more “risk” oriented in nature now finds
itself much less so due to the fact that roughly 75% of it is comprised of government
guaranteed / supported debt (think Fannie and Freddie). This investment grade index
returned 5.33%.
The High Yield index returned 4.51%, clearly taking a breather after last year's stellar
run. We remain positive on this asset class for several reasons, including the
expectation that default rates will continue to decline and that companies in this sector
have proven they had the financial strength to survive the recession. The yield on the
index is hovering around 9% and the average dollar price is ~ $95.5, so there is plenty
of room for price appreciation from the underlying securities. Even if bond prices don't
move higher and provide total returns, the asset class is still providing a decent dividend
yield.
The Emerging Market debt asset class provided a strong month of performance to
close out the first half of the year, up 5.65%. This may be seen as surprising due to so
much negative news about sovereign debt woes, though much of this negativity is from
more developed economies in the European region. The bigger picture here includes
emerging Asia and Latin America, where the news is much different. The thought is that
any significant sovereign debt concerns will be more contained and not extend to these
areas. Having emerging markets exposure is a good way to diversify a portfolio. Of
course, it should be viewed with the same risk profile as corporate high yield debt given
that so much of it is rated below investment grade. We recommend an appropriate
allocation, but suggest the use of a mutual fund to gain that exposure. Please see our
firm's website where my colleague Jeff DeMaso posted a research paper that discusses
fund flows, including those into the emerging market debt asset class.
The Municipal bond market performed well, even though many are predicting that this
asset class could be in trouble. I don't doubt the seriousness of the budget imbalances
or downplay the severity of the cuts that need to be made. But anyone who doubts it
can be done, should take a good look at New Jersey. This state should be applauded
for making the hard choices and making the necessary cuts to balance the books. It can
be done.
Investors should focus on municipal issuers with dependable revenue streams that will
support their debt service. This includes municipal utility bonds (water / sewer, electric
and gas), general obligation debt (backed by income, sales or property taxes) and
bonds backed by user fees (toll roads and gas-tax fees). Universities and hospitals with
higher ratings and endowments would represent the next level of concentration. Most
other areas should be viewed with an added degree of attention and caution.
Thank you for reading and enjoy the summer.
Christopher Keith
Fixed-Income Manager
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