Fixed-Income Market Monitor Archive

July 2008

• We did not see a full scale flight to quality in the bond market this June, like we saw earlier this year, but there was clearly a preference for quality as the lower you went down on the quality scale, the lower your returns were. The leader once again was the Treasury Inflation Protected Securities index and we can see in our data box below that inflation-linked debt is noticeably pulling away from all other sectors. (It will be interesting to see how that sector does over the next couple of weeks as TIPS auctions populate the new issue calendar.) The Treasury index returned 0.79% for the month but it was not enough of a return to erase the damage from prior months and this index registers its first quarterly decline (falling 2.1%) since dropping 0.43% in 2Q07. The benchmark 10-year Treasury closed the month with a yield of 3.96% and a YTD return of 2.03%
  
  
• The results from the late June FOMC meeting marked a shift in Fed policy. I could argue that the Fed took one step closer to raising interest rates by taking one step away from lowering them further, but there remains intense debate about whether or not they should resume rate cuts, let alone contemplate increases. That fact is that Chairman Bernanke and Fed decided to leave rates unchanged for now. What did change though was their assessment of risks facing the economy. In their statement, they emphasized the risk of higher inflation over the downside risk to growth. The economists we have followed for years tell us that this "tilt toward inflation fighting amid economic weakness, contracting housing and ongoing credit stresses puts the Fed in a bind. The Fed was careful not to provide any guidance about the timing of any rate hikes."
  
  
• The high yield market traded off during the month to the tune of ~ 2.80% and is now back in negative territory on the year. This occurred amid a fairly heavy new issue calendar that saw more than $15B come to the market in June. This heavy volume of new issuance came to market in spite of an expected upward spike in the default rate. Roughly 20% of the below investment grade market is trading at distressed levels (1,000 basis points above Treasuries) and renewed concern about the health of the auto sector is not helping. Spreads on debt from the big three auto makers have widened out to the point that suggest some pretty tough times ahead.

  There are a couple of reports circulating around predicting that high yield debt's first cousin, high yield bank loans, will see recovery rates from defaulted issuers drop. Moody's is forecasting that 1st lien recovery rates will decline to about 68¢ on the dollar, down from their historical average of 87¢. Still, some HY managers we have spoken with like the prospects of the loan market better than that of traditional HY bonds. That is because bank loan debt was considered a bit safer than traditional bonds. Loan holders are considered senior creditors and as such they are ahead of bondholders. We're told that for the Loan market to outperform the debt market that two events need to occur simultaneously - rising interest rates and rising default rates. It is arguable that we now have both. It does get a bit uncertain though should the default rate on loans move up sharply as is being predicted.
  
  

• The muni market did not perform well in June. The market endured a two-week losing streak before netting a positive day toward month end. Undoubtedly the further downgrades to the muni insurers had something to do with this. We also saw significant new issue volume during the month, which added a little pressure. Many of the auction-rate bonds that were redeemed were done so through refinancing with longer, more traditional structures. As for the insurance, one report suggests that only a quarter of new issue volume is coming to market with insurance as opposed to about half over the past few years. The yield on the Bond Buyer Weekly 20 Index closed at 4.83%. Not as high as they were in February, but giving back the performance we had in April and May.

Lehman Fixed Income Index Returns Through 6/30/08
Lehman Index	Duration	June		YTD		Ret . '07		Ret. '06		Ret. '.05		Ret. '04
US T Bill Index	0.27	0.17	%	1.26	%	5.01	%	4.82	%	3.05	%	1.24	%
US Treasury Index	5.15	0.79		2.23		9.01		3.08		2.79		3.54
US TIPS Index	7.00	1.53		4.88		11.63		0.41		2.84		8.46
US Aggregate Bond Index	4.68	-0.08		1.13		6.97		4.33		2.43		4.34
US Govt/Credit Index	5.30	0.10		0.98		7.23		3.78		2.37		4.19
US Credit Index {A2}	6.17	-0.53		-0.48		5.11		4.26		1.96		5.24
US High Yield Index {B1}	4.51	-2.80		-1.31		1.87		11.85		2.74		11.13
Caa Component	4.53	-2.96		-1.72		-0.13		17.66		0.64		13.80
Emerging Market ($$) {BA2}	6.53	-1.98		-0.21		5.21		9.96		12.27		11.89
Municipal Index	7.83	-1.13		0.02		3.36		4.84		3.51		4.48
Municipal Index - 5 Year	4.09	-1.02		1.11		5.15		3.34		0.95		2.72

Christopher Keith
Fixed-Income Manager