The majority of major central banks across the globe remained extremely accommodative. While the European Central Bank and the Bank of England were steady, the Bank of Japan increased the size of their asset purchase program. China injected further liquidity in their economy while Australia, Brazil and Korea reduced their policy rates. A common goal across the globe was to maintain a low interest rate environment to (1) stimulate economic activity (through lower borrowing costs); (2) to maintain competitive currencies so exports will be more attractive (higher exports are positive for domestic Gross Domestic Product (or GDP) and (3) to encourage portfolio rebalancing in an effort to appreciate asset prices. The surfacing of the banking crisis in Cyprus was another reminder that the financial crisis in Europe is not over and will have to be dealt with for years to come. Eventually, Europe’s economy will have to gain traction and generate positive economic activity in order to service its debt.
A common phrase is bull markets “climb a wall of worry.” The markets have a great deal to worry about at this time, but investors’ risk appetite has brushed off these concerns and pushed riskier assets, such as equities and high yield bonds, to higher levels. The broad domestic bond market, as measured by the Barclays Capital Aggregate Bond Index (“Aggregate Bond Index”), posted a quarterly return of -0.12%. In comparison, the S&P 500® Index, a broad measure of U.S. stocks, was up 10.61% during the first quarter.
Basic “bond math” is that bond prices rise (appreciate) when interest rates fall, and vice versa. Thus, all things being equal, bond investors want interest rates to fall to elevate bond prices. Since the early 1980s, the bond market has benefitted from a consistent tailwind of declining interest rates. This secular trend is now in transition. Today, yields are at historically low levels without much room to fall further; thus, there is not much potential for bond prices to appreciate, which limits total return capabilities. As a result, investors have become keenly focused on yield and taking on more risk to obtain that yield. The question in the marketplace today seems to be — “Are bond investors being compensated for the risk being taken?" For the first quarter, bond returns were generally moderately negative, with no sector posting meaningful positive absolute returns.
Monetary policy in the U.S. remained accommodative during the quarter, as the Federal Reserve maintained the federal funds rate at 0%-0.25%. Given the reports of moderate improvements in the U.S. economy, interest rates moved up modestly in the mid and longer end of the yield curve, causing the curve to steepen. With a rise in interest rates, the U.S. Treasury sector was one of the poorer performers, posting a quarterly return of -0.19%. Long-duration U.S. Treasuries, which are more sensitive to interest rate changes, were more negatively impacted, generating a return of -2.89%. The quarter ended with the 10-year U.S. Treasury and the 30-year U.S. Treasury yielding 1.85% and 3.10%, respectively. As previously written, expect upward pressure on U.S. Treasury yields on the intermediate and long end of the yield curve if economic conditions improve further, which would prove bearish for the U.S. Treasury sector. For the quarter, portfolios that were underweight the U.S. Treasury sector were generally better performers.
Non-U.S. Treasury sectors generally performed better, but not all generated positive quarterly returns. The U.S. investment-grade (defined as credit quality of BBB- or higher) credit sector produced a quarterly return of -0.11%. Returns within the corporate bond sector varied widely during the period, with industrial bonds performing the worst at -0.69% compared to financial bonds that generated a return of 0.88%. Corporate bonds trade at a spread (or risk premium) to U.S. Treasuries and were trading below their long-term average at quarter-end due to strong investor demand and low corporate defaults. U.S. agency mortgages, a large constituent of the Barclays Aggregate Bond Index, was one of the few bond sectors that posted a positive absolute return at 0.12% for the quarter.
High yield bonds (defined as below investment-grade corporate bonds) were one of the top performing sectors, posting a quarterly return of 2.89%. Like investment grade corporate bonds, this sector continues to be supported by low default rates and investors’ risk appetite. Also, many high yield issuers are taking advantage of the low interest rate environment to refinance existing debt and improve their balance sheets. Spreads for high yield bonds were also trading below historical levels at quarter-end. After strong performance in 2012, emerging markets debt posted a quarterly return of -1.46%.
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