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Second Quarter 2013 Fixed Income Market Review

The second quarter marked a change in course for the bond market due to comments given by the Federal Reserve (“Fed”). Over recent quarters, the fixed income markets were characterized by money flowing into riskier fixed income assets due to investors seeking higher yielding securities amidst the wave of the Federal Reserve’s quantitative easing. The Fed’s accommodative monetary policy (federal funds rate of 0% - 0.25%), coupled with the purchase of $85 billion in securities per month, maintained short-term rates at artificially low levels. Expectations in the market were for the current monetary policy, including the security repurchase program, to continue throughout 2013 and into 2014 given domestic economic growth was modest and unemployment and inflation were below the Fed’s publicly stated targets. (The unemployment rate of 7.6% was well above the stated threshold of 6.5%, and the inflation level of roughly 1% was below the Fed’s 2% target). Although somewhat unintuitive, the equity markets and riskier segments of the bond market had been reacting positive to news of modest (not high) economic growth with the thought the Fed would continue its benevolent accommodative policies which provided a safety net of last resort for the domestic economy.

Investors and the capital markets quickly changed their focus in the second quarter with the concept of the Fed “tapering” or reducing its security repurchase program becoming the overwhelming central theme. The capital markets had expected the tapering of the repurchase program to be the first step in the Fed’s measured efforts to reduce quantitative easing, but the shock to the capital markets was the potential timing. The Federal Reserve surprised the markets by stating that it may begin reducing the security repurchase program over upcoming months and as soon as September, despite economic indicators being well short of target. Markets, generally speaking, do not like surprises and tend to act (or overreact) very quickly when unexpected events occur. This change in expectations defined the second quarter, leading to a strong elevation in U.S. Treasury rates and an increase in credit spreads. As a result, this environment proved difficult for bonds during the period as almost all sectors and bond indices posted negative returns. In other words, investors did not have a place to hide within the bond market during the second quarter other than in cash or money market funds. The broad domestic bond market, as measured by the Barclays Aggregate Bond Index (“Aggregate Bond Index”) posted a quarterly return of --2.32% bringing its year-to-date performance down to -2.44%. In contrast, the broad U.S. equity market, as measured by the S&P 500® Index, posted quarterly and year-to-date returns of 2.91% and 13.82%, respectively.

With U.S. Treasury yields adjusting to new expectations, the performance of the U.S. Treasury sector was negatively impacted by the rise in interest rates although the sector did outperform some other sectors during the quarter. U.S. Treasuries posted a quarterly return of -1.92%. Long-duration U.S. Treasuries, which are more sensitive to interest rate changes, were more negatively impacted, generating a quarterly return of (5.81%). The quarter ended with the 10-year U.S. Treasury and the 30-year U.S. Treasury rising sharply, yielding 2.49% and 3.50%, respectively, compared to 1.85% and 3.10% at the end of the first quarter.

Non-U.S. Treasury sectors did not fare any better. The U.S. investment grade (defined as credit quality of BBB- or higher) credit sector posted a quarterly return of -3.31%. All underlying segments of the credit market were negative with financial bonds performing the best at -2.78% while industrials and utilities were down (3.49%) and -3.99%, respectively. Demand for the sector declined as investors’ concerns over rising interest rates elevated which led to much lower flows into bond funds during the quarter.

U.S. agency mortgages, a large constituent of the Aggregate Bond Index, posted a negative absolute return of -1.96% for the quarter. Rising interest rates caused mortgage durations to extend during the period due to modifications in prepayment assumptions while concerns over mortgages supply/demand dynamics surfaced due to the potential tapering in the Fed’s purchases of mortgages.

High yield bonds (defined as below investment grade corporate bonds) posted a quarterly return of -1.44%, outperforming its investment grade counterparts. Spreads widened in this segment of the market despite evidence of modest economic improvement and strong corporate balance sheets. The higher yielding orientation of these securities helped offset price depreciation, limiting the impact to negative returns.

Emerging market debt suffered during the second quarter, generating a return of -6.22%. A strong U.S. dollar, lower commodity prices, slowing growth in China and fund outflows hurt the sector.

In summary, the bond market experienced a difficult period during the period primarily in response to the Fed signaling a tapering of its bond repurchase program. As a result, the bond market is attempting to revalue securities based on fundamentals and without the “distortion” of the Fed’s repurchase program. It may take some time for the capital markets to appropriately absorb this change in expectations and as a result, bond prices may be volatile. The good news is that the economic environment has possibly improved to levels that may warrant a reduction in quantitative easing.


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