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First Quarter 2014 Fixed Income Market Review

The year 2014 began with optimism given the robustness of the U.S. equity markets and continued improvements in the U.S. economy that have been buoyed by the Federal Reserve’s accommodative monetary policy. Investors that have had exposure to riskier assets such as U.S. equities and high yield bonds have benefited from the “risk-on” environment during the past year.

However, robust “risk-on” markets do not last forever. The market sentiment shifted to be “less positive” during the first quarter due to a broad array of factors including softening domestic economic reports blamed on a harsh, cold winter weather which dampened economic activity; continued concerns over the health of several emerging markets economies, including China, and the potential “spill-over” impact to the larger developed economies; and the geopolitical concerns related to the battle between Ukraine and Russia over the Crimean Peninsula region. Early in the first quarter, U.S. stocks corrected and interest rates fell while both reversed course later in the period. The overall market sentiment did not shift to a strong “risk-off” environment whereby riskier assets such as equities were severely punished, but the overall tone was one of slightly more caution and higher volatility during the quarter than at previous year’s end. The broad domestic bond market, as measured by the Barclays U.S. Aggregate Bond Index, posted a quarterly return of 1.84%, slightly outpacing the quarterly return of the broad U.S. equity market of 1.81%, as measured by the S&P 500® Index.

During the first quarter, the Federal Reserve had two regularly scheduled meetings, with the last meeting occurring in March. The Federal Reserve maintained the federal funds rate at 0%-0.25%; however, several noteworthy announcements came out of the last meeting. First, the Federal Reserve, as anticipated, will continue to taper its asset purchase program by $10 billion a month. Therefore, starting in April, the Fed will purchase agency mortgage-backed securities at a pace of $25 billion per month and will add to its holdings of U.S. Treasuries at a pace of $30 billion per month. If the tapering in asset purchasing continues at its current pace, the repurchasing program will be completed in November 2014. Additionally, the Federal Reserve updated its forward guidance by eliminating the 6.5% unemployment rate threshold, moving to a more qualitative assessment. This announcement was somewhat anticipated given discussions over the declining unemployment rate. Lastly, Chairman Yellen, in her post FOMC conference, suggested that the first rate hike could occur as soon as six months after the tapering process is completed. This indicates that the Federal Reserve’s first rate hike could be as soon as mid-2015. On this news, U.S. Treasury yields generally backed off of lower levels set earlier in the quarter.

Despite Yellen’s “more-than-expected” hawkish comments, U.S. Treasury yields fell during the quarter, providing a tailwind for bond returns. For illustration, the yield on the 10-year U.S. Treasury declined from 3.03% to 2.72%, while the yield on the 30-year U.S. Treasury fell from 3.97% to 3.56%. In general, bonds with longer maturities (or durations) outperformed their shorter-term counterparts given longer maturity bonds are more sensitive to interest rate movements. For example, the 10-year U.S. Treasury Bond posted a quarterly return of 3.38% compared to the 30-year U.S. Treasury Bond’s impressive quarterly return of 8.11%. Overall, the U.S. Treasury sector posted a quarterly return of 1.34%.

In addition to U.S. Treasuries, most other bond sectors posted positive returns during the quarter. The U.S. investment grade (defined as credit quality of BBB- or higher) credit sector posted a quarterly return of 2.94%, which led all investment grade domestic bond segments for the quarter. U.S. corporate bonds continued to benefit from high demand as investors seek higher yields in the low rate environment. The demand for corporate bonds caused further compression in risk premiums, or spreads, during the quarter. Within the corporate bond sector, utilities were the best performers followed by industrials and financials. U.S. agency mortgages, a large constituent of the Barclays U.S. Aggregate Bond Index, posted a quarterly return of 1.59%. Mortgages outpaced U.S. Treasuries but lagged corporates.

Other extended sectors posted positive absolute returns for the quarter. High yield bonds (defined as below investment grade corporate bonds) generated a quarterly return of 2.98%. Performance for high yield was solid across all rating segments with the CCC segment returning 3.31%. Credit spreads for high yield continue to narrow as investor demand remained solid. Yields in this segment have materially declined over the past few years, making some question how much longer investors will take on this amount of credit risk at these yield levels. This segment, which is often correlated with the equity markets, outpaced the S&P 500® Index during the period.

Despite geopolitical and economic concerns across the emerging markets, emerging markets debt posted a quarterly return of 3.48% as some viewed the segment as an attractive value opportunity.

In summary, the bond market posted a respectful return during the first quarter, already outpacing its negative absolute return produced during 2013. However, expectations going forward for the bond and equity market should be one of higher volatility with more muted absolute returns. The bond markets will be faced with prospects of potentially higher interest rates during the “rate normalization process” as the Federal Reserve tapering continues. On the other hand, the equity market, which some argue is at or nearing full valuation, is becoming increasingly dependent on earnings growth (and not multiple expansion) for positive returns.


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All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.

GuideStone Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.