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Second Quarter 2014 Fixed Income Market Review

The U.S. is roughly six years removed from the great recession of 2008. Since that time, the Federal Reserve (“Fed”) has utilized aggressive monetary policy, including unprecedented quantitative easing to spur the economy from the depths of the financial crisis. Other major central banks around the world, including the European Central Bank and the Bank of Japan, are also in the midst of implementing aggressive policies. Such a backdrop has provided somewhat of a “safety net” for investors and has led to a material appreciation in riskier assets, such as stocks and high yield bonds, while bringing overall asset price volatility to very low levels. During this quarter, investors were more than willing to take risks (“risk-on” trades) despite uncertainties in the global markets, leading to record highs in the equity markets and continued spread tightening in the bond market. (Note — spread is the yield gap between U.S. Treasuries and other bonds which reflects the amount of compensation investors demand to be paid for taking the incremental additional credit risk. A decline or narrowing in spreads generally results in price appreciation.) Returns experienced year-to-date, in both the equity and bond markets, are well ahead of expectations established at the beginning of the year. The S&P 500® Index, the proxy for the broad domestic equity market, was up 5.23% for the quarter (and 7.14% year-to-date) and the Barclays U.S. Aggregate Bond Index, the proxy for the broad U.S. fixed income market, was up 2.04% for the quarter (and 3.93% year-to-date).

The second quarter began with some questions related to the strength of the U.S. economy. The U.S. economy had been showing signs of modest economic growth and improvement in employment, leading to discussions about the timing of future actions by the Fed. However, gross domestic product (“GDP”) came in at -2.9% for the first quarter. The setback in economic growth was largely blamed on a historically cold winter, dampening economic activity during the period, as well as a surprise reduction in spending on health care. As economic related reports came in during the second quarter, it became increasingly apparent the economy was improving and the setback was most likely temporal. Most notably, consumer confidence improved and the unemployment rate fell to 6.1%. Forecast for second quarter GDP is around 3.0%. With economic conditions improving, the capital markets are balancing the tailwinds of economic growth with the opposing headwind of monetary policy normalization (tapering and future rate hikes).

Given much of the “risk-on” trading activity is currently undergirded by the global accommodative monetary policies (i.e., low interest rates), all eyes were on the Fed during the second quarter, with its last scheduled meeting taking place in June. As expected, the Fed maintained the federal funds rate at 0%–0.25% and announced it will continue to taper (or reduce) its asset purchase program by $10 billion per month. As written in last quarter’s commentary, consensus is for the tapering to continue at its current pace and will be completed by the end of October 2014. More notable, Janet Yellen, chair of the Fed, made “dovish” comments following the latest meeting. She downplayed threats of inflation and indicated that the Fed was willing to bear inflation exceeding target levels in the short-term as long as unemployment is at elevated levels. In other words, expectations are for the Fed to possibly keep rates low longer than conditions warrant in an effort to ensure the labor markets and the economy improves at the risk of enduring inflation. If this does in fact play out, the Fed risks putting itself in a position where it must quickly reverse course and be very aggressive in its tightening efforts in an attempt to quickly curb inflation. Although market pundits differ on the exact timing, it is generally anticipated that the Fed will implement its first rate hike by mid-2015.

During signs of improving economic activity, U.S. Treasury yields surprisingly fell during the quarter. For illustration, the yield on the 10-year U.S. Treasury declined from 2.72% to 2.53%, while the yield on the 30-year U.S. Treasury fell from 3.56% to 3.36%. Current consensus, in general, is for the 10-year U.S. Treasury yield to reach 3.00% at year-end, well below prognostications given at the beginning of the year. Given the inverse relationship between yields and bond prices, investors in U.S. Treasuries benefited from both income and price gains. In general, longer maturity U.S. Treasuries outpaced their shorter-dated counterparts given they are more interest-rate sensitive. The 10-year U.S. Treasury posted a quarterly return of 2.66%, compared to the 30-year U.S. Treasury return of 5.24%. Amazingly, the 30-year U.S. Treasury bond has generated a year-to-date return of 13.77%. Overall, the U.S. Treasury sector posted a quarterly return of 1.35%.

Declining yields and tightening spreads made it a very favorable environment for all bond sectors. In general, the more risk taken by an investor and the longer the maturity, the higher the return experienced. The U.S. investment grade (defined as credit quality of BBB- or higher) credit sectors posted a quarterly return of 2.66%, making it the top performing sector among all investment grade domestic bond segments during the quarter. This sector continues to benefit from narrowing spreads. Spreads, or risk premiums, are currently at very narrow levels, reflecting low default risk, a moderately improving economy, strong balance sheets and very low market volatility. Within the corporate sector, industrials were the best performers followed by utilities and financials. From a credit perspective within investment grade, BBB-rated corporates were the top performer during the quarter at 3.18%. Despite the Fed’s tapering efforts (reduction in mortgage purchases), spreads for mortgages also narrowed, benefitting from low rate volatility and demand for incremental yield. Mortgages posted a quarterly return of 2.41%.

Benefitting from the “risk-on” environment, other extended sectors posted solid positive absolute returns for the quarter. Like investment grade corporates, high yield bonds (defined as below investment grade corporate bonds) generated a strong quarterly return, up 2.41%. Performance for high yield was sound across all rating segments with the BB segment at the top, returning 2.65%. Investors' “insatiable” appetite for yield in the low rate environment has pushed spreads to historically low levels.

The best performing sector during the quarter was emerging market debt, generating an impressive quarterly return of 5.81%, bringing the sector’s year-to-date performance to 9.47%. The sector has benefited from some improvements in geopolitical risk, especially associated with Russia/Ukraine. Attractive valuations relative to developed market securities, low volatility and strong inflows also benefitted the sector.

In summary, the bond market added to positive returns gained in the first quarter. Going forward, bond investors should be closely watching economic growth. Many anticipate rates to stay “range bound” given economic growth is slowly improving while the Fed is tapering. Eventually, it is expected that rates will rise due to higher economic growth and potential inflationary pressures which would provide a headwind for bond returns and most likely increase price volatility.


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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.