Regarding monetary policy, the quarter began as the second quarter ended with investors and the capital markets continuing their expectations that the Federal Reserve would taper, or reduce, its security repurchase program over upcoming months, most likely at its September Federal Market Open Committee (FOMC) meeting. These expectations were borne from the Federal Reserve Chairman’s comments in May that the Fed would begin tapering when the U.S. economy could sustain moderate growth without the need for the same level of stimulus. With some signs of an improving economy, these expectations strengthened and became an overall consensus during the quarter, causing interest rates to increase materially over a rather short period of time. As evidence, the yield on the 10-year U.S. Treasury Note, the benchmark for borrowing costs, increased by 78 basis points from 2.11% on May 1 to 2.89% on September 15. Thus, the bond market had fully adjusted, or “priced-in,” tapering prior to the September meeting. This rising rate environment proved to be a headwind for the bond market, especially during August.
However, at the September 18 FOMC meeting, the Fed surprised, or one could even say “shocked,” the capital markets by electing to stay the course and not taper, continuing to purchase $45 billion in long-term U.S. Treasury securities and $40 billion in agency mortgage-backed securities on a monthly basis. The Fed announced that the tightening in financial conditions caused by a rise in long-term interest rates coupled with concerns associated with the U.S. fiscal policy (budget and debt ceiling) uncertainty led them to have worries over the sustainability of economic growth without continued monetary accommodation. Although surprised, the capital markets reacted favorably to this announcement as rates readjusted downward from August levels and riskier assets such as equities, high yield and emerging market debt benefitted. The declining rate environment in September proved to be bullish for bonds and pushed most sectors into positive territory for the quarter. After the Fed’s announcement, all eyes redirected focus to the looming fiscal impasse in Washington, D.C. The lack of agreement and constructive action by Congress led to elevating concerns over a government shut-down on the domestic economy under the looming deadline to raise the debt ceiling by October 17. September was further marked by the withdrawal of Mr. Larry Summers as a potential replacement for Mr. Bernanke. In October, the Administration nominated Fed Vice Chair Janet Yellen to replace Mr. Bernanke next year. Ms. Yellen’s positions on monetary policy are perceived to be very similar to the current chairman’s.
The broad domestic bond market, as measured by the Barclay’s U.S. Aggregate Bond Index (“Aggregate Bond Index”), posted a quarterly return of 0.57%, bringing its year-to-date performance to (1.89%). Bonds continued to trail equities which rallied during the period. The broad U.S. equity market, as measured by the S&P 500® Index, posted quarterly and year-to-date returns of 5.24% and 19.79%, respectively.
Almost all bond sectors posted positive returns, albeit modest, for the period. The U.S. Treasuries sector posted a quarterly return of 0.10%, lagging most other sectors during the quarter. In general, intermediate U.S. Treasuries fared better than their longer duration counterparts for the period.
The U.S. investment grade (defined as credit quality of BBB- or higher) credit sector posted a quarterly return of 0.82%, making it one of the better performers. All underlying segments of the credit market were positive with financial bonds performing the best at 1.54% while industrials and utilities were up 0.54% and 0.14%, respectively. September experienced a record amount of monthly issuance, pricing $135 billion in bonds with Verizon issuing the largest deal in history at $49 billion.
U.S. agency mortgages, a large constituent of the Aggregate Bond Index, posted a positive absolute return at 1.03% for the quarter. The sector benefitted from the FOMC’s decision not to taper which contributed to the demand/supply imbalance as the Fed continues to purchase mortgages on a monthly basis.
High yield bonds (defined as below investment grade corporate bonds) posted a quarterly return of 2.88%, outperforming its investment grade counterparts. The sector was positively impacted by its higher yielding orientation and the “risk-on” environment as the sector experienced positive fund flows. High yield bonds were one of the few segments of the bond market that generated positive returns on a year-to-date basis.
Emerging market debt recovered somewhat after a difficult first half of the year, generating a quarterly return of 0.51%. The sector benefitted from the Fed’s non-taper announcement which allowed the possibility of more liquidity being directed towards the emerging markets. The sector also benefitted from better than expected economic news coming out of China. This sector has struggled over recent periods due to fears of lower capital inflows and negative current account balances in several large countries including Brazil, India and South Africa.
In summary, the broad U.S. bond market posted its first positive quarterly performance for the year, largely due to the Fed’s announcement in September, causing a shift downward in interest rates. At quarter end, expectations seem to be centered on a modest, but ongoing economic recovery in the U.S. clouded by the possible negative implications of decisions made in Washington, D.C. Also, outlooks were for tapering to begin in the near-term and for Ms. Yellen to be approved as the next chairman of the Federal Reserve. Prospects for material positive returns from the bond market should be muted as rates remain at low levels and will most likely elevate as tapering begins.
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