Bond Markets & Research

• Market Update
• Newsletter
• Research
• Resources
• Treasury Yield Curve

Fixed Income Sector Review

Written by Dwight Sector Specialists

GOVERNMENT-RELATED DEBT

Treasuries rallied sharply in the second quarter as the European sovereign debt crisis led to deteriorating financial conditions and a reduction of global economic growth forecasts. Stubbornly high unemployment, waning fiscal stimulus, and accommodative monetary policy increased the appeal of Treasuries, leading to declines in Treasury yields and a flattening of the curve. The strong rally in Treasuries led to a hefty 4.69% return for the Barclays Capital U.S. Treasuries Index, its best quarterly performance since the fourth quarter of 2008.

Notably soft inflation data caused TIPS to lag the performance of their non-indexed counterparts during the quarter, with implied inflation breakevens moving sharply lower during the period. Low resource utilization should keep inflation low in the near term, but steady demand growth should prevent the current disinflationary trend from turning into outright deflation.

A relative lack of new issuance in high-quality fixed income assets helped maintain a stable tone in the agency market during the quarter. As a result, agencies matched the performance of duration-adjusted Treasuries during the period, with their modest yield advantage offsetting the effects of slightly wider spreads. With an average option-adjusted spread of just over 30 basis points, however, we believe that agency debt is rich relative to other high-grade assets, and remain underweight the sector.

We believe that further upside in the Treasury market is limited and that the risk/reward relationship favors higher rates in the second half of the year. We have positioned our portfolios modestly shorter than their duration benchmarks and have underweighted Treasuries in favor of high-grade spread product. We continue to believe that the economy is in a sustainable recovery, and that explosive growth in the monetary base and the nation’s fiscal deficits will set the stage for steadily rising interest rates in the medium to longer term.

CORPORATE CREDIT

Investment-Grade Corporates: Investment-grade corporates posted a positive total return of 3.42% in the second quarter, bringing the year-to-date total return to 5.79%. The sector trailed duration-matched U.S. Treasuries for the quarter by 225 basis points, reversing the first quarter’s outperformance and bringing year-to-date excess returns to -1.10%.

Investors reduced risk in May as several events added uncertainty to a psychologically fragile market. In addition to the general unease about the strength of the economic recovery, factors weighing on sentiment included concerns regarding European sovereign default risk, uncertainty surrounding the pending financial regulatory overhaul, potential litigation risk for financial issuers, and the fallout from the oil spill in the Gulf of Mexico.

As a result, the average yield on investment-grade corporate bonds ended the quarter 193 basis points above Treasury yields, which was 43 basis points wider than its level on March 31. All three major sectors, industrials, financials and utilities, posted negative excess returns relative to Treasuries. Industrials were the most resilient at -1.80%, while financials and utilities came in at -2.96% and -2.07%, respectively. Aerospace defense and diversified manufacturing were the only two subsectors able to muster positive excess returns. The subsectors with the largest negative excess returns were those with the greatest exposure to the Gulf spill. Oil field services registered -9.72% and independent energy posted -6.36%.

Even in a slower growth environment, we believe corporate spreads are compelling as they offer both an attractive yield relative to other investment-grade sectors and the potential for tightening. Given the current uncertainty in the market, sector rotation will continue to be an important driver of performance during the second half. Therefore, we will maintain our overweight positioning versus our benchmarks while continuing to closely monitor developments in the market that could impact the relative attractiveness of corporate credit.

High Yield Corporates: The high yield market had a rough second quarter as market participants reduced risk amid heightened uncertainty in Europe's southern periphery. In contrast to the first quarter, high yield lagged duration-matched Treasuries by 386 basis points and now trails duration-matched Treasuries by 36 basis points for the year. The total return was a modestly negative 0.11%, which lowered the year-to-date return to 4.51%—on pace for a coupon-like total return for 2010.

In many ways, the market’s second quarter performance was diametrically opposed to that of the first in terms of performance, issuance, and fund flows. While the primary market remained open, the pace of issuance slowed markedly from the frenetic pace of the first quarter. Moreover, spreads returned to year-end 2009 levels (700 basis points) erasing the earlier tightening. Lastly, investors withdrew approximately $3 billion from high yield mutual funds, countering the market-supporting inflows from the first quarter. Continuing in the spirit of the "opposites" theme, the BB credit tier outperformed the B and CCC credit tiers as investors modified their portfolios away from riskier names toward higher quality, more defensive credits. All told, company fundamentals remain on the positive trajectory of recovery as we continue to see incremental top-line revenue growth and cash generation. In addition, as companies focus on extending maturities and managing their capital structures, continued access to the primary market coupled with trend economic growth is critical to balance sheet improvement.

Despite recent volatility and spread widening, we believe that the high yield market remains attractive given our constructive economic view. We retain our high quality bias as CCC spreads are not compensatory on a risk-adjusted basis because of elevated jump-to-default risk. We expect to continue to selectively participate in the primary market given attractive pricing and deal structure. Lastly, we will continue to actively reassess our overall strategy pending changes in our economic view and in the quality and depth of the primary market.

Municipal Bonds: The total return for the Barclays Capital Municipal Bond Index for the second quarter of 2010 was a positive 2.03%, which brings the year-to-date total return to 3.31%. Once again, top-quality AAA and AA municipals outperformed lower rated A and BBB munis. New issue volume totaled approximately $96 billion bringing the first half total to $203 billion, which is 3.92% ahead of last year’s pace. We expect issuance to surpass 2009 volume of $409 billion.

In the taxable municipal market, spreads have been trending wider mainly due to anxiety over state fiscal deficits, unfunded pension liabilities, and prognostications in the press around the potential for increased municipal defaults. Taxable spreads widened 74 basis points in the quarter from their 2010 tights, and over this same period U.S. Treasury yields have declined 78 basis points. The total return for the Barclays Capital Taxable Municipal Bond Index was 4.64% and 8.21% for the second quarter and year-to-date periods, respectively.

While we acknowledge that states and local governments continue to struggle with severe fiscal pressures (46 states face a combined budget shortfall of $115 billion for the fiscal year-ending June 2011), we continue to believe that market concerns are overblown, with states having a wide range of fiscal management tools. Although there are some notable exceptions, by the time the 2011 fiscal year began on July 1, 2010, most states had passed balanced budgets as required by state law using the usual assortment of tools at their disposal. These include reduced spending, increased fees and taxes, and an assortment of one-shot solutions designed to get them through the current economic environment. While the fiscal environment will remain difficult for some time, we expect the vast majority of states to successfully manage their way through their challenges.

STRUCTURED PRODUCT

Mortgage-Backed Securities: The mortgage-backed securities (MBS) sector returned 2.87% in the second quarter of 2010. On a duration-adjusted basis, MBS outperformed U.S. Treasuries by 1 basis point. Mortgages reached record-high dollar prices this quarter, which is especially surprising given the absolute level of U.S. Treasuries.

The major event of the quarter was the fallout from Fannie and Freddie buying out delinquent loans. Post buyouts, higher coupon speeds slowed markedly causing them to outperform lower coupons on a duration-adjusted basis. Ginnie Maes also fared well as investors fled the buyouts in conventional mortgages. Investors also favored the improved delinquency disclosure of Ginnie Mae securities, which was enhanced to a security-level basis.

We believe the Fed is divided when it comes to asset sales. Selling its MBS holdings would placate the regional presidents and reinforce the Federal Reserve’s independence. We think the Fed will announce a small selling program sometime during the fourth quarter of this year, which will give the market clarity and the FOMC the ability to judge the impact. If the program is received well, we would expect the Fed to produce a regular schedule for selling off the rest of its holdings.

Non-agency mortgage prices showed some weakness this quarter. While AAA-rated bonds continued to show fervent demand, prices on below investment-grade bonds fell about 3–5 percentage points. Ratings downgrades pushed prices lower as fewer investors can purchase lower-rated bonds. Investors also became nervous about taking on more risk with the revelation of the crisis in Europe. Prices have since found some stability and we think these securities offer good relative value and will perform well.

We maintained our underweight position in agency MBS this quarter. We expect that mortgage valuations will bounce around for the better part of the year, but that on average they will cheapen.

Commercial Mortgage-Backed Securities: The commercial mortgage-backed securities (CMBS) sector was somewhat muted in the second quarter, delivering a total return of 2.78% but underperforming U.S. Treasuries by 67 basis points on a duration-adjusted basis.

Real money investors remained largely on the sidelines for the second quarter, unable to discern a definitive direction for the commercial real estate sector. While fundamentals such as lease rates, occupancy levels, and CMBS delinquencies continued to deteriorate, the pace of deterioration began to slow and the wide spreads relative to other sectors largely compensated investors for the fundamental weakness. The elephant in the room was macroeconomic uncertainty. While commercial real estate seemed poised to find a bottom in terms of price declines and regain some measure of strength, the specter of continued high unemployment and lowered economic growth expectations provided a headwind to any rebound, keeping the bulls at bay.

From a technical standpoint, buyers were able to absorb a lower volume of bonds for sale but there were few investors out actively looking for bonds or attempting to extend their long positions. Broker-dealer inventories were full with 2006–2007 vintage deals that have been perceived to carry more risk. There was some modest new issuance during the quarter, but new supply remained sparse. We saw a large multi-borrower conduit deal and a very high quality single borrower deal come to market, both of which were well received.

We continue to favor an overweight to the CMBS sector to take advantage of the positive carry and the relative value it provides. We maintain a bias toward earlier vintage deals and bonds at the top of the capital structure to mitigate the risk associated with deteriorating fundamentals or a meaningful backup in spreads for credits that may have appreciated too far for their risk profile.

Asset-Backed Securities: The asset-backed securities (ABS) sector of the Barclays Capital Aggregate Index posted a total return of 2.54% during the second quarter of 2010. On a duration-adjusted basis, ABS underperformed Treasuries by 8 basis points. Rate reduction bonds were the best performer in the ABS sector, posting a total return of 3.23%. We experienced some light volatility surrounding the news from Greece, but the sector was well insulated from any significant weakness.

AAA consumer ABS bonds sustained their rally during the second quarter. The strong demand of high-quality short-duration assets and limited supply technicals should keep spreads flat or potentially tighter for the remainder of the year.

The improved earnings of ABS servicers along with encouraging economic news for the consumer have been positive for performance and spreads. Credit fundamentals for consumer loans have been steadily improving over the course of the year. Delinquency rates, loss severities, and total net losses have continued to decrease. This should also support the positive trend in spread tightening we have seen thus far in 2010.

The home equity market had a relatively benign quarter compared to many other fixed income sectors. Investors continued to favor shorter, current-pay subprime bonds to reinvest cash at attractive loss-adjusted yields over longer, less credit-enhanced paper. Subprime collateral performance showed ongoing signs of stabilization over the last several months with late-stage delinquencies slowing and roll rates improving. A good deal of this improvement in fundamentals has been derived from increased servicer activity in making loan modifications and working through the backlog of foreclosed inventory.

We will opportunistically reinvest in the consumer sector, concentrating on top-tier, AAA-rated classes with low spread duration. We are comfortable with our current subprime positioning as the outlook for credit fundamentals continues to improve.

CASH

U.S. commercial paper outstanding has fallen 10.75% since starting the year to $1.03 trillion. The decline was led by a drop in asset-backed commercial paper (ABCP) and domestic financial commercial paper which declined 12% and 19%, respectively, over the period. The declines were partially offset by gains in both tier-2 and non-financial issuance.

Of the prevailing trends in the commercial paper market, the decline in ABCP is unquestionably the most remarkable. Since the peak of $1.2 trillion in the summer of 2007, the sector has declined 67% through mid-year 2010. While demand has been constrained in the wake of the credit crisis, a portion of the decline is due to looming regulatory changes such as FAS 166 and 167, whereby bank sponsors are moving to bring assets onto their balance sheets. This has had the added effect of entities being forced to either consolidate or wind down various programs.

Sovereign risk has been a large driver behind asset flows in the money markets as the situation in Greece and the broader EU has left global investors on edge. Foreign banks are typically large borrowers in the U.S. money market, although names with perceived headline risk, such as Spanish and Italian banks, have had more difficulty funding lately. In contrast, high-quality Australian, Canadian, and Nordic banks are trading well inside of 3 months where they have been funding at sub-LIBOR levels.

After spiking in early May, USD LIBOR has reached a temporary plateau as 3-month USD LIBOR hovers in the 0.53% area. Helping to ease the strains in the interbank funding market has been an extension of ECB refinancing operations, which provides temporary credit to eurozone banks. This has helped keep the spread between LIBOR and the overnight indexed swap rate (or the LIBOR-OIS spread, a closely watched measure of credit availability) in the low 30 basis point range after tripling at the start of May.