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Fixed Income Sector Review

Written by Dwight Sector Specialists

GOVERNMENT-RELATED DEBT

Steadily improving economic conditions and heavy new issuance put upward pressure on Treasury yields during the fourth quarter, leading to a loss of 1.3% in the Treasury component of the Barclays Capital Aggregate Index. The yield curve also steepened as the Fed reiterated its commitment to holding the target overnight lending rate at the zero-bound for an "extended period" while Congress continued on a path of seemingly unrestrained federal spending. Net of maturities, the Treasury issued over $250 billion in new securities and increased its total debt outstanding by more than $400 billion in the fourth quarter, to finish the year with over $12.3 trillion worth of IOUs. Yields on 2- and 10-year notes rose 19 and 53 basis points, respectively, while the yield on 30-year bonds rose almost 60 basis points, closing at 4.64%, just shy of their highest level of the year.

Meanwhile, with more than $1 trillion of excess reserves sloshing around on the Fed's balance sheet, some investors also began to grow increasingly concerned about the risk of an eventual buildup of inflationary pressures. This view was manifested in a continued widening of TIPS inflation breakevens, which increased from an implied 10-year rate of inflation of 1.75% at the beginning of the period to over 2.4% by the end of December. Moreover, 5-year forward 5-year inflation breakevens, a closely watched gauge of long-term inflation expectations, rose over 30 basis points in the fourth quarter to end the year above 3%.

Agency securities and other government-related debt outperformed Treasuries during the fourth quarter as a scarcity of AAA-rated bonds left investors with limited alternatives for their high-grade portfolios. Continued large-scale purchases of agency debt and agency mortgage-backed securities by the Fed and scant new issue supply in asset-backed and commercial mortgage-backed securities helped drive spreads on agencies five basis points tighter on average, according to Barclays Capital Aggregate Index data. The modest incremental yield earned on these securities, coupled with the spread tightening over the period, produced excess returns of 37 basis points over Treasuries. Government-guaranteed bank debt issued under the FDIC's Temporary Liquidity Guarantee Program (TLGP) also tightened in spread during the quarter, but remains cheap relative to agencies. Although the TLGP sector does not enjoy the same liquidity as the agency market, its unconditional federal guarantee and spread advantage make it an attractive alternative to Fannie and Freddie debentures.

Given the unresolved questions concerning the future of the housing agencies and the absolute level of spreads, we believe that investors are no longer adequately compensated by owning agency debt and are generally underweight the sector relative to our broad-market benchmarks. We continue to believe that risks are skewed toward higher interest rates in 2010 and are positioned slightly short of our duration benchmarks. While we do not anticipate a rapid rise in inflation in the near term, we believe that real yields are likely to remain biased higher. The factors supporting this view include ongoing improvement in economic conditions, continued heavy debt issuance, an increase in private sector borrowing, and the gradual completion of the Fed's large-scale asset purchase programs and eventual removal of monetary policy accommodation. While the economy remains vulnerable to an exogenous shock, barring any major surprises we anticipate that yields on 10-year Treasuries will breach 4% and possibly rise above 4.5% by the end of the year.

CORPORATE CREDIT

Investment-Grade Corporates – Investment-grade corporate bonds closed out a historic year with a solid quarter, posting a total return of 1.35% and outperforming duration-matched Treasuries by 3.07%. The sector posted a total return of 18.68% for the year and beat Treasuries by 22.76%, with an option-adjusted spread that ended the year 383 basis points tighter at 172 basis points.

Corporates began the quarter on a solid footing as economic data and third-quarter earnings generally came in better than expected. This fundamental backdrop, combined with a dearth of issuance during the earnings black-out period, caused the corporate market to reach new tights in early November. This rally came to a sudden halt later in the month, however, as state-owned Dubai World announced a standstill on near-term maturities, indicating liquidity issues. With the prospect of a default in the Middle East, both the international and domestic debt market paused to re-evaluate risk in their respective markets. Ultimately, a cash injection from Abu Dhabi aimed at easing Dubai World's liquidity concerns and a continuation of the aforementioned fundamental and technical factors helped the rally to regain momentum.

While the market remains in recovery mode from an economic standpoint, valuations are certainly not where they were twelve, six, or even three months ago. This indicates that while value remains in the corporate sector, diligent credit selection and sector rotation will become more important in adding value for 2010. That said, we are maintaining an overweight to corporate bonds with an overweight to the banking, and metals and mining sectors. Primary risks to our view include a disruption in the economic recovery, a dramatic uptick in corporate leverage led by aggressive merger and acquisition activity or shareholder-friendly behavior, and an unexpected increase in new issue supply.

High-Yield Corporates – The high-yield market closed out 2009 with an impressive 6.19% total return for the fourth quarter. Incremental improvement in key economic indicators coupled with an active primary calendar provided the impetus for advancement. Excess returns against duration-matched Treasuries approximated 6.90% as the high-yield sector was able to absorb the late-year increase in Treasury yields. For the year, the Barclays Capital High Yield Index returned a record 58.21%, a far cry from the -26.16% return the sector provided in a panic-stricken 2008.

As increased tolerance for risk returned to the financial markets, the primary market reopened—initially to the highest-quality issuers and eventually to all companies along the credit spectrum. Ready access to the primary markets allowed companies teetering on the precipice of default to restructure their balance sheets and refinance near-term maturities. Increased investor demand for paper allowed companies to term out senior lending facilities and extend bond maturities. With greater flexibility, many companies now have several years to grow into their capital structures as the economy continues to mend. Accordingly, the default rate—which began the year at 5.53% and peaked in November at 13.76%—is expected to decline closer to historical averages and approximate 5% by the end of 2010.

Despite the remarkable rally in high yield, we believe that spreads remain compensatory given our constructive economic view. We will retain our high-quality bias as spreads of lower-quality CCC names have rallied much more relative to higher-quality tiers and offer less compelling risk-adjusted return potential. In addition, we expect to continue to actively 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 municipal bond market continued to benefit from very limited tax-exempt issuance and strong demand throughout 2009. The Barclays Capital Municipal Bond Index returned -0.96% in the fourth quarter, and put in a phenomenal year-to-date performance of 12.91%. The sector had its best year versus the Barclays Capital U.S. Treasury Index in 2009, outperforming by 34 basis points for the quarter and 16.84% for the year.

Total issuance for 2009 came in at $409 billion, the second-highest level on record. Tax-exempt issuance was down slightly from 2008 levels, while taxable issuance increased to $85 billion, which includes approximately $64 billion in Build America Bonds. A supply-and-demand imbalance that left a dearth of long paper, the relative safety of the asset class, and continued concerns about impending tax hikes were the primary contributors to municipal bond performance during the year.

The current highest federal tax bracket of 35% will sunset at the end of 2010 and revert back to 39.6%. Many states have already raised taxes, and we expect that to continue into the foreseeable future as states look for ways to close budget gaps. While tax hikes should increase the appeal of tax-exempt municipal debt, we also believe investors will continue to harbor concerns about some of the same issues we have discussed throughout the year, namely the deterioration of state and local government tax receipts, declining property values, headline risk, ratings downgrades, double-digit unemployment, and record federal deficits.

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STRUCTURED PRODUCT

Mortgage-Backed Securities – The mortgage-backed securities (MBS) sector returned a meager 0.57% in the fourth quarter of 2009. On a duration-adjusted basis, MBS outperformed Treasuries by 75 basis points, marking the sector’s fourth straight quarter of strong relative performance. For the year, mortgages returned 5.89% and outperformed Treasuries by 495 basis points. Mortgage-backed securities had an incomparable year as they began 2009 near their cheapest valuations ever, and finished near their richest.

The Fed continued its purchase program and was the main contributor to MBS performance for both the quarter and the year. As rates rose in December, mortgage supply from originators dried up while the Fed continued to buy, causing MBS to richen.

Non-agency mortgage prices were relatively stagnant for much of the quarter as most dealers closed their books early and were unwilling to take any risk for the remainder of the period. For the year, however, prices were up massively. The credit crisis peaked around the end of the first quarter, and since then prices have increased 20 to 40 points. Similar to other structured product sectors, supply-and-demand dynamics overwhelmed fundamentals. Despite deteriorating collateral, valuations increased significantly, indicating that investors were running less-draconian scenarios.

We increased our underweight position in agency MBS during the fourth quarter. With the Federal Reserve nearing the end of its purchase program, we continue to be concerned that mortgages will perform poorly without that backstop. We expect non-agency mortgages to perform well going into 2010, as investors search farther afield for ways to add value.

Commercial Mortgage-Backed Securities – The commercial mortgage-backed securities (CMBS) sector finished the year on a positive note, providing a total return of 3.27% and outperforming duration-matched Treasuries by 3.74% in the fourth quarter. The CMBS sector was the top-performing sector in the Barclays Capital Aggregate Index for the year, posting total and excess returns of 28.45% and 29.6%, respectively.

The big news of the quarter was the re-emergence of the CMBS new issue market. In mid-November, Goldman Sachs brought a deal to market resembling those that originated the securitized commercial real estate market in the 1990s—a single borrower with a small number of relatively large but very conservatively underwritten loans. The solid deal structure and improved loan underwriting brought buyers to the table and the bonds traded well. Other broker-dealers followed suit with similar deals, and more are said to be in the pipeline for 2010.

Government programs continued to provide a backstop to the CMBS sector. However, lack of clarity from the Fed and Treasury concerning acceptable collateral and compressed spread levels contributed to diminished utilization of both the Public-Private Investment Program (PPIP) and the Term Asset-Backed Securities Loan Facility (TALF).

During 2009 we saw strength in technical factors drive spreads in the CMBS market tighter in spite of deteriorating fundamentals. While we believe the sector's positive carry and relative value are compelling, it appears that there will be a steepening of the credit curve as investors increasingly favor performing loans and well-structured deals, leading to a division between the "haves" and the "have-nots." Our bias toward solidly underwritten, earlier-vintage deals and bonds that sit at the top of the credit structure should benefit from this steepening. We will continue to keep a slight overweight in the sector and monitor sector fundamentals in an effort to minimize portfolio risk.

Asset-Backed Securities – The asset-backed securities (ABS) sector of the Barclays Capital Aggregate Index posted a total return of 1.34% and outperformed duration-matched Treasuries by 1.68% for the fourth quarter of 2009. The sector showed significant improvement during the year, posting a total return of 24.72% and outperforming duration-matched Treasuries by 24.96%. Outperformance was widespread among ABS subsectors; however, the auto and credit card market were the primary contributors to overall returns.

The initiation of the Federal Reserve's TALF program was instrumental to the improvement of the consumer ABS sector. This program revitalized the new issue market and brought interest back to the sector. TALF managers and money managers alike were pleased with the increased credit enhancement, solid underwriting, and overall structural strength of the ABS deals. As spreads tightened and the volatility of the market decreased, investors aggressively returned to the ABS market, allowing it to become one of the top performers in the Barclays Capital Aggregate Index for 2009.

ABS consumer products ended the year very quietly, as issuance was muted and many investors were satisfied with their current positioning. The subprime market continued its recovery from lows earlier in the year, a trend partially driven by the Public-Private Investment Program contributing to positive sentiment and the Street building up inventories in anticipation of increased investor demand. Lack of supply, combined with increased investor interest, outweighed deteriorating fundamentals.

Going into 2010, we expect the volume of issuance to be flat to slightly lower than the 2009 level. TALF concludes in March and issuers may look for alternative sources of funding. Supply will likely remain constrained, which could lead to further tightening of spreads. We will opportunistically reinvest in the consumer sector, concentrating on top-tier, AAA-rated classes with low spread duration. While we are comfortable with our current subprime positioning, we will continue to sell bonds that we believe to be overvalued relative to weakening fundamentals.

CASH

In the money market sector, year-end supply constraints sent short Treasury yields into negative territory. The federal effective rate, the average rate at which depository institutions lend balances to one another, closed out the year at a record low of 0.05%. Some investors were forced to pay depositors to take their late day funds so as to avoid even stiffer penalties for uninvested cash imposed by clearing banks. This abundance of liquidity is clearly evident by observing the spread between LIBOR and the overnight indexed swap (OIS) rate, which is a measure of the willingness of banks to lend. This LIBOR-OIS spread, which widened to over 350 basis points in the wake of the Lehman collapse, closed the year at a meager 9 basis points. This places us well below the 25 basis point threshold widely considered normal.

As evidenced by the broad-based asset inflation that emerged in the second half of the year, investors have once again embraced the risk trade. What is difficult to discern, however, is how much of the rebound in the economy is the result of government spending and subsidy versus real demand. The debate surrounding an exit strategy for the Federal Reserve is sure to heat up this coming year as the Fed tries to stay ahead of the curve. In the meantime, the Fed has been quick to reassure anyone who will listen that it has "no shortage of tools" for firming policy…when the time is right.