This is my fourth quarterly examination of various fixed income markets. I generally try and publish the article by the beginning of the second trading week following quarter-end, giving me time to analyze trailing results and synthesize my thoughts. Given Friday's outsized rally in long Treasuries due to BOJ easing and a meaningful miss on the U.S. non-farm payrolls print, perhaps I need to shorten my timeline.
The recent market move notwithstanding, the first quarter of 2013 should be a microcosm of the market we will see over the next several years. Slowly rising Treasury yields produced anemic bond returns in the first quarter with most higher risk instruments outperforming due to modestly compressing credit spreads. The days of equity-like returns in domestic fixed income fueled by monetary accommodation are likely largely in the rearview. This article will discuss how to position your fixed income portfolio in a market where excess returns will be more scarce prospectively.
As seen above, Treasury yields sold off modestly in the quarter with the yield curve steepening. The front end of the yield curve remains anchored by the Fed's commitment to keep rates low through mid-2015. The long end of the curve has been where the action has been, and with Seeking Alpha readers actively debating the merits of various levered (UBT) and inverse levered long Treasury bond funds (TBT,TMV, TTT), will continue to generate activity and interest. With Treasury bond volatility now roughly equivalent to the trailing volatility of the S&P 500 (SPY), this market will continue to be a place for traders to tactically position with the hopes of short-term gains. January saw a sharp sell-off as the fiscal cliff reprieve gave way to a broad rally for risk assets, lowering the price of safe haven securities like U.S. Treasury bonds. A late March Treasury rally reversed a portion of bond losses as the Cypriot depositor bail-in sparked concerns about a renewal of the European Sovereign Debt Crisis. In the table above, I included Treasury yield moves through Friday's close because the Treasury rally has pushed the intermediate and long part of the curve to new year-to-date lows.
Like levered Treasury bond funds that have garnered increased interest in Treasury bonds from retail investors, investors' interest in mortgage REITs has increased the importance of the Agency MBS market to Seeking Alpha readers. The Agency MBS market continues to be driven by the Federal Reserve's open-ended commitment to continue to purchase $60-$80bn of Agency MBS per month. While the Federal Reserve is supporting the market on one hand, Fed Governor Jeremy Stein has recently warned about risk taking in the mortgage REIT market in a quixotic and hypocritical "do as I say not as I do" moment for market participants.
While mortgage REITs (REM) continued their strong performance in the first quarter, Agency MBS languished despite support from both the Fed and equity raises by Mortgage REITs. The MBS Index (MBB, MBG) performance in March was flat versus Treasury hedges, as the gains due to the higher coupon carry were negated by the widening mortgage/agency basis. March's underperformance followed February's weakness that was driven by concerns about the ultimate duration of Fed Purchases, and January's weakness given the large rate selloff.
Unlike the agency MBS market, the non-agency MBS market continued its strong performance in the first quarter as RMBS continues to be favored by fixed income investors as one of the highest spread sectors. Rising home prices, declining mortgage delinquencies, and a fledgling restart of the non-agency securitization machine have all benefited the asset class in recent periods.
Investment Grade Corporate Bonds
While the domestic equity markets produced solid first quarter returns, investment grade corporate bond spreads ended the quarter roughly flat. The Barclays Corporate IG Index, replicated roughly through LQD, produced a return of -0.11%. With corporate bond yields still hovering near historic lows, investors must be cognizant of the possibility of idiosyncratic re-leveraging events where companies take on additional debt, lowering the value of existing debt to the benefit of shareholders. External leveraging events at Dell (DELL) and Heinz (HNZ) were the most noteworthy, but activist intervention at Hess (HES), Transocean (RIG), and Life Technologies (LIFE) also pushed bond spreads wider.
Despite volatility in single issuers, returns in the first quarter were directly related to risk with AAA bonds lagging (-.76% total return) and BBB bonds outperforming (0.19%). More interestingly was the outperformance of financials (0.88%) relative to industrials (-0.69%). With leveraging events less likely to occur in the bank and finance space, and bank balance sheets continuing to strengthen, financial spreads traded through industrial spreads for the first time since late 2007.
High Yield Corporate Bonds
High yield corporate bonds ended the first quarter with yields on the Barclays Capital High Yield Index, proxied by ETF JNK, hovering near all-time lows at a yield-to-worst of 5.67%. Like investment grade corporate bonds, high yield corporate bond returns were monotonically related to risk with CCC's (5.79%) outperforming B's (2.73%) which outperformed BB's (1.96%). With the junk bond market continuing to offer historically low cost financing, expect additional M&A to occur, supported by this marketplace. Retail fund flows have been mixed and netted to a de minimis figure in the quarter. Conversely, the nascent leveraged loan fund market has seen robust flows as investors seek both the floating rate nature of loans to protect against higher interest rates and the security of the traditional seniority of loans in a company's capital structure.
Emerging Market Bonds
Hard currency emerging market corporate bonds generated flat returns in the first quarter, consistent with the low returns of high quality corporates despite their traditionally higher beta status. Like EM equities, which have decoupled with the US and Japan due to disappointing growth in the developed world, EM credit spreads lagged in the first quarter. The iShares Emerging Market Corporate Bond ETF (CEMB) lagged even the uninspiring returns in domestic investment grade, returning -0.14% in the first quarter.
Possibly the most interesting market in the first quarter was emerging market sovereigns, the lagging asset class in fixed income. Hard currency emerging market sovereigns returned -1.3% in the first quarter. The iShares Emerging Market Bond ETF (EMB) returned a disappointing -3.5% in the first quarter. In January, rising U.S. Treasury rates pressured EM countries with outsized external funding needs. Treasuries rallied late in the quarter based on developments in the Cypriot banking sector, but emerging market credit spreads in turn widened, especially in Eastern Europe. While the first quarter was an unfavorable period for emerging market sovereigns, government balance sheets in the developing world remain in better shape than their developed world counterparts, which should provide a longer-term favorable fundamental backdrop.
Commercial Mortgage-Backed Securities
While this is still a relatively small sector in the retail bond universe, the dramatic recovery in market prices over the last four years has important implications for the health of the overall market, especially the regional banking sector, which has a lot of commercial mortgage loans on its collective balance sheet. The high quality iShares Barclays CMBS ETF (CMBS) returned 0.31% in the first quarter, while higher risk AM and AJ securities produced returns equivalent to the speculative grade market.
Municipal bonds produced low nominal returns in the first quarter consistent with low returns in other high quality domestic bond markets. Total returns of the Barclays Municipal Bond Index, proxied by ETF TFI, were 0.42%, 0.30%, and -0.43% in January, February, and March respectively.
The Build America Bond Market (BAB) has been a source of investor interest and uncertainty in recent periods. With the sequestration reducing the federal interest subsidy on these bonds, there are concerns that the "Extraordinary Redemption Provision" in many of these bonds could be triggered. Given that this market is trading materially over par, this could lead to strong negative returns in individual issues. The BAB ETF produced 1.34% in the first quarter, a return entirely attributable to the coupon carry. With credit spreads near all-time tights and no new primary issuance of Build America Bonds, the performance of this orphaned taxable municipal market will largely be driven by the performance of the long U.S. Treasury bond.
With the Barclays U.S. Aggregate (AGG) producing a negative return in the first quarter at -0.12%, some might contend that the ballyhooed Great Rotation from fixed income and back into equities is under way. While this was the first quarterly loss for the broader bond market since 2006, we are unlikely to see a massive rise in interest rates and re-pricing of the bond market. The collective forces of global central banks just outweigh the collective might of bond vigilantes.
While markets are inherently forward looking, I write these bond market reviews because past returns in fixed income necessarily impact forward returns. When bond prices rise, yields decline, and since yield-to-maturity is a function of the bond price and its future coupon payments, understanding historical moves can help Seeking Alpha readers glean relative value. I hope that this article is an instructive examination of performance over the last three months, and can stimulate debate about forward returns.