U.S. Treasury Bonds
As equity markets and other risky assets performed strongly in the first quarter, the traditional flight to quality instrument, U.S. Treasury bonds, had their worst quarter since the end of 2010.
Source: Bloomberg, U.S. Treasury
Stronger economic data prints in the United States, especially in the labor markets, reduced market expectations of further asset purchases from the Federal Reserve. A stronger economic recovery, coupled with rises in oil prices, has also raised the specter of accelerating inflation. Investors earning a nominal return from Treasury bonds would need to be compensated more if inflation rose to earn a commensurate real return.
The rate sell-off in U.S. Treasury bonds left holders facing comparatively more negative returns compared with other 10-yr maturity sovereign debt. Given the "risk-on" attitude of global markets, it should not be a surprise that top performers included issuers with greater credit spread components: Greece, Italy, and Spain. Of note, Spain did not join the rally. Spanish 10-yr debt, which enjoyed a nearly 200bp advantage to Italian sovereign debt at the beginning of the year, now trades 20bp behind its southern European counterpart, consistent with my end of January prognostication.
State and local government debt returned roughly two percent on average in the first quarter as marginally tighter credit spreads offset higher Treasury yields. Year to date issuance has rebounded from historically low levels in early 2011, but net issuance should remain negative as strengthening municipal balance sheets reduce the need to come to the market outside of refinancing debt into lower coupons. Most municipal credit profiles will remain stable, but their is rising pockets of municipal distress for local issuers, which will bear watching. On the taxable side, Build America Bonds continued to grind tighter moving within ten basis points of their all-time tights. As municipal credit spreads tighten towards their long-run average, returns on municipal bonds will become more linked with future interest rate movements. Presumably, this would most negatively affect the BAB (BAB) market, which is predominantly very long duration issuance.
Investment Grade Corporate Bonds
Corporate bond returns in the first quarter were directly related to risk as seen in the chart below. Credit spread tightening in lower quality ratings cohorts drove excess returns and outperformance; while the interest rate sell-off lowered relative returns in the ultra high quality segment where spread tightening was more muted. Underperforming sectors in 2011 led the way in 2012 as Yankee banks were the best performing sector in investment grade. Investors call on financials will still dominate their return profile given the weight of this sector within investment grade, and the variability of returns that this sector has experienced. Investors who want to increase their investment grade bond yield should not look to extend out the yield curve. Investors should prefer to add leverage (through margin or embedded in closed-end funds) to bonds and bond funds with shorter durations and show preference to the intermediate part of the curve which has some positive roll-down and carry.
High Yield Corporate Bonds
High yield returns in the first quarter were impressive. As we close in on credit cycle tights reached in May 2011, expect high yield to take a little bit of a breather. In the high quality end, BB-rated bonds are now in many instances call-constrained as the embedded optionality caps further appreciation. The lower quality end of the spectrum will continue to see strong issuance as lower tier companies tap favorable markets to term out bank debt, improve their debt distribution, or add incremental leverage at favorable coupons. The strong calendar effect of high yield corporate bonds is not a factor I take lightly, and I strongly believe that over half the return in high yield corporate bonds was achieved in the first quarter.
Non-agency residential mortgage backed securities have to be the most heterogeneous sector in all of fixed income. Differences in the structure, cash flow profiles, collateral performance, vintage, borrower type, issuing shelf, and servicer all contribute to driving disparity in security-level returns. Absent a standard benchmark for cash securities, it is also difficult to gauge the average performance of the market. Securities backed by prime (high FICO score, but non-conforming loan size) and Alt-A (credit challenged borrowers between subprime and prime) collateral have rallied back or through their highs of last May. Subprime remains the laggard. Overall, the market appears to be approaching full valuation. Market volatility and increased secondary supply from the Fed's sale of the Maiden Lane portfolio in mid-2011 put pressure on prices. The asset class continues to shrink absent new issuance and given either prepayments or defaults. While it would appear that there is more downside than upside at current levels, the absence of supply and the "hunt for yield" in spread sectors could drive more marginal upside.
CMBS returns were directly related to capital structure position and vintage in the first quarter of 2012 as lower structure positions (i.e. higher risk, more embedded leverage) and more recent vintage deals (i.e. the loosest underwritten deals occurring closest to the start of the credit crisis) outperformed. Generic 2007 vintage A4s (the longest sequential of the "super-senior" tranches) and AMs (so-called "AAA Mezzanine" with typically a 20% attachment point and 30% detachment point) tightened by approximately 50 basis points and 150 basis points respectively. Lower quality AJs, "AAA Juniors" with a 10% attachment point and 20% detachment point, and even higher levered mezzanine and subordinate tranches typically outperformed to an even greater extent, but returns were disperse and deal dependent based deal-level interest shortfalls and expected losses. Retail investors should be cognizant that owning an AJ tranche with 10% credit support is 10x levered through the CMBS pool, and that these securities are inherently risky. Owning higher quality tranches that cannot be completely wiped out by rising commercial loan defaults in a leveraged vehicle (i.e. on margin or in a closed end fund) is probably a more palatable option.
Emerging Market Corporate Bonds
Gains in emerging market corporate debt have been solid with returns on investment grade rated securities average approximately 4% and speculative grade returns around 10%, far outpacing domestic credit.
I expect higher spread sectors to continue to outperform prospectively albeit at a more moderate pace than the gap tighter experienced in the first quarter. I also continue to expect equities to outperform both credit and rate markets. Higher interest rates will continue to drag down the performance of the highest quality segments of the fixed income universe.