In the first quarter of 2012, fixed income returns were monotonically related to risk as the most speculative fixed income instruments performed the best and lowest-risk instruments lagged. In the second quarter of 2012, fixed income returns followed the opposite pattern as the highest-quality instruments posted outsized returns compared to more speculative securities. The third quarter featured a mixture of both patterns, with the inflection point for returns happening in late July as risk markets began outperforming flight to quality instruments amidst optimism for central bank intervention in the United States and abroad. This article discusses the relative performance of various fixed income asset classes in the last quarter, and implications for future returns.
U.S. Treasury Bonds
Below is a chart of the change in yield in the third quarter for the benchmarks of the Treasury yield curve.
The front of the yield curve rallied slightly as the Federal Reserve extended its commitment to exceptionally low rates into mid-2015, anchoring short Treasury securities. The longer end of the curve sold off slightly, steepening the term structure of interest rates. Most of the increase in long Treasury yields occurred the day after the Fed's announcement of a third round of quantitative easing as markets priced in the longer-term inflationary effects of continued balance sheet expansion and that the Fed's commitment to bringing down the unemployment could strengthen economic growth.
Agency Mortgage-Backed Securities
With the Federal Reserve's recent announcement of a third round of quantitative easing, mortgage-backed securities issued by Fannie Mae, Freddie Mac, and Ginnie Mae saw meaningful spread tightening. The open-ended nature of the Federal Reserve's balance sheet expansion is aimed at lowering the unemployment rate, and will essentially absorb the net supply of mortgage issuance in the United States for the foreseeable future. Forty billion dollars per month of purchases of Agency mortgage backed securities will keep mortgage spreads tight. sending the rate on conventional mortgages to its all-time low of 3.4%. Investors in mortgage REITs, leveraged holdings in mortgage-backed securities, have continued to benefit from the central bank's efforts to lower longer-term interest rates and mortgage financing rates. As the credit component of Agency Mortgage Backed Securities compresses towards all-time lows, owners of Agency-focused mortgage REITs' future return profile will more closely resemble a levered Treasury portfolio.
Global Sovereign Bonds
In an extension of the "risk-on" mentality that permeated the majority of August and September and drove the S&P 500 (SPY) to a four-year high, the best performing global sovereigns in the third quarter were the beleaguered PIGS. In the table below displaying the ten-year benchmark bond of a host of countries, the sovereign yields of Portugal, Italy, Greece, and Spain compressed the most. As seen in the earlier table, U.S. Treasury bonds hit their year-to-date lows on July 25th, the same day that the weakest European sovereign yields hit their quarterly highs. The next day, European Central Bank president Mario Draghi pledged to do "whatever it takes" to save the euro, marking the aforementioned inflection point in fixed income markets in the third quarter. The words were later backed by action as the ECB pledged to buy one to three-year sovereign bonds in exchange for recipient governments signing onto a program of fiscal discipline.
Troubled sovereign bonds weakened into the end of the quarter as Spain used the market rally to forestall a formal bailout request. This leaves sovereign bonds in a precarious position. Spanish Prime Minister Mariano Rajoy openly pined for ECB intervention when Spanish yields were stuck at unsustainably high levels, but a market rally and looming Spanish elections has slowed his rhetoric. Sovereigns will only implement reforms if the market forces them, which means we are likely to see frenetic moves in the PIGS sovereigns again in coming periods.
The return profile of corporate bonds in the third quarter exhibited a seeming negative credit convexity. Return on high grade bonds were an increasing function of risk, but returns flattened out as investors dipped into high yield. For much of the quarter, triple-CCC bonds lagged the upper bound of high yield before staging a late quarter Fed-fueled rally as investors used the positive macro backdrop to reach down the credit spectrum.
For more detailed thoughts on the relative valuation of high yields bonds as they approach all-time low yields, see yesterday's article: "The High Yield Corporate Bond Conundrum". The article discusses the conundrum investors face given the rise in high yield bond prices towards record highs, but palatable spreads given low bond defaults.
Tax-exempt municipal bonds returned 2.3% on average in the second quarter, positioning the return of this high quality asset class between AA and A rated corporate bonds. While stories surrounding idiosyncratic municipal default risk will remain in the news, the asset class as a whole remains well positioned given right-sized municipal budgets and rebounding tax receipts.
Emerging Market Bonds
Emerging market bonds continued their astounding 2012 performance. While dollar-denominated emerging market corporate issuance has already surpassed annual record issuance through the third quarter, even stronger investor demand has driven returns as fixed income investors seek assets in nations with lower public debt ratios and positive growth dynamics.
The unleash of a third round of quantitative easing benefited non-agency mortgage backed securities and commercial mortgage backed securities. The Federal Reserve's absorption of the net Agency mortgage issuance continues to push investors out the credit curve to assets with higher carry. CMBS issuance rebounded in September, but the increased supply was easily digested by the market given the favorable macro backdrop.
Risky fixed income assets in totality generated another strong quarter. As yields continue to fall, the risk/return dynamics across the fixed income spectrum continue to be skewed further to the downside. With the 2012 return for high yield bonds and emerging market debt now solidly in the low double digits, the vast majority of returns to be achieved in 2012 are in the rearview mirror. Expect another risk flare out of Europe to renew concerns about the sovereign debt crisis and its potential detrimental impact on the continent's financial system. While much uncertainty remains about the path forward for fiscal and economic integration in the eurozone, we do know that market stress will have to once again be an ingredient to spur action.
This is the obvious downside case for fixed income assets. The less obvious downside case is that the domestic fiscal cliff is addressed expediently post-election, and Europe pacifies short-term market concerns. These collective actions would lead to an increase in Treasury yields, and negative returns on high quality fixed income instruments. High yield bonds, emerging market debt, and topical structured securities would perform well under this scenario, but trail more favorably valued global equities.