November 2010

Fixed Income Market Recap
November could be characterized as a month in which old news, thought to be resolved and impotent, reemerged to the detriment of the capital markets. With attention focused on the Federal Reserve and its well broadcast plan to reduce rates through a second round of quantitative easing (QE2), investors had positioned their portfolios for a continued fall in rates. When the anticipated rate decline failed to materialize, traders were quick to shed holdings of Treasury notes, pushing interest rates more than 40 basis points higher mid-month trough-to-peak. Exacerbating the rate rise was an unexpected, but welcome improvement in domestic economic activity. Just as the Fed’s public handwringing spooked investors into pushing the 5-year treasury yield down to nearly 1% during the month, improvement in employment, retail sales, and manufacturing served to reverse that trend, launching the 5-year note yield 50 basis points higher on an intra-month basis.

Economic Overview
While investors were caught off guard by the unexpected volatility in Treasury notes, even greater volatility was evident in the Municipal bond market. A reemergence of state and local debtor solvency concerns gained steam throughout the month, culminating during the week of the 14th, during which investors staged a stampede out of the sector. Over the course of that week, $4.2 billion redeemed from municipal mutual funds; the single heaviest week of redemptions ever. Several high-profile, long maturity municipal bond funds were down between five and ten percent for the month.

Concurrent with heightened fears in the Muni market, investors again began to worry that the weaker peripheral countries of the Euro were at risk of default. Investors were cheered earlier this year with the bailout of Greece and what appeared to be a “more-than-sufficient” stabilization fund. However, as economic activity remained depressed throughout Europe, investors began to again worry that the weaker, peripheral countries were at risk of default. Such worry spiraled into reality with Ireland, as borrowers became unwilling to lend to the sovereign, ultimately forcing an EU bailout similar to what was extended to Greece. As was the case with the Greek bailout, a relief rally ensued and at the time of this writing, the as-yet-unrescued nations of Portugal, Spain, and Italy are enjoying a reprieve from default concerns. However, just as Ireland required a Greek-style bailout, we wouldn’t rule out a requirement of similar support for the three remaining peripherals.

As we head in to the final month of 2010, we continue to believe that the economy will continue to improve, and that fixed income investors have overpriced government and government-related debt. As such, we will continue to significantly underweight the government sector, overweight corporate notes, maintain a weighted average duration well below benchmark, and employ interest rate hedges.