December 2010

Fixed Income Market Recap

Despite ongoing open-market Government bond purchases by the Federal Reserve, investment grade bond prices declined in December. The most intense selling pressure occurring in the first half of the month, as the market continued to be buffeted by the selling pressure that commenced in November. The principal driver was a much better than expected holiday selling season and the positive spillover effect that surprise had on the broader economy. As was the case last month, the sharp selloff in the overall bond market was the overriding negative contributor to performance. The rise in interest rates was offset marginally by a slight tightening in credit spreads and an exceptionally strong performance in the High Yield bond market. Despite the sharp rise in interest rates associated with longer maturity bonds, interest rates for securities of less than one-year actually fell for the month.

Economic Overview
The unexpected improvement in domestic economic activity that materialized in November continued to drive rates higher. Coincident with the mid-term election, consumers began to appear more confident and willing to consume. Additional contribution to the acceleration in economic activity came from the manufacturing sector, which has recovered to pre-recession levels, and the stock market which finished the year less than a basis point from the two-year high. The irony is that interest rates hit a bottom just as the Fed outlined the details of its planned buyback of public securities. When viewed from the intramonth low yield in November to the intramonth high yield in December, interest rates on 5-, 10-, and 30- Treasury securities were all approximately 100 basis points higher.
However, the improvement in economic activity did little to calm either the troubled European government bond market or the domestic municipal bond market. On December 31st, the yield-to-maturity on 10-year government bonds of Greece, Ireland, Spain and Italy were all at, or near multi-year highs, as investors continue to believe that some form of default or restructuring is inevitable. Similarly, investors in the municipal bond market continued to reduce their exposure to the sector, resulting in a 194 basis point loss in the Barclays Municipal bond index. With municipal bonds now yielding more than 100% of U.S. Treasury notes, we believe municipal bonds offer an attractive value play and will be selectively be buying them for our taxable and tax-exempt clients.

Outlook
Looking forward, we expect volatility to be heightened and, with that, the opportunity to add value to the portfolio through active trading. Moreover, we believe that as the economy continues to expand, rhetoric from the Federal Reserve will begin to refocus from monetary stimulus to how they intend to sop up the massive amount of liquidity they’ve added in the last two years. Expecting that it will prove more problematic than they’ve acknowledged, 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.

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.

Outlook
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.

October 2010

Fixed Income Market Recap
Dominating attention through the month was the Federal Reserve with the Fed and Wall Street trading-desks attempting to out-game each other. Clearly, the Fed has not handled the idea and implementation of QE2 very well. When the concept was first floated, interest rates fell as the Fed had certainly hoped. Then, concluding that the easing was fully “priced-in”, traders sold bonds and pushed rates back up to the pre-announcement level. The Fed countered by hinting that QE2 would be bigger than first suggested. Rates tumbled and the cycle repeated itself. In our opinion, QE2 is a flawed strategy. The back and forth on interest rates and the public debate among Fed governors and presidents only serve to confuse and alarm consumers. Nonetheless, the Fed has committed and it’s their move. In 2001, the yield on the 30-year bond fell 40 basis points in two days on the news of the elimination of the security as a funding vehicle. With the interest rate spread between the 10-year and 30-year Treasury’s close to a record wide, a strategy of focusing purchases on the very long end of the yield curve could have a similar effect and force the entire term-structure lower. At least temporarily. Back in 2001, the 30-year rate rose back to the pre-announcement level one month later.

Economic Overview
Buried amidst the monetary policy rhetoric, recent economic activity has showed some sign of improvement. Specifically, Retail Sales grew at a faster rate than was expected. Similarly, recent news on housing sales and new home inventory hinted that the worst may be behind us. However, the employment picture has yet to signal that job creation is imminent. While employment is a lagging indicator, the naggingly high unemployment rate is likely to continue to be an impediment to acceleration in economic growth. With the holiday selling season rapidly approaching, it will be telling to see if consumer spending will hold up. If it does, the possibility exists that it could be enough to ignite a virtuous circle with enough momentum to make a meaningful dent in the unemployment rate. If such an outcome were to materialize, talk would quickly shift from quantitative easing to the mountain of excess reserves sitting in the banking system.

Outlook
Anticipating continued heightened volatility and mindful of the potential for extreme moves in the capital markets, we continue to maintain a defensive posture in the portfolio and have implemented long option positions to mitigate the impact of an extreme outcome.