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.

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.