Are Bonds Boring Again?

October was marked by a significant drop in volatility in global bond markets. In the United States, speculation that the recovery is modest at best has suggested that the Federal Reserve will be able to follow through on its plan to keep interest rates "exceptionally low" for an "extended period."

The Morningstar US Core Bond Index, our broadest measure of the U.S. bond markets (including governments, corporate, and mortgage-backed bonds), rose 0.4% in November and is up 5.0% year to date.

Weaker Dollar Aids Treasuries
U.S. Treasury buyers managed to absorb the recent record supply with only a small increase in yields. Foreign buyers increased their holdings for a fourth consecutive month as the declining dollar made Treasuries cheaper. On the flip side, should the dollar's weakening persist, those same foreign investors will see a decline in the value of their dollar holdings.

The record supply, which has no doubt been a drag on performance year to date, is expected to slow down significantly in the fourth quarter. Domestic buyers are unlikely to abandon Treasuries anytime soon, while futures markets project a rate increase is on hold until the second half of 2010. Banks continue to participate in a big way, borrowing at very low overnight rates to buy higher-yielding bonds and, in the process, shoring up their balance sheets. The Morningstar US Treasury Index fell 0.05% in October and is down 2.45% on the year. The U.S. Treasury market remains the only domestic sector with negative performance year to date.

Economic indicators are providing few hints of inflation but this has failed to prevent money pouring into Treasury Inflation Protection Securities (TIPS). Rising commodity prices and the falling dollar are heightening the fears of inflation. Investors can take comfort in the fact that TIPS are still cheap from a historical perspective (yield differential to nominal Treasuries is lower than the five-year average). The Morningstar TIPS Index has gained more than 10% this year, outperforming nominal Treasuries by more than 12%.

Corporate Credit Settles In
The breakneck pace of the corporate credit rally has decidedly slowed as yield premiums continue to move toward long-term historical averages. Some have cautioned excessive borrowing at low rates to buy risky assets, including corporate bonds, has reinflated bubbles that could lead to a repeat of the crisis. The ongoing debate with respect to corporate credit worthiness is, what would be the impact of the inevitable retreat of the government from the markets? Fixed-income investors are well-experienced in guessing the Federal Reserve's next move and managing systematic risk. New to the investment equation is the qualitative easing that has propped up bond prices and rescued segments of the private sector.

The financial sector continues to play catch-up to nonfinancial corporate sectors and has outpaced both the industrials and utilities for the third consecutive month. The Morningstar Corporate Financial Index gained 1.55% in October, while industrials and utilities gained 0.28% and 0.16%, respectively. To argue for additional outperformance, with the premise that the crisis has passed, one can reference pre-crisis 2006 levels, when financial sector yield premiums were lower or equal to those of the nonfinancials. At the end of October the financial yield premium of 2.28% is 0.5% higher than industrials' and 0.4% higher than utilities' yield premiums.

The broad corporate credit market as measured by the Morningstar US Corporate Index gained 0.74% in October and 16.6% for the year. European corporate credits have also taken pause following a very strong first three quarters. The Morningstar EUR Corporate Index has gained 10.4% on the year and the UK Corporate Index has gained 8.41%.

Risk Produces Returns
Money continues to flow into the riskiest of emerging-market regions, in some cases producing 2009 country-level returns in excess of 100%--Pakistan 169%, Argentina 132%, and Ukraine 113%. The yield premium to buy emerging-market government debt fell 27 basis points in October and 300 basis points on the year. The Morningstar Emerging Markets Sovereign Index has returned 24.5% year to date. Risk-takers in most credit markets have been handsomely rewarded so far in 2009 with total returns in excess of anything seen in history. Investors' fears of the downside have been replaced by fears of missing huge upside potential. Whether the buying is rational and at true value will likely be borne out in the balance of the year.