Reversal of Fortunes for Bonds

Having suffered record losses in December, U.S. bond markets witnessed a reversal of fortune in January. Investor demand for corporate credit combined with restrictive bank lending prompted a flood of issuance, as well as additional yield spread premium tightening.

The specter of Greece continues to loom over the global government markets, with Germany being a primary beneficiary of those seeking safety. The January optimism for economic strength faded late in the month with China's intent to deploy the drag chutes on borrowing and Washington's proposed banking reforms.

The Morningstar US Core Bond Index, our broadest measure of the U.S. bond markets (includes government, corporate, and mortgage-backed bonds), rose 1.5% in January.

Slow Death?
Sovereign credit deterioration has assumed a disturbing viral component, and has put both government and corporate lenders on edge. Moody's Investors Service opined that both the Greek and Portuguese economies may face a "slow death" as liabilities grow with little prospect for bolstering revenues.

The "PIGS" (Portugal, Ireland, Greece, and Spain) continue to underperform significantly relative to their European Union partners. The Morningstar Greece Government Bond Index fell 5.2% in January. In contrast, the German Government Index rose 1.4%. Over the last three months, Germany has outperformed Greece by over 12% (Germany up 1.6% versus Greece down 10.8%). Speculation surrounding the prospect of an actual Greek default was discredited by the head of the group of euro-area finance ministers, Jean-Claude Juncker, when he declared: "Two things won't happen: Greece won't go bankrupt" and "the hypothesis that a country will leave the euro group or euro zone is not a question. It's absurd."

In spite of record debt sales, U.S. Treasury yields fell in January on concerns the recovery experienced during the fourth quarter of last year is unsustainable. Futures markets suggest the probability of the Federal Reserve raising rates by June of this year has fallen to 20% from 53% over the course of the month.

The Morningstar US Treasury Index rose 1.5% in January while the average yield fell 0.3% to 2.2%. If investor surveys are to be trusted, 2010 will not be a reprieve from 2009, which witnessed the worst U.S. Treasury total returns in a decade. Yet, the Bloomberg survey described U.S. Treasury investors as the most bearish they have been in two years, and have expectations of the 10-year note yield rising to 4.14% at the end of the year--the 10-year is currently yielding 3.65%.

Credit Cleansing
Improving corporate balance sheets have kept demand for credits healthy. Yield spread premiums in the U.S. and Europe contracted in January. Rating agencies are now on pace to produce more rating upgrades than downgrades for the first time in three years.

The Morningstar US Corporate Index rose 1.6% in January, and the average yield spread premium now stands at 1.53%. Both the Morningstar EUR and Sterling Corporate Indexes rallied in January--up 1.3% and 2.1% respectively--while the yield spread premiums contracted for a 10th consecutive month.

Many, however, see clouds on the horizon. The yield premium contraction has slowed dramatically, and the volumes of borrowing appear to some to be unsustainable. Skeptics of a continued rally point to increasing sovereign credit risk, China's restrictive policies, lackluster earnings, and proposed bank restrictions.

Emerging Sovereign Hiccup
Yield premiums over U.S. Treasuries on emerging market sovereigns increased in January, as developed market sovereigns' credit concerns justified a re-examination of the market that rose 26% in 2009. The current yield premium of 2.5% is 5.5% narrower than the peak in November 2008. The Morningstar Emerging Market Sovereign Index rose 0.7% in January. Emerging market corporate yield premiums contracted for an 11th consecutive month, and now stand at levels not seen since October 2007. The Morningstar High Yield Emerging Market Corporate Index rose 3.0% in January.

Global credits have almost come full cycle. During 2008, absolute yields and yield premiums reached historic highs in many sectors, only to see reversion to the mean in 2009. Through the course of the cycle, most sovereign rates held relatively steady as the flight to safety and central bank target rates at historic lows put a ceiling on rates. As we emerge from the crisis, those governments that spent to support their economies are now getting the bill. Those successful at rejuvenating their economies face the prospect of inflation. Those countries who weren't so successful face an overwhelming debt load, with little prospects of offsetting receipts and deteriorating credit worthiness.