Yields Continue Retreat in 'Unusually Uncertain' Economy

With reinforced expectations for little or no inflation, strong corporate earnings and evidence of a strong recovery lacking, bond markets rallied during July. Yields in most sectors retreated last month, offering investors the lowest corporate yield premiums since 2004. The 2-year Treasury benchmark traded at a record low yield of 0.55% in July (and hit a new record low on Friday Aug. 6 below 0.50%), and the U.S corporate yield spread premium contracted 30 basis points, to 130.

The encouraging results of the European bank stress test helped bring a measure of stability to the markets, even as the rating agencies issued downgrades and warnings for several sovereign borrowers. The Morningstar US Core Bond Index, our broadest measure of the U.S. bond markets (includes government-, corporate-, and mortgage-backed bonds), rose 1.0% in July, and is up 6.3% for the year.

Unusually Uncertain
Despite rates at or near record lows, investors still had sufficient appetite to pressure U.S. Treasury yields for a fourth consecutive month. The upward pressure on rates that is typically associated with growing deficits has yet to materialize. This is evidence to some that the majority does not believe the economy is in a material recovery, or that inflation is of little risk.

A weaker-than-expected GDP report did little to change those sentiments. Federal Reserve Chairman Bernanke characterized the economy as "unusually uncertain," and suggested that the central bank is prepared to take more policy action.

In their quest for yield, in addition to migrating to riskier sectors, investors have been seen extending maturity up the relatively steep yield curve. The Morningstar US Treasury index rose 0.7% in July, and has risen 6.6% year-to-date. The yield between 10-year Treasury Inflation-Protected Securities and 10-year nominal Treasuries contracted to 1.8% from 2.5% in January, indicating diminished expectations for rising consumer prices.

Unwanted attention from the rating agencies continues to preoccupy the weaker European sovereign borrowers. Moody's suggested that Spain will probably lose its Aaa rating after being put under review for possible downgrade in June. The agency also downgraded Ireland's government bonds, citing deteriorating public finances. The one-notch downgrade puts it even with Standard & Poor's rating, and one notch above Fitch's. The downgrades stopped short of catching the markets by surprise, and the already heavily discounted issuers posted strong returns in July. The Morningstar Eurozone Government Index rose 1.0% last month. Portugal reversed course, rising 3.3%, while Germany fell 0.7% after posting six consecutive monthly gains.

Back to Contraction
If the Treasury market is reflecting a lack of confidence in a meaningful recovery, the corporate bond market is reflecting a growing confidence in borrowers' ability to service their debt burdens. The increased confidence is based in large part on strong earnings and ongoing improvement in corporate balance sheets.

The Morningstar Corporate Bond Index rose 2.0% in July, and is up 7.6% for the year. Yield on corporate debt is at or near historic lows, and yield spread premiums witnessed their most aggressive contraction in a single month since December. The yield on the Corporate Bond Index fell 0.36% to 3.54%, the lowest yield since its inception. The yield spread premium contracted 30 basis points to 130, still short of the 109 basis points recorded in May.

The results of the European bank stress test eased investor concerns and buoyed credits throughout the region. Bank credits were the primary beneficiaries, leaving the cost of insuring bank bonds at their lowest level in three months. Yield spread premiums for Eurozone and sterling credits narrowed last month after two consecutive months of widening. The Morningstar Eurobond Corporate Index rose for a seventh consecutive month, returning 0.7% in July, and UK credits rose 0.6%.

The steady performance from global credits continues apace. European stabilization, greater visibility regarding possible financial regulation, improving emerging-market credits, and healthy earnings reports have all contributed to the better-than-average year-to-date returns. Developed market sovereign balance sheets remain in dire shape, yet have not led to rising rates, as history would suggest. With the risk of near-term inflation all but gone, it is not hard to imagine an environment of persistently low rates in all sectors until such time that economies demonstrate reliable and credible proof of a strong and sustainable recovery.