Market Update
A snapshot of bond market returns may lead one to believe October was an uneventful month. Nothing could be further from the truth.
The inflation/deflation debate raged through the confluence of diametric trends as the markets awaited the details of the next wave of quantitative easing. The hunger for yield persists as U.S. Treasury inflation protection notes rallied and unhedged U.S. investors benefited again from the weakening dollar. The Morningstar US Core Bond Index, our broadest measure of the U.S. bond markets, rose 0.34% in October and 8.13% on the year.
The Federal Reserve Open Market Committee meeting in early November announced a second wave of quantitative easing, commonly referred to as QE2. The flood of cheap money is intended to raise the expectations of moderate inflation, preventing price stagflation that could derail any recovery momentum. Hints of partial success from QE1 were reflected in both the steepening of the yield curve and a TIPS rally leading up to the announcement. Those in opposition to the Fed's efforts see QE2 as pushing on a string.
It's an artificial mechanism that does not allow the market to reflect true fundamentals. Only economic strength--as yet to be evident--will provide the desired results.
Historically a steeper yield curve has been a sign that investors are anticipating rising prices resulting from economic growth. The Morningstar US Treasury Index fell 0.16% in October, dragged down by the longer maturities. The Short Term Treasure Index rose 0.30% while the Long Term Treasury Index fell 1.68%. TIPS significantly outperformed Treasuries, rising 2.52% on the month--yet another signal that the market expects the Fed's action will lead to a higher rate of inflation. With nominal yields near historic lows, the auction yield on the $10 billion of five-year TIPS resulted in a negative yield (-0.55%) for the first time.
The Dollar Impact
Recent weakness in the dollar has benefited the equity market as well as commodities. The impact on foreign bond investors has also proved significant. The Morningstar Global Ex-US Government Bond Index fell 0.55% in October when hedging the foreign currency into U.S. dollars. In contrast, the unhedged index rose 1.93%. On a year-to-date basis, the two indexes are up 4.33% and 8.48%, respectively.
For the European sovereign investor, country allocation was paramount. German bonds have traded in step with U.S. Treasuries, reacting to economic indicators and speculation as to the magnitude and perceived impact of QE2. The peripheral European debt--namely Ireland and Portugal--moved less on broad economic indicators and U.S. developments than on the struggles to implement austerity measures and social unrest locally and across borders. The Morningstar Eurozone Government Bond Index fell 0.47% in October, and the UK Bond Index fell 1.39%.
Spread Premiums Contract
The persistent reach for yield from ever lower sovereign rates and shrinking high-grade yield spread premiums put a strong bid into the riskiest assets. High-yield corporate and emerging market credits posted positive returns and narrower spreads over the course of the month. Sales of high-yield securities set a record in October, and signs that issuance will persist could be taken from the fact that Standard & Poor's raised its ratings on 20 high-yield issuers while cutting 12.
Investment-grade yield spread contraction in U.S. credits was a modest 0.04% in October, to 1.65%. Just the same, the reach for yield was evident where the triple BBB sector of the Morningstar US Corporate Bond Index narrowed in excess of the higher-rating sectors.
European and sterling credits narrowed modestly in October. European investors' reach for yield was evident in the more robust spread contraction observed in the bank capital indexes (high-quality credits with additional spread being offered to compensate for the relative subordination of the bonds in the bank's capital structure).
As low yields have persisted, migration to riskier assets has continued unabated. History suggests the improved relative performance of those assets is only sustainable should the economic fundamentals catch up with the asset prices. Those who have placed their bets will be rewarded if--in some window of time--the lofty levels prove justifiable. But if indeed the Federal Reserve is pushing on a string, that window could slam shut in a hurry.
