Bond Market Overview, April-June 2012
While the first three months of the year was characterized by steady global growth and elevated investor optimism, the second quarter brought a steady stream of negative news. Most important, the European debt crisis returned to the forefront with headlines suggesting that Spain’s banking system was experiencing severe stress. As was the case in each of the past two summers, investors again grew nervous because of the seemingly limited risk posed by Europe’s ongoing fiscal problems.
The news on the economic front was also unfavorable. Here in the United States, economic data came in at disappointing levels after a solid first quarter. While this raised hopes that the Federal Reserve would step in with another round of quantitative easing, the Fed opted for the middle ground of extending its Operation Twist program (which seeks to keep longer-term rates down by selling short-term bonds and buying longer-term issues) through the end of the year. Growth was also disappointing overseas, as China continued to report weak numbers and Europe likely moved into a recession.
The affect of these various developments was felt across the bond market, with largely positive results. The Vanguard Total Bond Market exchange-traded fund (ticker:BND), which represents the investment-grade segment of the U.S. market, returned 1.90% in the quarter. Unlike stocks, which react negatively to crises and signs of slowing growth, the interest-rate sensitive segments of the bond market tend to benefit from adverse news.
Bad News is Good News for Government Bonds
The asset class most likely to benefit from negative news flow – U.S. Treasuries – indeed staged an enormous rally in April and May. Worries that the crisis had moved past the point where governments could stop the spread of “contagion” from Greece and Spain to the rest of the Continent caused investors to stampede out of higher-risk assets and into the relative safety of U.S. Treasuries – a phenomenon known as a “flight to safety.” Yields plunged (and prices rose) as a result, with both the 5- and the 10-year note reaching record lows. Treasury-linked investments surged as a result, particularly those that invest in longer-term issues. For example, the iShares Trust Barclays 20+ Year Treasury Bond Fund (TLT) gained 10.48% in the quarter.
The decline in prevailing rates was also very supportive of Treasury Inflation-Protected Securities, or TIPS. Demand for TIPS was strong due to their ability to perform well during periods of falling interest rates. Demand was so high, in fact, that investors are willing to accept negative yields in five- and ten-year issues. At these levels, inflation will need to rise dramatically in order for investors to be better off in TIPS than plain-vanilla Treasuries, a potential red flag. Nevertheless, the iShares Lehman TIPS Bond Fund (TIP) returned 2.74% for the quarter.
Overseas government bonds also benefited from investors’ search for safety. Other markets deemed to be relatively insulated from the troubles in southern Europe, including the United Kingdom and Germany, also rallied.
Municipal Bonds Rally
Investors who have ignored the concerns about state and local finances and held on to their investments in municipal bonds continued to benefit from munis’ robust performance in the second quarter. The largest municipal bond ETF, iShares S&P National AMT-Free Municipal Bond ETF (MUB) returned 1.30% in the quarter. The asset class has been supported by a low level of defaults overall (notwithstanding the high-profile bankruptcy filing by Stockton, CA), the continued demand for tax-free investments, and the combination of rising state revenues and declining budget deficits. High-yield municipals generated particularly strong performance in the quarter, based on the 4.56% return of the Market Vectors High Yield Municipal Index ETF (HYD).
Investment-Grade Corporates Gain Ground
While corporates can often underperform once investors start shying away from risk, that wasn’t the case during the second quarter. The iShares iBoxx US Dollar Investment Grade Corporate Bond ETF (LQD) rose 2.49%, building on its gains of 2.34% in the first quarter and 9.74% in 2011. One reason for corporates' strong performance is obvious: they offer more yield than government bonds, providing investors with a chance to stay ahead of inflation. But another, equally important, reason is less evident for the average investor: the continued improvement in the health of U.S. corporations. First quarter earnings – reported in April and May – came in ahead of expectations, companies have record levels of cash on their balance sheets (increasing the likelihood that bond investors will be paid back), and many corporations have used the low-rate environment to refinance their existing debt at more attractive rates. What’s more, the low-rate environment is likely to be with us for at least another two years, based on statements from the U.S. Federal Reserve. So while corporate bonds will still suffer if there is a meltdown in Europe or another calamity in the global economy, the asset class continues to feature sound fundamentals to accompany yields that are well above those on U.S. Treasuries.
High Yield Bonds Ride out the Storm
Despite investor unease, high yield bonds ended with a positive return of 2.23%, based on the iShares iBoxx $ High Yield Corporate Bond (HYG) fund. However, the quarter also brought elevated volatility: during May, which brought the worst phase of concerns about Europe, HYG declined 3.22%. High-yield bonds are notoriously sensitive to investor risk appetites, and this has scared off some investors given the ongoing concerns about the debt crisis in Europe and the slow economic growth here at home. However, many analysts point out that while the yield on the market typically tracks the default rate (the rate at which high-yield companies fail to make interest and principal payments in the past 12 months), defaults in the asset class remain exceptionally low at levels near 2%. In addition, high yield bonds continue to attract assets due to its role as an alternative to low-yielding U.S. Treasuries.
Learn about other, higher-yielding – but higher-risk – alternatives to government bonds.
It's true that high yield bonds will be hit the next time investors begin to panic about the situation in Europe. But over time, it's paid to ride through these periods of elevated volatility: in the ten years ended on May 31 - a time that has featured no shortage of market downturns - the Credit Suisse High Yield Index has produced an average annual return of 9.17%, well above the 4.14% return of the S&P 500 stock index and the 5.72% return of investment grade bonds, as measured by the Barclays Aggregate U.S. Bond Index.
Emerging Markets Hold Up Well
Emerging market economies are among the strongest in the world - in terms of both their growth rates and their fiscal strength, but emerging market bonds remain very sensitive to trends in investor risk appetities. The asset class therefore exhibited weakness in May, but the subsequent recovery in June helped the iShares JPMorgan USD Emerging Markets Bond ETF (EMB) finished the quarter with a gain of 3.23%. However, bonds denominated in local currencies underperformed significantly.
While investor attitudes toward the global economic outlook continue to drive the short-term performance of emerging market debt, the asset class has treated investors well over time: in the ten years ended May 31, 2012, the JP Morgan EMI Global Diversified Index had produced an average annual total return of 10.34%, far above the 5.72% of the Barclays Aggregate.
Yields by Asset Class
Finally, here is a look at the approximate 30-day SEC annualized yields of each asset class, as of June 30, based on nine of the largest exchange-traded funds:
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
The news on the economic front was also unfavorable. Here in the United States, economic data came in at disappointing levels after a solid first quarter. While this raised hopes that the Federal Reserve would step in with another round of quantitative easing, the Fed opted for the middle ground of extending its Operation Twist program (which seeks to keep longer-term rates down by selling short-term bonds and buying longer-term issues) through the end of the year. Growth was also disappointing overseas, as China continued to report weak numbers and Europe likely moved into a recession.
The affect of these various developments was felt across the bond market, with largely positive results. The Vanguard Total Bond Market exchange-traded fund (ticker:BND), which represents the investment-grade segment of the U.S. market, returned 1.90% in the quarter. Unlike stocks, which react negatively to crises and signs of slowing growth, the interest-rate sensitive segments of the bond market tend to benefit from adverse news.
Bad News is Good News for Government Bonds
The asset class most likely to benefit from negative news flow – U.S. Treasuries – indeed staged an enormous rally in April and May. Worries that the crisis had moved past the point where governments could stop the spread of “contagion” from Greece and Spain to the rest of the Continent caused investors to stampede out of higher-risk assets and into the relative safety of U.S. Treasuries – a phenomenon known as a “flight to safety.” Yields plunged (and prices rose) as a result, with both the 5- and the 10-year note reaching record lows. Treasury-linked investments surged as a result, particularly those that invest in longer-term issues. For example, the iShares Trust Barclays 20+ Year Treasury Bond Fund (TLT) gained 10.48% in the quarter.
The decline in prevailing rates was also very supportive of Treasury Inflation-Protected Securities, or TIPS. Demand for TIPS was strong due to their ability to perform well during periods of falling interest rates. Demand was so high, in fact, that investors are willing to accept negative yields in five- and ten-year issues. At these levels, inflation will need to rise dramatically in order for investors to be better off in TIPS than plain-vanilla Treasuries, a potential red flag. Nevertheless, the iShares Lehman TIPS Bond Fund (TIP) returned 2.74% for the quarter.
Overseas government bonds also benefited from investors’ search for safety. Other markets deemed to be relatively insulated from the troubles in southern Europe, including the United Kingdom and Germany, also rallied.
Municipal Bonds Rally
Investors who have ignored the concerns about state and local finances and held on to their investments in municipal bonds continued to benefit from munis’ robust performance in the second quarter. The largest municipal bond ETF, iShares S&P National AMT-Free Municipal Bond ETF (MUB) returned 1.30% in the quarter. The asset class has been supported by a low level of defaults overall (notwithstanding the high-profile bankruptcy filing by Stockton, CA), the continued demand for tax-free investments, and the combination of rising state revenues and declining budget deficits. High-yield municipals generated particularly strong performance in the quarter, based on the 4.56% return of the Market Vectors High Yield Municipal Index ETF (HYD).
Investment-Grade Corporates Gain Ground
While corporates can often underperform once investors start shying away from risk, that wasn’t the case during the second quarter. The iShares iBoxx US Dollar Investment Grade Corporate Bond ETF (LQD) rose 2.49%, building on its gains of 2.34% in the first quarter and 9.74% in 2011. One reason for corporates' strong performance is obvious: they offer more yield than government bonds, providing investors with a chance to stay ahead of inflation. But another, equally important, reason is less evident for the average investor: the continued improvement in the health of U.S. corporations. First quarter earnings – reported in April and May – came in ahead of expectations, companies have record levels of cash on their balance sheets (increasing the likelihood that bond investors will be paid back), and many corporations have used the low-rate environment to refinance their existing debt at more attractive rates. What’s more, the low-rate environment is likely to be with us for at least another two years, based on statements from the U.S. Federal Reserve. So while corporate bonds will still suffer if there is a meltdown in Europe or another calamity in the global economy, the asset class continues to feature sound fundamentals to accompany yields that are well above those on U.S. Treasuries.
High Yield Bonds Ride out the Storm
Despite investor unease, high yield bonds ended with a positive return of 2.23%, based on the iShares iBoxx $ High Yield Corporate Bond (HYG) fund. However, the quarter also brought elevated volatility: during May, which brought the worst phase of concerns about Europe, HYG declined 3.22%. High-yield bonds are notoriously sensitive to investor risk appetites, and this has scared off some investors given the ongoing concerns about the debt crisis in Europe and the slow economic growth here at home. However, many analysts point out that while the yield on the market typically tracks the default rate (the rate at which high-yield companies fail to make interest and principal payments in the past 12 months), defaults in the asset class remain exceptionally low at levels near 2%. In addition, high yield bonds continue to attract assets due to its role as an alternative to low-yielding U.S. Treasuries.
Learn about other, higher-yielding – but higher-risk – alternatives to government bonds.
It's true that high yield bonds will be hit the next time investors begin to panic about the situation in Europe. But over time, it's paid to ride through these periods of elevated volatility: in the ten years ended on May 31 - a time that has featured no shortage of market downturns - the Credit Suisse High Yield Index has produced an average annual return of 9.17%, well above the 4.14% return of the S&P 500 stock index and the 5.72% return of investment grade bonds, as measured by the Barclays Aggregate U.S. Bond Index.
Emerging Markets Hold Up Well
Emerging market economies are among the strongest in the world - in terms of both their growth rates and their fiscal strength, but emerging market bonds remain very sensitive to trends in investor risk appetities. The asset class therefore exhibited weakness in May, but the subsequent recovery in June helped the iShares JPMorgan USD Emerging Markets Bond ETF (EMB) finished the quarter with a gain of 3.23%. However, bonds denominated in local currencies underperformed significantly.
While investor attitudes toward the global economic outlook continue to drive the short-term performance of emerging market debt, the asset class has treated investors well over time: in the ten years ended May 31, 2012, the JP Morgan EMI Global Diversified Index had produced an average annual total return of 10.34%, far above the 5.72% of the Barclays Aggregate.
Yields by Asset Class
Finally, here is a look at the approximate 30-day SEC annualized yields of each asset class, as of June 30, based on nine of the largest exchange-traded funds:
- Total U.S. investment-grade bond market: Vanguard Total Bond Market ETF (BND), 1.97%
- Treasuries: iShares Lehman 20+ Year Treasury Bond Fund (TLT), 2.49%
- TIPS: iShares Lehman TIPS Bond Fund (TIP), n/a
- Mortgage-backed securities: iShares Lehman MBS Fixed-Rate Bond Fund (MBB), 3.32%
- Municipal bonds: iShares S&P National Municipal Bond Index Fund (MUB), 1.93%
- Corporate bonds: iShares iBoxx US Dollar Investment Grade Corporate Bond ETF (LQD), 3.40%
- High yield bonds: iShares iBoxx $ High Yield Corporate Bond ETF (HYG), 6.84%
- International government bonds: SPDR Lehman International Treasury Bond ETF (BWX), 1.75%
- Emerging markets: iShares JPMorgan USD Emerging Markets Bond ETF (EMB), 4.46%
Disclaimer: The information on this site is provided for discussion purposes only, and should not be construed as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.
