By Matt L. Peden, CFA, Vice President, Investment Officer 

During the second quarter, the bond market retracted a portion of the positive returns generated in the first three months of the year. The broad fixed income market, as represented by the Lehman Brothers Aggregate Bond Index, generated a negative quarterly return of -0.52%, bringing the index’s year-to-date performance to a modest 0.98%. The quarter was characterized by rising interest rates which proved bearish for bonds given the inverse relationship between bond prices and yields. The rise in rates was primarily attributable to further indications of economic growth as evidenced by low unemployment and an anticipated up-tick in second quarter GDP. Optimism over economic growth provided fuel for the equity markets, but caused bonds to significantly lag other major areas of the capital markets during the second quarter.

The Federal Reserve (“the Fed”) met twice during the second quarter, leaving the Fed Funds target rate unchanged at 5.25% on both occasions. Remaining on the sidelines, the Fed has kept the key interest rate at this level since the summer of 2006. Market expectations for a Fed easing in 2007 were recalibrated and pushed back into 2008 in response to inflation being within the Fed’s acceptable range and a resilient, late-stage domestic economy.

Investors in the bond market experienced an increase in volatility during the second quarter. The U.S. bond market was affected by the release of strong economic data as well as concerns over the troubled housing and sub-prime markets. Yields increased materially across most segments of the Treasury yield curve, most notably during May. By quarter-end, yields on the 2-year Treasury increased by 28 basis points to 4.86%, while yields on the 10-year Treasury elevated by 38 basis points to 5.02%. The yield on the 30-year Treasury rose by 28 basis points to 5.12% during the quarter.

Weakness in the bond market negatively impacted all major sectors during the second quarter. Albeit negative, Treasuries, with their lower relative yields, generated returns in-line or better when compared to other sectors within the Lehman Brothers Aggregate Bond Index. Investment grade corporates, supported by positive economic data and a strong equity market, were the other top performing sector. Disadvantaged by higher volatility and extension risk, mortgages were one of the worst performing sectors during the quarter. Over recent periods, extended sectors such as emerging market debt and high yield have been used by investment managers to add value. High yield bonds, being one of a few areas of the bond market that generated positive quarterly returns, continued their upward trend. Lower quality high yield outpaced its higher-quality counterparts. Emerging market debt issued in U.S. dollars lost ground during the second quarter, while local-pay emerging market debt generated positive returns, benefiting from currency gains. As a reflection of the difficult environment, cash and cash equivalents outpaced other maturity segments.

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