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

From an economic and financial perspective, history will be unkind to calendar year 2008 as it concluded as one of the most tumultuous and difficult years since the Great Depression era. No one could have imagined or predicted the unprecedented path of devastation that stormed through the capital markets and the economy due to the unforgiving financial crisis. As the year came to an end, investors across the globe gave a brief sigh-of-relief hoping that unparalleled central bank intervention and government programs on a global basis would dampen and eventually reverse the unrelenting course of the financial crisis and the economic recession. The year ended with investors seeking safe, high-quality assets, regardless of their price or return (at one point, U.S. Treasury bill yields were negative), while riskier assets experienced downward price pressure and illiquidity.

The U.S. financial system was severely strained in the latter half of 2008 as troubled balance sheets, mounting credit losses, bank failures, de-leveraging and fear obstructed capital flows necessary for normal, healthy economic activity. In an effort to stimulate the credit markets and the economy, the Federal Reserve continued to engage in massive quantitative easing, lowering the Fed Funds target rate on three separate occasions during the fourth quarter to a level approximating 0% - 0.25% by period-end. With little inflationary pressure, it was apparent that the Federal Reserve was committed to keeping rates low as long as needed to restore economic and lending activity. Aggressive monetary policy and extreme flight-to-quality by anxious investors resulted in a massive decline in U.S. Treasury yields as government yields reached historically low levels. The year ended with the 10-year U.S. Treasury yielding 2.21%, and the 30-year U.S. Treasury yielding 2.68%.

The broad U.S. bond market, as measured by the Barclays Capital Aggregate Bond Index (formerly the Lehman Brothers Aggregate Bond Index), posted a quarterly return of 4.58%. For the year, bonds generated a return of 5.24%, providing investors diversification benefits and downside protection relative to other asset classes, especially stock investments. For the year, bonds amazingly outpaced U.S. stocks, as measured by the S&P® 500 Index, by over 42% and outperformed non-U.S. stocks, as measured by the MSCI-ACWI Ex U.S., by roughly 50%.

Amidst the turmoil, returns with the bond market varied greatly during the fourth quarter. As to be expected, U.S. Treasuries were by far the best performing segment. The sector generated a quarterly return of 8.75% and an annual return of 13.74%. Long-dated U.S. Treasuries performed much better, generating remarkable quarterly and annual returns of 27.29% and 33.72%, respectively. At the beginning of the quarter, risk premiums (spreads) relative to U.S. Treasuries were pricing-in extreme deterioration in fundamentals and large default levels causing non-U.S. Treasury sectors to be under severe pricing pressure. Towards the end of the quarter, spreads began to contract, which led to solid returns in the corporate sector (3.98% for the quarter), including the struggling financial sector, which produced a quarterly return of 8.07%. While mortgages also produced positive returns for the quarter, asset-backed securities, commercial mortgage backed securities, high yield bonds and emerging market debt posted negative quarterly returns.

All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.