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

The term “unprecedented” has been used countless times over the quarter, yet remarkably remains relevant to the current conditions within the capital markets. One has to go back to the Great Depression era to see such stress placed on the U.S. financial system, and the need for government intervention to pull the private sector and capitalism back to a functioning state. As previously discussed, the tremendous amount of deleveraging (i.e. the forced selling of assets to reduce leveraged positions) in the financial system has indiscriminately cast downward pressure on asset prices ranging from housing to financial assets such as stocks and bonds. The deleveraging effect has also restricted the amount of liquidity and borrowing within the financial system as banks and other financial institutions are fearful of lending to each other, to businesses and to consumers. This effect has been negative for businesses that are dependent upon leverage for their funding, operations and future growth as well as consumers that serve as the primary cylinder within the country’s economic engine. The sluggish and uncertain economic environment coupled with technical downward pressure has caused upheaval in the markets and a difficult environment for all investors.

The financial sector has been at the epicenter of the tumultuous market, and as a result, has been one of the worst performing fixed income sectors during the third quarter. The deleveraging impact coupled with investor panic has led to the demise of many large financial institutions, many of which were previously deemed too large to fail. Lehman Brothers was forced into bankruptcy, while AIG (a major player in the credit-default swap market) was saved by government intervention. The mortgage giants of Freddie Mac and Fannie Mae were taken over by the federal government while other financial institutions (including Washington Mutual, Merrill Lynch and Wachovia) were salvaged by acquiring institutions. By quarter-end, the turmoil had extended to money market funds as one of the nation’s oldest money market funds, the Reserve Fund, had “broke-the-buck” and was forced into liquidation. Immediately following the third quarter’s close, the U.S. Treasury announced a $700 billion program (“Troubled Asset Relief Program” or “TARP”) in an effort to reinstate confidence, stability and liquidity within the financial system.

The broad U.S. bond market, as measured by the Lehman Brothers Aggregate Bond Index, posted a third quarter return of -0.49% as price depreciation more than offset the positive contribution from interest income. Year-to-date, bonds have generated a very modest positive return of 0.63%. While absolute returns for bond investors have been modest and well below historical norms, the asset class has provided diversification and downside protection against stock investments. As evidence, bonds have outpaced U.S. stocks, as measured by the S&P 500® Index, on a year-to-date basis through September 30th by approximately 20%. Furthermore, bonds have outperformed international stocks, as measured by the MSCI EAFE Index – (Net), by roughly 30% for the same nine-month period.

Asset pricing within the bond market has taken a substantial hit, partially due to deteriorating fundamentals. However, in certain areas of the bond market, one may argue that technical pressures and the lack of liquidity have been greater forces on price depreciation. Over recent quarters, there have been more sellers than buyers due to deleveraging, flight-to-quality and emotional selling. The turmoil and volatility within the market was too much for many investors causing a massive flight-to-quality and high demand for U.S. Treasuries. Such behavior caused the U.S. Treasury sector to outperform other bond market sectors during the third quarter. Overall, Treasury yields shrank during the period, most notably on the short-end of the yield curve, as yields on the 3-month U.S. T-Bills fell 82 basis points to 0.90%. By quarter-end, investors were basically willing to earn next to nothing in return for the safety of short-term government instruments. The next to best performing sector was higher-grade mortgage backed securities, led by agency pass-throughs. By contrast, corporate bonds posted negative absolute returns for the quarter as their spreads relative to risk-free U.S. Treasuries widened to historic levels. The corporate bond segment was dragged down by the performance of financials. High yield bonds (below investment grade corporate bonds) were also under severe stress, generating a quarterly return of -8.89% per the Lehman Brothers U.S. Corporate High Yield Index. Emerging markets debt, as measured by the JPMorgan EMBI Plus, was down -4.56% for the quarter.

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