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

The first quarter was characterized by opposing forces — a very weak economic environment and unconventional, aggressive government intervention. Unfavorable economic data was underscored by the release of fourth quarter Gross Domestic Product (“GDP”) of -6.30% coupled with rising unemployment and declining consumer confidence. Indications were that the U.S. economy has yet to recover from the negative feedback loop which began with the decline in the housing market, leading to a distressed financial system and dampening economic activity. The U.S. government, in their continued efforts to counterbalance economic weakness and disrupt the negative feedback loop, unveiled further stimulus and bailout programs. The Federal Reserve (“Fed”) maintained its 0%–0.25% interest rate policy and announced plans to purchase up to $300 billion in U.S. Treasuries in an effort to keep borrowing costs low and inject further stimulus. Other new policies included the Fed’s announcement to purchase additional agency mortgage-backed securities, and government programs aimed at increasing investment into securitized debt obligations.

Despite the Fed’s plans to purchase U.S. Treasuries thereby increasing demand (and providing artificial downward pressure on yields), yields on U.S. Treasuries rose during the quarter, most notably on the long-end of the curve as investors became increasingly concerned over the elevating level of new Treasury issuance to fund new stimulus/bailout initiatives. Given the rise in yields, the U.S. Treasury sector was one of the worst performing segments of the bond market, posting a quarterly return of -1.32%. The sector’s performance was dragged down by the performance of long-maturity Treasuries. The 10-year and 30-year Treasuries generated quarterly returns of -2.68% and -13.45%, respectively. These negative returns come on the heels of a very strong return environment for U.S. Treasuries during 2008. The quarter ended with the 10-year note yield at 2.66% and the 30-year bond yield at 3.53%.

The broad U.S. bond market, as measured by the Barclays Capital Aggregate Bond Index, posted a very modest quarterly return of 0.12% despite wide dispersion among different sectors and maturities of the market. While the U.S. Treasury sector posted negative returns, many non-Treasury sectors rallied in response to government programs and investors’ renewed interest in attractive valuations.

Agency mortgage-backed securities (“MBS”) added positive value during the quarter with a return of 2.20%. Unprecedented government support through the MBS purchase program helped drive the performance of this sector. Performance of non-agency mortgages and commercial mortgage-backed securities continued to struggle. As a sector, corporate bonds posted a return of -1.93%, primarily due to the demise of the financial industry. Long-term financial bonds performed a dismal -19.61% for the quarter. However, some areas of the corporate market were positive, including utilities and industrials. Asset-backed securities (“ABS”) were one of the top performing sectors with the primary outperformers being credit cards and autos. The ABS rally was largely in response to the government’s Term Asset-Backed Securities Loan Facility program, which sought to restore liquidity to the consumer loan markets.

Several extended bond sectors performed very well during the quarter. Fixed-income strategies that utilized these extended sectors were benefited. High-yield bonds (below investment grade corporate bonds) posted a quarterly return of 6.61%. Bonds rated BB category were the best performers. High yield bonds outpaced their investment grade counterparts and the broad domestic equity market during the period. Emerging market debt was another top-performing sector, posting a quarterly return of 3.37%. Treasury Inflation Protected Securities (“TIPS”) returned 5.52% for the quarter. These securities, which provide investors a hedge against inflation, benefited from changes in future inflation expectations shifting higher.

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.