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

The broad bond market, as measured by the Barclays Capital Aggregate Bond Index (“Aggregate Bond Index”), posted a modest quarterly return of 0.20%. For the year, the Aggregate Bond Index generated a total return of 5.93%, within close distance of its long-term historical average. While the overall return of the bond market appeared somewhat serene, the return dispersion among bond sectors, industries and securities was extremely broad; therefore, investors’ returns during the quarter and year were greatly dependent upon their risk tolerance and their portfolios’ underlying exposure. The bond market had several major themes during the fourth quarter and most of 2009: an increase in investors’ demand for riskier assets (seeking additional yield) resulting in a strong rally in spread (non-U.S. Treasury) sectors; a tremendous amount of U.S. Treasury issuance; historically aggressive monetary policy by the Federal Reserve (“Fed”); and rising interest rates and a steepening yield curve.

During 2009, the Fed maintained the federal funds target rate at 0-0.25%. The Fed was determined, through monetary policy and other sponsored programs, to pump a tremendous amount of liquidity into the economy to counteract the effects of negative economic growth, elevating unemployment, slumping household spending and business investment and a dismal housing market. At the regularly scheduled December 16, 2009, meeting, the Federal Open Market Committee (“FOMC”) stated “that it would maintain the target range for the federal funds rate at 0-0.25% and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” While concerns existed over the Fed leaving rates too low for too long, the central bank appears committed to use all of its available tools and resources to stimulate “sustainable” economic growth going forward.

During the fourth quarter, the U.S. Treasury yield curve steepened dramatically as short-term rates remained anchored to the federal funds target rate while prospects of economic growth and fears of higher Treasury issuance (market’s ability to absorb additional supply) served as the catalysts for higher mid- and long-term rates. At year-end, the spread between the two-year U.S. Treasury and the 10-year U.S. Treasury was 270 basis points, a steepening of 125 basis points. Given the inverse relationship between yields and bond prices, the upward movement in U.S. Treasury rates put negative pressure on the U.S. Treasury sector. As evidence, the Barclays Capital Treasury Index posted a quarterly return of -1.30% and an annual return of -3.57%. Longer-dated U.S. Treasuries were the worst performing bonds during 2009 (a complete reversal from 2008), posting returns for the fourth quarter and year of -5.07% and -12.19%, respectively.

The reversal in the flight-to-quality trade during 2009 was significant. The appetite for riskier, higher-yielding assets was fueled by attractive relative valuations, improved corporate fundamentals, prospects for economic recovery and the low return environment in money market funds and other traditionally safe investments. To illustrate the disparity between low and high risk performance, the three-month Treasury Bill (often used as a proxy for money market returns) posted an annual return of 0.16%, while the Barclays Capital High Yield Index (proxy for below investment-grade corporate bonds) posted an amazing annual return of 58.21%. During 2009, high yield bonds well outpaced the U.S. equity markets, which were up over 26%.

Investment-grade corporate bonds continued to perform well, posting a quarterly return of 1.35% and an annual return of 18.68%. Financials led during the quarter while utility bonds outpaced for the year. Mortgages also outperformed U.S. Treasuries for the quarter and year, generating quarterly and annual returns of 0.57% and 5.89%, respectively. This sector benefited tremendously from the unprecedented direct government purchase of mortgages which restored demand and confidence in the sector. In addition to high-yield bonds, emerging market debt was also a key driver in bond market returns as this sector benefited from accommodative monetary policies in developed countries and their economies’ contribution to the overall global economic recovery. The emerging market bond sector generated strong quarterly and annual returns of 1.37% and 25.95%, respectively. 

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.