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

As the calendar turns, we look back at a year that was turbulent and impacted by numerous macro-economic and political events that pushed and pulled at the capital markets. Although corporate fundamentals were improving, the potential outcomes of such macro events were difficult, if not impossible, to accurately predict, which fueled investors’ fears leading to extreme uncertainty and capital market volatility. When reflecting over 2011, the game of “tug-of-war” came to mind and can easily be used as a metaphor for the year. During 2011, there was a negative team and a positive team, both pulling on the rope (the rope symbolized the capital markets with its center-mark denoting equilibrium). One could strongly argue that the negative team had the strong upper-hand throughout most of the year.

On the negative team, there were many forces pulling mightily on the rope, with the most notable being the numerous economic problems in Europe. The European zone continued to suffer without a lasting, implementable solution to their sovereign debt and financial system problems, which has led to concerns over a European recession, higher sovereign debt borrowing costs and a distressed banking system. The size, depth and complexity of the European crisis were large, and without a workable, permanent plan, there remained a high probability of contagion leading to a global recession. Other negative factors influencing market emotions were the downgrade by Standard & Poor’s of U.S. debt, the headwind of the U.S. fiscal position (growing debt), Middle-East political uncertainty and concerns over moderating economic growth in China (one region in the world that appeared poised to serve as the global economic engine). Offsetting these negatives was the positive team that was pulling hardily, but hanging on for dear life in an attempt not to lose the game. Toward the end of the year, U.S. economic reports indicated some indications of improvement, softening fears of a “double-dip” recession. As evidence, U.S. unemployment had fallen to 8.6% by year-end, its lowest level since February 2009, while consumer confidence was rising. The fundamentals of U.S. corporations remained strong as profits have led to vastly improved balance sheets and flush cash positions. With the fundamental health of many corporations strong, one can argue that their valuations in both the bond and stock markets look attractive, providing investors the potential for upside. Lastly, monetary policy was accommodative with the Federal Reserve committing to a low rate environment through mid-2013 and the implementation of Operation Twist. As the year closed, the primary question was – can the U.S. economy recover and stay resilient despite fiscal headwinds and the uncertain outcomes of the European crisis? In other words, can the positive team hang-on and maybe gain some ground on the negative team? If not, one should expect further difficult and volatile times ahead.

The bond market, especially the U.S. Treasury sector, benefited from the economic uncertainty and overall risk aversion. During 2011, the broad domestic bond market, as measured by the Barclay’s Capital Aggregate Bond Index (“Aggregate Bond Index”), posted an annual return of 7.84%, compared to the U.S. stock market which generated a return of 2.11%, as measured by the S&P 500® Index. For the fourth quarter, the broad domestic bond market posted a return of 1.12%.

During 2011, the most notable story within the domestic bond market was the U.S. Treasury sector. Yields fell from their already low levels throughout the year in response to the Federal Reserve maintaining its commitment to a near zero fed funds rate for the foreseeable future and the implementation of “Operation Twist”. Treasuries also benefitted from high demand, as global investors often sought the “safe haven” assets when implementing “risk-off” trades. The declining interest rate environment was extremely bullish for the sector as evidenced by the 10-year and 30-year Treasuries, which produced annual returns of 17.18% and 35.60%, respectively. The year ended at remarkably low levels with the yield on the 10-year U.S. Treasury at 1.88% and the 30-year U.S. Treasury at 2.89%. The historically low rate environment, especially on the short-end of the yield curve, was painful for money market fund investors as these funds struggled to generate returns above zero percent.

The performance of the other bond sectors were also positive, but varied. The U.S. Investment Grade corporate bond sector (defined as a credit quality rating of triple BBB- or higher) was the top performer during the fourth quarter, posting quarterly and annual returns of 1.93% and 8.15%, respectively. Corporate bond returns were led by bonds within the industrial and utility sectors. Not surprisingly, the financials segment materially lagged other corporate sector counterparts. Mortgage-backed securities, a large component of the Aggregate Index, posted quarterly and annual returns of 0.88% and 6.23%, respectively.

There was also return dispersion within the bond market occurred in sectors outside of the Aggregate Bond Index. These riskier assets performed better in the fourth quarter as investors were more willing to embrace risk during the period. High yield corporate bonds (defined as below investment grade corporate bonds) generated a quarterly return of 6.46% and an annual return of 4.98%. Emerging market debt posted a quarterly return of 5.26% and an annual return of 9.20%.

In closing, I must admit that I looked at my fourth quarter 2010 commentary in preparation of writing this piece. There was some language in last year’s commentary providing thoughts on the future of bond returns and the role bonds play in an overall portfolio that I believe are still applicable today. Given the historically low level of interest rates, there is a material probability that the diversification benefits of bonds in a well-diversified portfolio of stocks and bonds may be more important than the absolute return benefits. If economic conditions improve or even stabilize, yields could trend upward, limiting potential bond returns going forward. In contrast, there are negative scenarios that could be beneficial to the broad bond market but detrimental to the global economy and the equity markets. Such a scenario is a further deterioration in Europe. This scenario could lead to a flight-to-quality, possibly even lower interest rates and a demand for U.S. Treasuries. Thus, from an asset allocation perspective, bonds may play more of a “risk reduction” and/or diversifier role to other asset classes over the near term.

S&P 500^® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard and Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.

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.