Podcast: October 2009 Market Recap

Hello, my name is Sean Simko. I am Managing Director of SEI Global Fixed Income Management. Today’s discussion is a recap of the market activity and performance for the month of October.

During the third quarter, gross domestic product (GDP) expanded for the first time in more than a year. The only question is whether or not the growth will carry into 2010. A 3.5% increase in GDP is nothing to rave about, but it shouldn’t be ignored either. The growth is a result of various government programs, which included “Cash for Clunkers” and a tax credit for first-time home buyers. Without these programs, it is likely that third-quarter GDP would have been significantly weaker. However, these stimulus plans have now or will soon come to an end, raising questions about the economy’s ability to grow in upcoming quarters. It is a concern, as consumers continue to feel pinched and curb their spending. Unfortunately, this scenario is unlikely to change any time soon, since the labor market remains weak. At the end of October, the unemployment rate remained elevated at 9.8%—a 26-year high. In early November, it rose to 10.2%, the highest level since April 1983. If job seekers are unable to find permanent work, the economy will not support sustainable growth.

The Barclays Capital Aggregate Bond Index moved higher, returning 0.49% for the month and 6.24% year to date. October performance signaled a shift in overall quality performance with A-rated and AA-rated issues outperforming lower-quality names. Only time will tell whether or not this is a new trend, but on the surface, risk appetite appears to be diminishing. U.S. investment-grade corporate debt returned 0.70% for the month, and asset-backed securities returned 1.16%. Commercial mortgage-backed securities returned 2.40%, led by double-A names. The Treasury sector was pretty much unchanged with a loss of 0.05% for the month, pushing the Treasury sector down 2.34% year to date.

The Federal Open Market Committee (FOMC) was absent from any scheduled meeting in October but not absent from media headlines. The focus during the month was on various Fed officials’ speeches regarding the language of the Committee’s prior statements. In particular, officials focused on the phrase “exceptionally low” and the language around keeping rates low for “an extended period of time.” Even with central banks around the world starting to tighten monetary policy, comments from Fed officials have not been hawkish, fueling media speculation about the timing of a policy change. In our view, there is no rush for the Fed to start raising interest rates. There is significantly more immediate downside risk if interest rates are increased too early, particularly since inflation remains low. While the hawks argue that current Fed policy may create additional bubbles in the future, it will be difficult for the Fed to gracefully unwind its current positions without disrupting the markets.

Cash and short-term markets remain challenged by the lack of supply and near-zero interest rates at the front end. Investors are holding larger cash positions than normal, juggling risk and reward. Some of the positions are by choice; others are due to the supply shortage. Commercial paper issuance continued to shrink as non-seasonally adjusted numbers painted a true picture of the market’s health, while seasonally adjusted numbers didn’t look as bad. Short-term markets are trading better than they have in the past year. Although the markets feel healthier, they continue to face significant challenges. Near-zero interest rates place additional pressure on investors as they balance additional risk with only a modest pickup of incremental yield. For the month, three month LIBOR rate held fast at 28 basis points. We are now well within the historical 12 to 15 basis points range in which three-month LIBOR should trade above the federal funds target rate.

The Treasury market sold off in October, moving toward the upper end of the recent trading range. The 30-year underperformed, with yields moving 17 basis points higher to close the month with a yield of 4.22%. As a result, the Treasury curve steepened for the month. The front end was anchored due to the near-zero-interest-rate policy and the view that the economy may remain sluggish. The long end was affected by the continued onslaught of supply as well as by differing views on the outlook for inflation. We expect the curve to move from a steepening bias to a flattening bias as we turn the corner into the New Year. This flattening will occur as the market starts to adjust to expectations that the Fed will continue its exit strategy even after it discontinues its Treasury purchase program.

The Treasury Inflation Protected Securities (TIPS) market continued its trend of positive performance. For the month, the Barclays U.S. TIPS Index returned 1.23%, bringing the year to date return to 10.82%. Oil traded in a tight range, closing at $77 a barrel. Oil at these levels is likely to bolster inflation discussions, creating demand for TIPS. The difference between the yield on 10-year notes and the 10-year TIPS narrowed to 2.01 percentage points from last month’s 1.71. The spread has averaged 1.49 basis points in 2009.

Credit spreads were buoyed by solid third-quarter earnings, although we did not see a meaningful rally as a result. The combination of stronger results and positive guidance helped spreads to grind tighter throughout the month. The expectation is for positive fundamentals to remain through year end. Investor demand has remained resilient due to significant stockpiles of cash, and positive economic data that points to better corporate profits ahead. There was volatility across all credit-quality tiers, which is different than what we have recently seen. Prior to this month, higher-beta names created the volatility and outperformed higher-quality names.

The Barclays Capital Credit Index posted 73 basis points of excess return over duration-matched Treasuries. The index option-adjusted spread tightened 11 basis points in October, ending the month at 186 basis points over Treasuries. As mentioned earlier, higher-quality paper led the charge. Single-A paper provided 83 basis points of excess return, marginally outpacing BBB at 80 basis points.

We expect credit spreads to continue to outperform through year end and the credit curve to steepen. Caution is warranted at these levels, as there is the potential for a temporary pullback. Supporting our credit view, if a pullback occurs we expect it to be met with additional buying. If a pullback is avoided, credit technicals should support additional spread tightening through year end.

Municipal debt reversed its recent trend of positive performance, posting negative returns for the month of October. The Barclays Capital Municipal Index returned -2.10% for the month while posting an 11.61% return year to date through October. As a result, yields in October at the ten-year point of the AAA curve rose approximately 41 basis points, while the 30-year point moved higher only by 15 basis points. High-grade municipals as a percentage of Treasuries ended the month cheaper than levels seen at the start of the month. The 10-year AAA general-obligation debt percentage to Treasuries started the month around 87%. At month end, this ratio was at 96%, remaining above historical averages. Historically, October is a challenging month, and October 2009 was true to form. Greater volatility, wider bid/ask spreads and an overall thin market have created this year’s hurdles. Issuance through October 29 totals 39.7 billion. Of that figure, 37% was issued in the taxable space. There is no reason to believe that any of these trends will change in the near term.

If you have any questions regarding this commentary, or questions surrounding the market, please contact your SEI representative. Thank you.

Glossary

The Barclays Capital U.S. Aggregate Bond Index (formerly Lehman Brothers U.S. Aggregate Bond Index) is a benchmark index composed of U.S. securities in Treasury, Government-Related, Corporate, and Securitized sectors. It includes securities that are investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

The Barclays Capital Credit Index is an unmanaged index composed of U.S. investment-grade corporate bonds.

The Barclays U.S. TIPS Index measures the aggregate performance of the inflation-protected bonds market in the U.S.

The London Interbank Offer Rate (LIBOR) is the rate that banks charge each other for loans, usually in Eurodollars.

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. This information is for educational purposes only. SEI Investments Management Corporation acts as investment advisor for SEI Global Fixed Income Management. There are risks involved with investing, including loss of principal.