Podcast: November 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 November.

Our proprietary fixed-income sentiment model continues to show improvement for the month, although caution is warranted. If sentiment continues to improve, you may wonder why Treasuries, particularly T-bills, are trading at such rich levels. For the first time since the collapse of Lehman Brothers, T-bills are trading at zero and even at negative yields. When Lehman went bankrupt, it made sense that a flight to quality would follow, driving yields down, since return of principal was more important than return on principal. Risk appetite has returned, though, which can be seen from the performance of the equity markets and high-beta credit names. However, setbacks are expected—for example, Dubai World announced it may need to restructure its debt to avoid missing coupon and interest payments. Hopefully, this is an isolated incident and not the start of a domino effect. The market took this news in stride. At first, Treasuries rallied and equities sold off, but both of these moves were short-lived, as within 48 hours the markets were back to levels existing before Dubai World’s news.

The Barclays Capital Aggregate Index moved higher again, returning 1.29% for the month and 7.61% year to date. Although markets moved higher, there were times throughout the month that it felt as if the wind was changing direction and with it, a change in sentiment. Risk appetite turned into risk aversion, and why not? We are heading into year end with the markets rebounding significantly off the lows back in March. For the moment, investors have pared back their bets on riskier assets, providing temporary support to the U.S. dollar. The wild card is, of course, whether this type of activity will continue.

The Federal Reserve has made it clear that it is planning on leaving rates at exceptionally low levels for a prolonged period of time. This was reiterated through its statement at Federal Open Market Committee (FOMC) meeting on November 4. As expected, the Committee left the overnight lending rate unchanged in the range of 0 to 25 basis points. Chairman Bernanke and other Fed Governors seemed confident that stimulus efforts can be removed without spurring on inflation, but we feel it is going to be very challenging. Chairman Bernanke has also addressed the question on timing of future rate hikes, stating that timing is everything and will be the biggest challenge. In our view, there is no rush for the Fed to start raising interest rates. There is significantly more immediate downside risk if they move too early, particularly since inflation remains low. Although members of the Fed have commented that interest rates may remain exceptionally low, the question is what constitutes “low.” From a historical perspective, 50 basis points, 75 basis points or even 1% is a historically low rate. The Committee could raise interest rates by 75 basis points and still keep their word. We feel it is too early to believe that the Fed will start tightening in the near term.

Cash and short-term markets continue to struggle. The impact from the liquidity and credit crunch of 2008 continues to wreak havoc on the front end, as the contraction of supply has never regained traction from an issuance standpoint. This causes a real problem, as demand remains strong from money markets and short-term accounts, which we expect to continue in 2010. Default risk is lower than it was in 2008; however, liquidity risk remains a concern. Commercial-paper issuance remains soft and is expected to shrink as we approach year end. Interest rates remain abnormally low with little to no relief in sight. To capture double-digit yields within the Industrial sector, money needs to be locked up for a minimum of three weeks. Inside of that term, high single-digit yields are the norm. The three-month LIBOR moved lower by 3 basis points to 25 basis points. The front end of the yield curve remains anchored by the low federal funds rate and uncertainties around the pace of economic recovery in upcoming quarters. There will come a time when the cash market will start to forecast additional economic growth and tightening monetary policy. This anticipation will push yields higher, helping the front end of the yield curve resume some sense of normalcy, and we expect this to occur in the first two quarters of 2010.

Dubai World’s request for additional time to make debt payments created an unsettling feeling in the rates market. November ended with the Treasury market well-bid on concerns that Dubai World debt may need to be restructured. Treasuries responded by rallying approximately 10 basis points in the following days before retracing the move at month end. Treasuries traded choppy throughout the month, taking direction from economic indicators. The spread between the two- and ten-year points on the curve steepened for the month to 253 basis points from 250. The three- and five-year part of the curve led the way, moving lower by 32 basis points. The 30-year underperformed, with yields moving lower by only 6 basis points. The front end remained anchored due to the near-zero-interest-rate policy and a flight–to-quality bid; as a result, the two-year note traded at 0.65%, a level not seen since December 16, 2008.

The Treasury announced that, starting in 2010, it would issue 30-year Treasury Inflation Protected Securities (TIPS) instead of 20-year TIPS, which was widely expected. The initial auction is slated for February with a reopening in August. This move will help round out the yield curve and provide additional liquidity to the sector. The TIPS market continued its trend of positive performance. The Barclays U.S. TIPS Index returned 2.78% for the month, bringing the year-to-date return to 13.90%. Oil ended the month close to its opening level of $78 per barrel. After hitting $80 per barrel, an inter-month high, oil fell back to $77 per barrel. These levels continue to increase the possibility of future inflation. The difference between the yields on 10-year notes and 10-year TIPS narrowed to 2.11 percentage points from last month’s 2.01.

The unrelenting spread tightening we have seen over the past two quarters was muted in November, as investors moved to reduce risk and lock in gains heading into year end. Aggregate investment-grade option-adjusted spreads (OAS), as measured by the Barclays Capital Credit Index, were flat for the month. The index returned 1.47%, underperforming duration-matched Treasuries by 2 basis points and providing negative excess return. November also highlighted the demand for short-dated bonds, as the one- to four-year maturity sector showed the strongest performance, adding 34 basis points of excess return. In contrast, the long end of the curve (15 years of more) underperformed, generating -44 basis of return versus Treasuries. On a sector basis, Industrials and Utilities continued to show strong demand, delivering excess returns of 17 basis points and 14 basis points, respectively, while the rally in Financials ground to a halt with the sector generating -52 basis points of excess return. New issuance, although down from September, remained robust at $80.1 billion.

We expect credit spreads to continue to perform in line with Treasuries, providing a coupon pick-up. Spreads should remain range-bound through year end, and caution is still warranted as there is the potential for a temporary pullback. Fundamentals and technicals should support modest additional spread tightening through year end.

Municipal debt moved forward, posting positive returns. The Barclays Capital Municipal Index returned 0.83% for the month while posting a 12.53% year-to-date return through November 30. As a result, yields at the ten-year point of the AAA curve rallied approximately 19 basis points, while the 30-year point moved higher by only 1 basis point. High-grade municipal bonds 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 93%, and by month end, this ratio was at 97%, remaining above historical averages. Supply was significant, surpassing November 2008 by approximately 47%. This is a large increase even if you discount all the dislocations that took place in the markets due to the collapse of Lehman Brothers. Year to date, municipal issuers have sold approximately $373 billion in debt. Our expectation is for supply to creep toward if not surpass the $400 billion mark, as municipalities need to borrow heavily to fund budgetary gaps and finance projects. The Build America Bond program is expected to provide additional supply in December and increase significantly as we move through the first quarter of 2010. We feel that there is no reason to believe that supply will pull back anytime soon, and it should be met with strong demand.

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.