Podcast: January 2010 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 January.

The economic landscape continues to show signs of improvement. As the economy recovers, the overall tone of the fixed-income market remains upbeat despite hiccups along the way. Our proprietary Fixed Income Sentiment Model continues to show improvement although at a slower pace. While Treasuries continue to be well-bid as market sentiment broadly improves, we have seen pockets of weakness confirming our cautious view. In particular, Treasury bills briefly traded with a negative yield toward the end of the month.

While an appetite for risk has returned to the markets, participants remain uncertain about the fragile recovery. Headlines around sovereign risk plagued the market as Greece remains in a precarious state. The market was also hit with the Obama administration once again talking tough on bank regulation and the potential for increased and additional taxes. This rhetoric put the financial sector in a tailspin toward month end. Negative headlines surrounded Federal Reserve Chairman Bernanke and the reaffirmation of his position. His role was in question pretty much up to the eleventh hour even with the President‘s endorsement. Treasury Secretary Geithner was also in the hot seat over his involvement with the rescue of AIG.

Although the market took one blow after another without falling to the mat, it felt at times as if it was one blow away from falling hard. While it did give back recent gains, things could have been a lot worse.

The Barclays Capital Aggregate Bond Index started the year moving higher in fits and starts, returning 1.53% for January. There were times throughout the month when it felt like sentiment could have easily moved in the other direction. Participants continued to hold exposures to riskier assets and even continued to add modestly to positions when markets decline. The wild card is the amount of intervention by the government in the form of new regulation.

The Federal Open Market Committee (FOMC) remained cautious regarding the pace of the recovery and health of the labor market. The headline from the January FOMC meeting was the dissenting vote from Kansas City Fed president Thomas Hoenig. He disagreed with the language in the FOMC statement, arguing that the current economic conditions didn’t warrant the need to keep wording about holding rates low for an extended period of time. Although the content of the statement was similar to the last statement, the tone could be looked at as dovish or hawkish depending on what the reader focused on.

The Committee left the lending rate unchanged, holding it in the range of 0 to 25 basis points. We believe the lack of job growth and the high unemployment rate will continue to hold the fed funds rate at its current range. At some point, we will see the trend shift from negative to positive job growth, but it may take some time before we see enough growth to lower the unemployment rate. Once there is consistent growth leading to a lower unemployment rate, the Fed will be in a more comfortable position to raise interest rates. We continue to feel there isn’t a rush for the FOMC to change its policy and start raising interest rates.

Low yields and little supply characterized the fixed-income markets. In other words, it was business as usual.

On the legislative front, the Securities and Exchange Commission (SEC) revealed its changes to Rule 2a-7, which governs money market funds. The changes will require 2a-7 money market funds to hold more liquid assets, reduce credit risk and increase transparency. These new liquidity requirements will likely hold yields at the front end of the money market curve at low levels. As money funds reposition in response to the new rules, our expectation is for the LIBOR curve to steepen as demand for longer-dated paper wanes. Yields are likely to move higher as participants reevaluate their risk budgets under the new rules, forcing the age-old trade-off between liquidity and yield. The steepening of the curve may take some time to develop, as the implementation date for the rules has not been determined.

Interest rates remain abnormally low and unlikely to move higher in the near term. For the month, three-month LIBOR held firm, closing at .249%. The front end of the yield curve remains anchored by the low fed funds rate and the uncertainty around the implementation of the new money market guidelines.

The glass-is-half-full mindset has carried the markets this far; however, participants within the Treasury sector are generally more of a glass-is-half-empty crowd. With that said, increased volatility or more upbeat data could disappoint the bond bulls. The Treasury market reversed course, rallying throughout the month, led by the five-year part of the curve. The Barclays Capital U.S. Treasury index returned 1.58% for the month. The move wasn’t straight up, as mixed economic data created volatility. The two-to-ten year curve steepened for the month to 277 basis points from 270. The five-year part of the curve led the way with yields moving lower by 35 basis points. The 30-year underperformed with yields moving lower by only 15 basis points. The front end remained anchored due to the zero-interest-rate policy and a flight–to-quality bid, as concerns surfaced around sovereign debt and new government regulation.

The Treasury Inflation-Protected Securities (TIPS) market continued its trend of positive performance. For the month, the Barclays U.S. TIPS Index returned 1.61% and 11.41% for 2009. After hitting an intermonth high of $83.18, oil prices fell to end the month at $72.89. The trend in the near term is likely to continue as the dollar strengthens in a flight-to-quality move.

Spreads came under pressure toward the end of the month. Profit taking, sovereign credit concerns and government rhetoric created a negative tone within the investment-grade credit markets. Aggregate investment-grade option-adjusted spreads (OAS), as measured by the Barclays Capital Credit Index, ended 1 basis point tighter for the month. The Index returned 1.55% while underperforming duration-matched Treasuries by 16 basis points. The five-to ten-year part of the credit curve posted an absolute return of 1.89%, coming in 11 basis points below Treasuries of similar maturities. The one-to five-year maturity showed the strongest performance, providing 27 basis points of excess returns. In contrast, the long end of the curve (over 15 years) underperformed Treasuries by 94 basis points. On a sector basis, Insurance and Utilities continued to show strong demand, delivering excess returns of 104 basis points and 12 basis points respectively, while the rally in Financials faded, providing zero excess return. In true form, issuance in January was strong, with $98.1 billion priced during the month.

We expect the calendar to remain robust, but that may be tested if credit spreads continue to widen and narrow without a clear trend. Not to sound like a broken record, but caution is warranted as concerns over sovereign debt—particularly in Greece and other Eurozone countries—are elevated and spreading. Fundamentals on an issuer basis remain positive as the economy works its way through the stages of a recovery.

Municipal markets continued to see flows move into municipal bond funds and longer-dated securities. Investors continued to shift assets away from low-yielding money market accounts to higher-yielding strategies. Investors did not shy away from risk, as the need for yield was the key driver, even with the ongoing headline risk around state budgetary gaps. Municipal performance for January was positive despite the looming months to come when municipal securities have historically underperformed. The Barclays Capital Municipal index returned .52% for the month following a 9.49% return for 2009. As a result, yields in January rallied only modestly at the ten-year point of the AAA curve, finishing the month 2 basis points lower at 3.24%. The 30-year point moved lower by only 1 basis point. 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 83%. At month end, this ratio was at 90%, remaining above historical averages. Supply in January was significant with over $31 billion of issuance. Build America Bonds represented 21% of the supply or just under $7 billion. Market expectations are for another robust year of issuance totaling over $400 billion, driven by the need to fund growing deficits and underfunded projects. It will depend on the extension of the Build America Bond program and government support.

Looking forward, we feel that Treasury yields in the near term will remain range-bound with a bias to move higher. Uncertain fundamentals, combined with the significantly low yield levels, will reduce the potential for significant outperformance within the investment-grade corporate sector and municipal markets. Participants within the municipal markets will also be on guard as we start to enter the period that has historically provided negative price action within the sector. Due to these factors, we are taking a more defensive approach through security selection and yield curve positioning when possible.

If you have any questions regarding this commentary, 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.