Podcast: March 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 March and the first quarter of 2010.

Investors were hit with concerns about sovereign debt and state budgets as well as regulatory changes. Even with all the distractions, participants remained involved, investing additional dollars in fixed income investments. The Barclays Capital U.S. Aggregate Bond Index¹ remained positive in 2010, returning -0.12% for the month of March and 1.78% year to date.

Our proprietary fixed-income sentiment model continues to show signs of improvement. The data points reflect a moderation in improvement, which we view as positive because it points to the fundamental data catching up to the market. This should help set the stage for a lasting positive trend. We continue to look for signs of a solid recovery in the labor market, as well as increased consumer demand.

The Federal Open Market Committee (FOMC) has clearly decided to remain accommodative, as the sustainability of the recovery remains in question. Current economic momentum is positive, but the labor market remains in the early stages of recovery. The combination of high unemployment, low inflation and general uncertainties about consumer spending should keep the FOMC on the sidelines for the near term. This view was confirmed by the dovish tone of the March FOMC minutes which confirmed our view that there is more risk to early tightening than to leaving the overnight lending rate at its current levels.

Early in the quarter, the Federal Reserve (Fed) hiked the discount rate to 75 basis points from 50 basis points, making it more costly for banks to borrow from the central bank. This move should be looked at as a purely technical change. It was the first increase in the discount rate since 2006, and it is likely that additional increases to the discount rate will occur prior to monetary tightening. The Fed continued to help guide the market through its statement, keeping the “extended period” language in place. The Committee made it clear that market participants should remove a set timeframe that has been attached to this statement. Policy can become more restrictive if needed and more accommodative if the economy shows signs of faltering. We believe these additional moves will commence early in the second quarter.

The Federal funds rate is likely to remain unchanged until the fourth quarter, if not the first quarter of 2011. There will be an increased amount of “Fedspeak” and various actions that need to be taken prior to monetary policy tightening. We are looking for not only a change to the Committee’s language but also additional tightening of the discount rate, stability following the removal of quantitative easing measures and testing of the reverse repurchases in the market to remove risk from the Fed’s balance sheet. After these actions occur and the economic landscape is favorable, we feel that the Fed may be ready to start raising interest rates.

The Treasury sector was subject to wild mood swings in the first quarter. Early in the quarter, there was healthy demand for the sector, as sovereign concerns moved from Dubai World to Greece. We saw yields bottom in early February, as an inflow of encouraging economic data hit the market. This data, combined with significant supply and hopes that the labor market is turning the corner, pushed yields higher. In the end, yields finished mostly in line to modestly lower compared to levels seen at the start of the quarter. The five-year part of the curve led the move, with yields pushing lower by 13 basis points to 2.54%. The underperformer was the 30-year, which actually sold off, pushing its yield higher by 7 basis points to 4.71%. The Barclays Capital U.S. Treasury Index² returned 1.12% for the quarter, supported by January’s strong showing of 1.58%. The 2- to 10-year curve steepened, finishing the quarter at 281 basis points from the 270 spread seen at year end.

The Treasury Inflation-Protected Securities³ (TIPS) market underperformed its nominal Treasury counterpart for the quarter. The Barclays U.S. TIPS Index returned 0.58% for the month and 0.56% for the quarter. Inflation data continued to trend lower, but with the Fed insisting that rates will remain low, there is the potential for increased inflation in the future which is keeping demand high for the TIPS market.

The investment-grade credit market extended its rally in the first quarter of 2010. Spread tightening was witnessed in most sectors as market participants were able to look past macroeconomic uncertainties and focus on strong fundamentals. European sovereign debt concerns and U.S. regulatory uncertainties gave way to a calmer tone. After a tumultuous February, credit spreads rallied in March. High-grade option-adjusted spreads⁴, as measured by the Barclays Capital Credit Index⁵, ended 22 basis points tighter for the quarter. The Index generated 113 basis points of excess return over Treasuries. Within high-grade bonds, broad-sector Financials outperformed, delivering 171 basis points of excess return, while Utilities and Industrials provided 93 and 80 basis points, respectively. Total primary market activity for the quarter was approximately $248 billion, marking a 44% increase over the fourth quarter of 2009. Demand for newly issued paper remained robust and, with few exceptions, new issues traded well once they were free to trade in the secondary market. Plain and simple, this was a result of healthier corporate balance sheets and investors’ ongoing search for yield.

The first quarter of 2010 also pointed to a new phase of the recovery. In reaction to tighter spread levels, emphasis has shifted to relative value plays among credits as opposed to the pure directional yield calls that were sufficient over the past few quarters. In addition, the search for yield has sparked a new interest in lower-quality credits, particularly financial subordinated debt and BBB-rated securities. Furthermore, despite its strong performance, investment-grade credit underperformed other risk assets, with the Barclays Credit Index posting a total return of 2.27% versus the S&P 500 Index’s return of 4.87%.

Seasonal patterns handcuffed the municipal markets in March to end the month higher in yield (lower in price) for the month. Even with negative performance in March, the sector performed well overall. The 10-year AAA general-obligation note, represented by the Bloomberg Fair Value Index of general-obligation AAA-rated 10-year bonds, rose by 20 basis points to close the month at 3.28%. The Barclays Capital Municipal Index⁶ returned -0.24% for the month and 1.25% year to date. The 30-year point moved higher only by 3 basis points to finish the month at 4.46%. This move is a reflection of the bear flattening move witnessed in the second half of the quarter. The curve remains historically steep, but we expect it to continue to flatten as the market prepares for the eventual removal of accommodative monetary policies and investors search for additional yield. High-grade municipals as a percentage of Treasuries ended the quarter cheaper than levels seen at the turn of the year. The 10-year AAA general-obligation debt percentage to Treasuries started the year around 83%, modestly under its historical average range. Volatility persisted, but the ratio ended the quarter at 85%, moving back in line with historical averages. We expect to see these levels cheapen dramatically, with continued supply in the pipeline and a quiet municipal environment free of negative events. Even with record-low yields, strong demand helped absorb the significant amount of debt that issuers brought to the markets. Municipal issuance totaled approximately just under $100 billion for the quarter. Insured bonds were down again with only $6.4 billion wrapped with insurance, according to Thompson Reuters, 42% less than the first quarter of 2009. There were just over $32 billion in taxable municipal bonds brought to market.

Looking forward, we feel that spread products still have room to move tighter. Treasury yields in the near term should remain at the upper end of the range with a bias to move higher from current levels. We are not discounting the possibility of a temporary move higher in prices if sovereign concerns escalate or additional problems surface. Municipal market participants should remain on guard, as we are in the middle of a period that has historically provided negative price action within the sector. We remain cautiously optimistic on the economy and markets but remain defensive due to the limited prospects for economic growth.

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

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¹ 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 of investment-grade quality or better, have at least one year to maturity, and have an outstanding par value of at least $250 million.

² The Barclays Capital U.S. Treasury Index is an unmanaged index composed of U.S. Treasuries.

³ The Barclays Capital U.S. TIPS Index is an unmanaged index composed of all U.S. Treasury Inflation- Protected Securities rated investment grade, have at least one year to final maturity, and at least $250 million par amount outstanding.

⁴ Option-adjusted spreads are the spread over the Treasury yield curve that is requested when discounting payments to match a security’s market price. “Option-adjusted” refers to the right to prepay the full amount of the security.

⁵ The Barclays Capital Credit Index is an unmanaged index composed of U.S. investment-grade corporate bonds.

⁶ The Barclays Capital Municipal Bond Index is an unmanaged index composed of investment-grade municipal bonds with maturities of one year or more.