JANUARY 2010

 

Bonds Rally Broadly in January

 

The Barclays Capital Aggregate Bond Index (BCAG) gained 1.5% during January.  Investment grade corporate bonds gained 1.6%, Treasuries matched the index at 1.5%, and agency residential mortgage-backed securities (RMBS) returned 1.4%.  In the smaller sectors of the BCAG, investment grade commercial mortgage-backed securities (CMBS) gained 4.4% and asset-backed securities (ABS) gained 1.7%.  In the non-investment grade market, bank loans gained 1.8% and high yield bonds gained 1.3%.  High yield CMBS gained the strongest returns, gaining 5.2%.  Outside of the U.S., dollar denominated developed international and emerging market bonds outperformed local currency bonds, as the U.S. dollar strengthened versus a broad basket of currencies, using the Dollar Index (DXY) as a proxy.

 

 

Lower Rated Corporates Outperform Higher Rated

 

Within investment grade corporate bonds, lower quality bonds outperformed higher quality, with BBB-rated bonds gaining 1.9% versus AAA-rated bonds’ increase of 1.4%.  Utilities were the strongest sector, gaining 2.0%, versus financials and industrials, which gained 1.6%.  Both utilities and industrials traded at a premium price of more than $108, while financials neared $104.  Financials continued to trade cheaper than utilities and industrials due primarily to lingering concerns about the balance sheet strength of regional banks.  Investment grade corporate bonds finished the month trading at option-adjusted spreads (OAS) of 1.6% points over Treasuries.  The  historical average OAS is 1.1% points over Treasuries, indicating further tightening to historical is possible, particularly in light of the sector’s yield advantage relative to agency RMBS and Treasuries.

 

 

Agency Residential Mortgage-Backed Securities Grind Tighter

 

The agency RMBS sector gained 1.6%, as the market appeared unconvinced that the Federal Reserve will end its mortgage purchase program sometime this spring.  Coupled with a lack of new supply, prices for agency RMBS remained strong.  Alternatively, the OAS for mortgage-backed securities remained near its all time low at just 0.16% points, indicating an asymmetrical risk profile for buyers of these securities.  In other words, there is not much upside in these bonds, as investors effectively equated the current government support with Treasuries’ government guarantee.  For a mere 16 basis points in risk premium, investors are subject to negative convexity, which means that as yields rise (prices fall), the increase in interest rate sensitivity (duration) rises.  As a result, at current prices buyers of agency RMBS have little upside and the potential for meaningful price declines if interest rates increase.

 

 

Bank Loans and High Yield Bond Returns Continue to Shine

 

Bank loans and high yield bond returns were positive in January.  Bank loans benefitted from an improved technical picture, as new issuance remained modest and supply continued to decline.  Non-investment grade issuers maintained efforts to term out their debt in the high yield bond market.  Both loans and bonds benefited from continued flows into taxable bond funds, and the yield advantage of high yield bonds versus other fixed income options continued to draw investors to this area of the market.  Lower quality bonds outperformed higher quality, with CCC-rated bonds gaining 1.7% versus 1.1% for BB-rated bonds.  OAS for high yield bonds, using the Barclays Capital High Yield Index as a proxy were 6.4% points versus Treasuries at the end of the month, approximately 1.0% point over the historical average OAS of 5.4% points, indicating there is the potential for further upside should default rates remain subdued.

 

 

 

Dollar Strengthens, Negatively Impacting Un-Hedged International Bonds

 

International bond performance was driven by the relative strength of the U.S. dollar versus key currencies, and hedged indices outperformed un-hedged in January.  Within developed markets, the dollar strengthened notably versus the euro and the pound.  Additionally, the Canadian dollar and Australian dollar declined in value versus the U.S. dollar, as commodity prices declined.  The Japanese yen, on the other hand, rallied against the dollar during the month.  Emerging Asian bonds with currencies pegged to the U.S. dollar outperformed un-pegged currencies in January.